- Question ID
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2023_6894
- Legal act
- Regulation (EU) No 2019/2033 (IFR)
- Topic
- Liquidity risk
- Article
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43
- Paragraph
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1
- Subparagraph
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d
- COM Delegated or Implementing Acts/RTS/ITS/GLs/Recommendations
- Not applicable
- Article/Paragraph
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- Type of submitter
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Investment firm
- Subject matter
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Definition of encumbrance for the purposes of inclusion of deposits into the category of liquid assets under the IFR
- Question
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Should the investment firm, which requires posting by client of cash collateral for margining purposes and which obtains ownership over the money placed for the market value of derivative transaction, consider the received cash collateral as unencumbered assets for the purposes of the calculation of liquidity requirement under the IFR, when the cash collateral received by the investment firm is posted as a short-term deposit at a credit institution?
- Background on the question
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Pursuant to Article 43 of the IFR, for the purposes of the calculation of liquidity requirement, unencumbered short-term deposits at a credit institution shall be considered as liquid assets (without limitation to their composition). However, the IFR does not provide any clear definition of encumbrance. That raises doubts in particular in terms of money received by an investment firm as collateral placed by a client for the market value of derivative transactions, further deposited by the investment firm at a credit institution. The following example illustrates the problem closely.
An investment firm dealing on own account, when executing client orders over the counter (OTC) enters into a derivative transaction which requires posting by a client of cash collateral for margining purposes. A collateral assignment follows, based on a contract between the investment firm and the client. In accordance with national law (which classifies the above-mentioned contract as civil-law agreement), the collateral assignment is not subject to restrictions laid down in Article 16 (10) of the MIFID. The investment firm obtains ownership over the money placed for the market value of derivative transaction. As a consequence of the ownership transfer, the investment firm considers the funds as its own (not as funds entrusted by a client).
However, when the money is further deposited by the investment firm at a credit institution, it remains unclear if it shall be treated as an unencumbered deposit under the liquidity requirement according to Article 43 of the IFR. As the IFR does not provide a definition of encumbrance, it seems reasonable to make reference to solutions adopted by the CRR.
The Annex XVII (“Instruction for reporting on asset encumbrance”) to the Commission Implementing Regulation (EU) 2021/451 provides a definition of encumbrance, which states that “an asset shall be treated as encumbered if it has been pledged or if it is subject to any form of arrangement to secure, collateralize or credit enhance any transaction from which it cannot be freely withdrawn. It is important to note, that assets pledged that are subject to any restrictions in withdrawal, such as for instance assets that require prior approval before withdrawal or replacement by other assets, should be considered encumbered. The definition is not based on an explicit legal definition, such as title transfer, but rather on economic principles, as the legal frameworks may differ in this respect across countries. The EBA sees the following types of contracts being well covered by the definition (this is a nonexhaustive list):
- secured financing transactions, including repurchase contracts and agreements, securities lending and other forms of secured lending;
- various collateral agreements, for instance collateral placed for the market value of derivatives transactions; (...)”
Bearing in mind the above mentioned provisions, it is worth noting that the Annex XVII presents the perspective of the reporting institution under the CRR (not the client’s perspective). Therefore, an investment firm’s money shall be considered as an encumbered asset as long as this is an investment firm that places cash collateral for the market value of derivatives (for instance, while entering into a transaction with other investment firm or credit institution).
As the investment firm entering into a transaction with its client on OTC market receives the collateral, the above mentioned provisions does not seem to apply.
However, the Annex XVII also raises the issue of collateral received by the reporting institution, pointing out that “for the collateral received by the reporting institution and the own debt securities issued other than own covered bonds or securitisations, the category of ‘non-encumbered’ assets is split between those ‘available for encumbrance’ or potentially eligible to be encumbered and those ‘non-available for encumbrance’. Assets are ‘non-available for encumbrance’ when they have been received as collateral and the reporting institution is not permitted to sell or re-pledge the collateral, except in the case of a default by the owner of the collateral”.
With respect to the investment firm in the above example, which obtains ownership over the money placed for the market value of derivative transaction, there are no further restrictions on the collateral. The transfer of the ownership provides the investment firm with the most extensive right to the subject of collateral (as opposed to the pledge or mortgage, which are limited rights). Consequently, the collateral received could be categorized as ‘available for encumbrance’. And more importantly, it would fall into the category of non-encumbered assets.
Considering the above, in case of a transaction which requires posting by client of cash collateral for margining purposes, where, based on a contract, the ownership to the collateral is transferred to the investment firm, the collateral should be categorized as non-encumbered assets. The collateral, if further deposited by the investment firm in the form of short-term deposit at a credit institution, could also be considered as liquid assets for the purposes of the calculation of liquidity requirement under the Article 43 of the IFR.
- Submission date
- Final publishing date
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- Final answer
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Article 43 of Regulation (EU) 2019/2033 (IFR) sets out the liquidity requirement that investment firms must fulfil. Paragraph 1 of that Article lists the eligible assets that an investment firm must hold in order to meet the liquidity requirement, and point (d) includes unencumbered short-term deposits at a credit institution. The IFR does not provide a definition of encumbrance. This definition is provided in Article 7(2) of the Commission Delegated Regulation (EU) 2015/61 and should be used in the context of the use of cash collateral posted by clients to an investment firm.
Thus, the investment firm may consider cash funds posted by clients on their transactions as eligible for the fulfilment of liquidity requirements pursuant to Article 43(1)(d) IFR if they meet all of the following criteria:
- the investment firm obtains legal ownership of the cash collateral received from the clients;
- the cash collateral received from the clients is not included in the scope of Article 43(2) IFR;
- Art. 16(10) of the Directive 2014/65/EU (MiFID II) is not applicable;
- the cash collateral is unencumbered according to Article 7(2) of Commission Delegated Regulation (EU) 2015/61;
- the cash collateral received from the clients is deposited in an unencumbered short-term deposit in the name of the investment firm at a credit institution.
This answer is without prejudice of Article 16(10) of Directive 2014/65/EU (MiFID II).
- Status
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Final Q&A