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State Street Corporation

The proposed RTS impose detailed operational and legal documentation requirements on counterparties. This is inconsistent with the BCBS-IOSCO framework which does not prescribe additional operational processes or how to confirm thresholds. We would therefore encourage the ESAs to align the draft RTS with the BCBS-IOSCO framework.

As mentioned in our general comments, ensuring global consistency will minimise both the cost and regulatory burden. In order to ensure consistency of approach, operational requirements (over and above when margin should be posted and what collateral is eligible), should be limited and kept to a high level in order to maintain flexibility for investors to operate on a global basis. Too much prescription in each jurisdiction will inevitably lead to inconsistencies and increased operational costs with little overall benefit.

For example, the requirements for counterparties to verify (a) at least annually the enforceability of netting for the initial margin calculation pursuant to Article 6 (2) MRM; and (b) at inception and at least annually in respect of the compliance of initial margin segregation arrangements with the requirements of Article 1 (3) and (4) SEG by way of satisfactory legal opinions in all jurisdictions (pursuant to Article 1(5) SEG) will impose significant cost. We suggest that these kinds of requirements should be modified to require firms to be in a position to provide on request a written and reasoned legal basis for enforceability and compliance, and have procedures in place to ensure that the legal validity of these arrangements is kept under review in the light of possible changes in the relevant laws.

We would also like to seek clarity on the segregation requirements of Article 1 SEG: presumably this requires segregation in the books and records of the third party holder or custodian, rather than the establishment of individual accounts on behalf of each counterparty which would be costly and administratively burdensome.
One particular operational concern is that investment managers acting on behalf of institutional clients may not necessarily have sight of the details of all of the institutional clients’ derivative trading relationships. For example, in the case of split mandates where a client has appointed more than one investment manager, it will be difficult if not impossible for an investment manager to know or calculate the clients’ total outstanding derivatives notional or whether the thresholds for posting initial or variation margin has been exceeded by their institutional client at an entity level. Obtaining this information from the institutional client will be hard to document or implement operationally. In addition, there is a risk that institutional clients with multiple investment managers will not be able to net positions with the same counterparty across separate portfolios for margin purposes. This will cause excessive margining impacting negatively the overall performance of funds to the detriment of the end-investor.

We note that managers often enter into ‘currency overlay’ mandates with clients whereby the managers enter into FX forwards or swaps on behalf of clients in order to hedge the currency risk in securities held by the client but which are not managed by the manager. To the extent that the margin requirements did apply to FX forwards and swaps entered into in connection with currency overlay mandates then this would create significant operational difficulties as an entity (potentially a third party collateral manager) would need to be appointed by the client to enable margin to be transferred and received by the client in connection with such transactions.

Furthermore, as funds authorised under the UCITS Directive as well as under the AIFMD already are subject to strict requirements in the area of risk management, should be exempt from the obligation to provide initial margin.
Article 51 (1) of the UCITS Directive requires a management or investment company to “[…] employ a risk-management process which enables it to monitor and measure at any time the risk of the positions and their contribution to the overall risk profile of the portfolio. It shall employ a process for accurate and independent assessment of the value of OTC derivatives. It shall communicate to the competent authorities of its home Member State regularly in regard to the types of derivative instruments, the underlying risks, the quantitative limits and the methods which are chosen in order to estimate the risks associated with transactions in derivative instruments regarding each managed UCITS.”
In addition, Article 15.2 of the AIFMD requires AIFMs to “[…] implement adequate risk management systems in order to identify, measure, manage and monitor appropriately all risks relevant to each AIF investment strategy and to which each AIF is or may be exposed.” AIFMs must, according to Article 15.3 AIFMD, also “implement an appropriate, documented and regularly updated due diligence process when investing on behalf of the AIF, according to the investment strategy, the objectives and risk profile of the AIF.”
Article 52.1 of the UCITS Directive further limits counterparty exposure to a maximum of 10% of the value of the UCITS and under Article 51.3, a UCITS must ensure that its global exposure relating to derivative instruments does not exceed the total net value of its portfolio. These risk measures reduce the impact of any counterparty default.

Moreover, State Street would welcome clarification with regards to the UCITS framework where we see an inconsistency between the proposed ban of the re-use of initial margin and the requirements of ESMA’s Guidelines on ETFs and other UCITS Issues. The guidelines require cash collateral to be placed on deposit with entities prescribed in Article 50(f) of the UCITS Directive; invested in high-quality government bonds; used for the purpose of reverse repo transactions provided the transactions are with credit institutions subject to prudential supervision and the UCITS is able to recall at any time the full amount of cash on accrued basis or invested in short-term money market funds as defined in ESMA’s Guidelines on a Common Definition of European Money Market Funds. We believe existing UCITs rules providing for limited reinvestment of received cash collateral fully address the goals of the RTS with respect to ensuring immediate availability of posted cash collateral, and suggest the proposal be revised to permit reinvestment of cash collateral pursuant to the UCITs regulatory framework.
State Street does not have comments in response to this question.
State Street would support the development of an industry-wide standardised approach with respect to valuation of margin that can be used by the parties to the transactions. This will create greater certainty between the parties to the transaction.

At the same time, counterparties should be allowed to use internal models for the calculation of the required initial margin should they agree to do so.
In line with ESMA’s recent decision in the context of its Guidelines on ETFs and other UCITS issues, we would strongly recommend to not apply the concentration limits to collateral in the form of transferable securities and money market instruments issued by sovereigns, their local authorities or other public international bodies.

Portfolios may hold a concentrated portfolio of assets and so may have difficulty complying with the margin concentration requirements. For example, many liability driven investment (“LDI”) portfolios managed by managers for pension schemes hold a mixture of cash and government securities and so introducing concentration requirements on margin which the portfolios can post and receive would mean that the LDI portfolios would need to diversify into holding other assets or markets in order to satisfy the concentration requirements, which could result in the pension schemes assuming additional risk or unwanted exposure.
State Street strongly supports the proposed requirement that initial margin be “[…] segregated from proprietary assets on the books and records of a third party holder or custodian, or via other legally effective arrangements made by the collecting counterparty.” We also support the proposed requirement that collectors of collateral must always offer the posting counterparty the option of “individual segregation”, particularly for posting of cash.

Tri-party custodian arrangements are particularly effective for segregation of margin, and are increasingly requested by parties posting collateral, even in the absence of a regulatory mandate. Tri-party custody arrangements protect the interests of both the poster and collector of collateral, and ensure that margin is not rehypothecated or otherwise reused by the collecting party.

While the proposed framework suitably encourages the use of robust segregation arrangements, such as tri-party custody, some additional clarification regarding the treatment of cash posted to such arrangements would be useful.

Under tri-party custody arrangements, cash is posted to a demand deposit account of the custodian bank. While we believe such deposit accounts qualify as eligible collateral under proposed Section 1(a) of Article 1 LEC as “cash in the form of money credited to an account in any currency […]”, it is unclear whether such accounts are limited to those provided by the counterparties to the swap. The suggestion in the Executive Summary that the “[…] list of eligible collateral is based on the provision laid down by Articles 197 and 198 of Regulation (EU) No 575/2013,” adds to the lack of clarity, since the referenced articles specifically refer to “cash on deposit with, or cash assimilated instruments held by, the lending institution” (emphasis added). As a result, we suggest clarification that the account to which eligible collateral is credited is not limited to those provided by the counterparties, and could be an account with a third party custodian.

Similarly, we suggest clarification under Article 1 REU of the requirement that the “[…] collecting counterparty shall not re-hypothecate, re-pledge nor otherwise re-use the collateral collected as initial margin.” We support this requirement, but suggest clarification related to posting of cash to custody bank deposit accounts. Cash held in such accounts is, by definition, a liability on the bank’s balance sheet, and the cash received by the bank is invested as part of the banks’ asset/liability management plan, consistent with extensive capital and liquidity prudential standards, which could conceivably create questions as to whether such activities constitute “re-use.” As drafted, Article 1 REU appropriately focuses on possible re-use by the “collecting counterparty,” placing custody banks in tri-party arrangements out of scope. Nevertheless, to provide certainty and encourage tri-party custody arrangements, we suggest the final rule clarify that the deposit of cash in a demand deposit account with a custody bank as part of a tri-party custody arrangement satisfies the segregation requirements, and does not give rise to prohibited re-use by the custody bank in the ordinary course of its business for purposes of the RTS.
Sven Kasper
+442033953723