Response to joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP
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EMIR establishes a temporary exemption from central clearing for pension scheme arrangements , due to the difficulty of IORPs to post cash variation margin in CCPs, and also in recognition of the “diversity of pension systems across the Union” and of the “special role of IORPs and the materially adverse effects that the new legislation would have on them and on pension beneficiaries” .
It is PensionsEurope’s firm view that the introduction of the obligation to exchange IM for IORPs would be against the rationale behind the transitional exemption from central clearing set for pension scheme arrangements under EMIR. Indeed, EMIR establishes that pension scheme arrangements should be subject to bilateral collateralisation , but it does not establish that this bilateral collateralisation should consist in the need to post both IM and VM. As explained in the previous question, posting IM would have significant “material adverse effects” on IORPs (regardless of their size) and on their beneficiaries and would compromise their “special role”.
We are aware that the IOSCO and BCBS report on Margin requirements for non-centrally cleared derivatives of September 2013 was agreed by international regulators. Nevertheless, EMIR was adopted by European democratically-elected institutions and therefore the spirit and rational of EMIR should prevail, in particular as regards European specificities. Moreover, the IOSCO/BCBS report would allow room for such treatment when it states that “the precise definition of financial firms, non-financial firms and systemically important nonfinancial firms will be determined by appropriate national regulation” .
The European Parliament and the Council will eventually be granted a scrutiny period to consider whether to endorse or not the proposed RTS in this consultation paper. It remains to be seen if they would endorse the RTS if they understand that they are against what they had originally approved in 2012 and could have a negative impact on the different pension systems of the European Member States.
With the occasion of the endorsement procedure of previous EMIR Delegated legislations, the ECON Committee of the European Parliament debated a motion for a resolution to reject the regulatory technical standards for similar reason . The resolution was finally not voted in the Plenary of the European Parliament so as to avoid further delays in the implementation of the Regulation, but warned against similar situations in the future. More recently, Ms Sharon Bowels, former Chair of the ECON Committee, expressed the need to respect the position of the European Parliament on EMIR on the Level II legislation as far as the treatment of European pension funds is concerned .
2. The use of external credit ratings by IORPs
a) The credit quality requirements for internal assessments and the use of external credit ratings should be the same
PensionsEurope understands the ESAs’ intentions to reduce the systematic reliance on external credit ratings. We support encouraging stakeholders to perform due diligence when using ratings of external credit assessment institutions (ECAIs) and to combine them with their own credit risk assessments.
However, we firmly consider that the reduction of the reliance in credit ratings must not result in entities such as IORPs having to replace the work undertaken by the credit ratings agencies. In the absence of viable and more reliable alternatives, the ESA’s may promote the use of internal credit ratings through broad principles, but in any case IORPs must be able to continue using credit ratings. Notwithstanding their drawbacks and limitations, credit ratings are a valuable tool to evaluate the credit worthiness of many businesses, governments and financial instruments.
In this sense, IORPs must not be penalised for using ECAIs instead of performing their own credit risk assessments. This is currently the case in the draft RTS. Indeed, Article 3 (5) LEC penalises the use of external credit ratings vis-à-vis the performance of own risk assessments (Article 3 (4) LEC).
PensionsEurope strongly believes that this is not an acceptable approach, since it would be applicable to the all entities, without taking into account the nature, scale and complexity of their activities which is required by the Credit Rating Agencies Regulation (CRA Regulation) . In this regard, on 12 May 2014 the Financial Stability Board (FSB) published its thematic peer review report on reducing reliance on credit rating agency ratings. In this report, the FSB states that “The FSB, in collaboration with the standard setting bodies, should provide clearer guidance for smaller financial entities, in particular pension funds, on how to more effectively implement the FSB Principles to address the issue of proportionality for smaller entities”. It also recognises that “the use of CRA ratings provides economies of scale in analysing credit on behalf of smaller and less sophisticated investors, and that implementation should differentiate according to size and sophistication of the firm”. Furthermore, it should also be noted that the implementation of the CRA Regulation as regards the reduction of overreliance in credit ratings it is still at a very early stage. The European Supervisory Authorities still need to develop the Guidelines that will inform stakeholders and national supervisory authorities how to proceed in this topic.
In view of the above, in PensionsEurope we strongly believe that the credit quality requirements for internal assessments and for the use ECAIs should be equal.
b) In those cases were an asset itself is not rated, it should be possible to assess the credit quality of the issuer.
An important part of the investment portfolio of IORPs and financial entities managing assets on their behalf is composed of government bonds, which are also exchanged as variation margin in their bilateral derivative transactions. In order to ensure the liquidity of the assets posted, often minimum ratings apply. Typically, these ratings are applied on the credit quality of the “issuer” of the security, since frequently government bonds themselves are not rated.
Therefore, in order to reduce the burden on IORPs, instead of Article 3 LEC only requiring the credit quality of “assets”, it should say also say that in case the asset itself is not rated, a valid approach would be the credit quality assessment of the “issuer”.
c) Minimum rating requirements should apply to all assets posted, irrespective of the issuer.
Contrary to what is established in Article 1 (3) LEC, we see no reason to exclude the assessment of the credit quality of government bonds issued by Member States governments, central banks, regional governments and public sector entities denominated in domestic currency. In PensionsEurope we believe that minimum rating requirements should apply to all assets posted, regardless of who is the issuer.
d) IORPs are likely to not be able to use the Internal Rating Based (IRB) model of their counterparty to assess the credit quality of collateral
When IORPs engage in OTC derivate transactions with banking institutions, traditionally the latter are not willing to share with IORPs information on the models and pricing techniques that they use to determine the credit quality of the collateral posted. Unless adequate measures are introduced to force/oblige banking institutions to share with their counterparties this information, chances are that they will continue with their current practice of not sharing such information. In case this circumstance was to persist, IORPs will not be in a position to adequately understand the IRB model of their counterparty, and therefore they will not be able to use it to assess the credit quality of collateral. This will leave IORPs in a disadvantageous position vis-à-vis their counterparties to assess the credit quality of collateral, especially if we take into account that many of the small and medium size IORPs are not sufficiently equipped to produce their own internal risk assessment models.
This point is further developed in our response to question 4 of the consultation paper.
3. Importance of government bonds for IORPs
Government bonds represent a key investment tool for IORPs and their asset managers. The imposition of concentration limits on government bonds will cause important operational disruptions to IORPs and their asset managers, not only in terms of costs but also, importantly, in terms of efficiency in the use of derivative instruments.
A very important part of the asset mix of European IORPs is composed by government bonds (in particular from the country of residence of the IORP) . Subject to credit risk, government bonds provide a certainty of return on the investment for the IORP and can be used by IORPs to hedge the interest rate risk inherent in calculating the present capital value of the obligations of the IORP to pay pensions in the future.
Historically, IORPs have been using government bonds as VM on their bilateral derivative transactions. Establishing limits to the use of government bonds in IM and VM will force IORPs to disinvest in government bonds and have in their portfolio bigger amounts of riskier assets. Decisively, concentration limits on government bonds will also bring to IORPS valuation issues of derivatives instruments, which would impact their efficiency in using derivatives; they valuation of high quality government bonds based on EONIA discounting will not be always possible due to diversification requirements.
PensionsEurope considers that concentration limits on government bonds should not apply to IORPs. Alternatively, we suggest less harmful measures for IORPs such as setting a maximum on the amount of collateral posted as a percentage of the total amount of government bonds issued by one single issuer.
In our response to question 5 the impact of concentration limits on government bonds on IORPs is further developed.
of the Internal Rating Based (IRB) model of its counterparty, then it is likely that this option will not be able to be used; IORPs will not have sufficient information, and therefore IORPs will not be able to adequately understand the IRB model of their counterparty. Exactly the same applies to the IM model of the counterparty.
If IORPs and their asset managers would have sufficient information on the IRB model, they would be able to use the IRB model of their counterparty banking institutions and therefore both counterparties would be in equal conditions. If they lack this information, IORPs will not be able to use one or two of the three options provided in Article 3 (1) LEC, as opposed to their counterparties of bilateral derivative transactions (banking institutions) which would be able to use the three options.
In the case of small and medium size IORPs, they will not be able to use 2 of the 3 options of Article 3 (1) LEC, since it is likely that they will not have the necessary resources to produce their own internal models. Indeed, small and medium size IORPs, (which regardless of the thresholds will likely need to apply the draft RTS since banks will not be willing to adapt their business model for smaller counterparties) are frequently not equipped with sufficient resources to set up internal models and therefore it is more cost-efficient for them to apply due-diligence when using external credit ratings.
PensionsEurope believes that this situation unfair and therefore we demand that measures are adopted to force banking institutions to provide sufficient information to their IORP counterparties on their IRB model. PensionsEurope supports requiring credit institutions to disclose to their counterparties sufficient information on the structure of the models that they use as well as the data they take into account to produce these models.
The latter would allow IORPs to reduce the use of credit ratings provided by ECAIs, which would be in line with the objective of the CRA Regulation of reducing the overreliance on external credit ratings without requiring further costs for IORPs. In order to ensure that this requirement is fulfilled by the banking institutions, IORPs and financial institutions managing assets on their behalf should be able to notify such behaviour to competent authorities. In exchange, IORPs should apply due diligence aiming to understand the functioning of the model and its potential limitations when using the IRB models of their counterparties.
Moreover, and bearing in mind the limitations of using the IRB model of their counterparties, it is PensionsEurope’s strong opinion that IORPs should not be penalised for using external credit ratings from ECAIs instead of internal credit risk assessments. The credit quality requirements for internal assessments and for the use ECAIs should be equal.
On 12 May 2014 the Financial Stability Board (FSB) published a report on this matter where it recognised the particularities of pension funds in this regards and established that “the use of CRA ratings provides economies of scale in analysing credit on behalf of smaller and less sophisticated investors, and that implementation should differentiate according to size and sophistication of the firm”. Article 5 (a) (2) of Regulation (EU) No 462/2013 (CRA Regulation) also establishes that in this issue competent authorities must take into account the nature, scale and complexity of the activities of the different undertakings, which not only is not currently the case, but on the contrary, the current draft RTS would leave the weaker counterparty (the IORP) of the bilateral derivate transaction in a disadvantageous position.
On the other hand, others see re-use of VM as incompatible with the segregation of their assets. In fact, VM is the value of an outstanding contract and in case of a default can be offset against outstanding positions. As the (liquidity) risk of re-use of VM lies completely with the VM receiver, VM re-use shall be allowed. It is already a current market practice for some IORPs and entities managing assets on their behalf to re-use VM collateral. VM needs to be re-used in cases when collateral needs to yield a certain return to be paid to the VM provider. Maintaining such a practice would not increase systemic risk, while restricting it would seriously impede on the pool of available collateral for IORPs which re-use VM.
Question 2. Are there particular aspects, for instance of an operational nature, that are not addressed in an appropriate manner? If yes, please provide the rationale for the concerns and potential solutions.
1. Rationale behind EMIR temporary exemption from the clearing obligation for IORPsEMIR establishes a temporary exemption from central clearing for pension scheme arrangements , due to the difficulty of IORPs to post cash variation margin in CCPs, and also in recognition of the “diversity of pension systems across the Union” and of the “special role of IORPs and the materially adverse effects that the new legislation would have on them and on pension beneficiaries” .
It is PensionsEurope’s firm view that the introduction of the obligation to exchange IM for IORPs would be against the rationale behind the transitional exemption from central clearing set for pension scheme arrangements under EMIR. Indeed, EMIR establishes that pension scheme arrangements should be subject to bilateral collateralisation , but it does not establish that this bilateral collateralisation should consist in the need to post both IM and VM. As explained in the previous question, posting IM would have significant “material adverse effects” on IORPs (regardless of their size) and on their beneficiaries and would compromise their “special role”.
We are aware that the IOSCO and BCBS report on Margin requirements for non-centrally cleared derivatives of September 2013 was agreed by international regulators. Nevertheless, EMIR was adopted by European democratically-elected institutions and therefore the spirit and rational of EMIR should prevail, in particular as regards European specificities. Moreover, the IOSCO/BCBS report would allow room for such treatment when it states that “the precise definition of financial firms, non-financial firms and systemically important nonfinancial firms will be determined by appropriate national regulation” .
The European Parliament and the Council will eventually be granted a scrutiny period to consider whether to endorse or not the proposed RTS in this consultation paper. It remains to be seen if they would endorse the RTS if they understand that they are against what they had originally approved in 2012 and could have a negative impact on the different pension systems of the European Member States.
With the occasion of the endorsement procedure of previous EMIR Delegated legislations, the ECON Committee of the European Parliament debated a motion for a resolution to reject the regulatory technical standards for similar reason . The resolution was finally not voted in the Plenary of the European Parliament so as to avoid further delays in the implementation of the Regulation, but warned against similar situations in the future. More recently, Ms Sharon Bowels, former Chair of the ECON Committee, expressed the need to respect the position of the European Parliament on EMIR on the Level II legislation as far as the treatment of European pension funds is concerned .
2. The use of external credit ratings by IORPs
a) The credit quality requirements for internal assessments and the use of external credit ratings should be the same
PensionsEurope understands the ESAs’ intentions to reduce the systematic reliance on external credit ratings. We support encouraging stakeholders to perform due diligence when using ratings of external credit assessment institutions (ECAIs) and to combine them with their own credit risk assessments.
However, we firmly consider that the reduction of the reliance in credit ratings must not result in entities such as IORPs having to replace the work undertaken by the credit ratings agencies. In the absence of viable and more reliable alternatives, the ESA’s may promote the use of internal credit ratings through broad principles, but in any case IORPs must be able to continue using credit ratings. Notwithstanding their drawbacks and limitations, credit ratings are a valuable tool to evaluate the credit worthiness of many businesses, governments and financial instruments.
In this sense, IORPs must not be penalised for using ECAIs instead of performing their own credit risk assessments. This is currently the case in the draft RTS. Indeed, Article 3 (5) LEC penalises the use of external credit ratings vis-à-vis the performance of own risk assessments (Article 3 (4) LEC).
PensionsEurope strongly believes that this is not an acceptable approach, since it would be applicable to the all entities, without taking into account the nature, scale and complexity of their activities which is required by the Credit Rating Agencies Regulation (CRA Regulation) . In this regard, on 12 May 2014 the Financial Stability Board (FSB) published its thematic peer review report on reducing reliance on credit rating agency ratings. In this report, the FSB states that “The FSB, in collaboration with the standard setting bodies, should provide clearer guidance for smaller financial entities, in particular pension funds, on how to more effectively implement the FSB Principles to address the issue of proportionality for smaller entities”. It also recognises that “the use of CRA ratings provides economies of scale in analysing credit on behalf of smaller and less sophisticated investors, and that implementation should differentiate according to size and sophistication of the firm”. Furthermore, it should also be noted that the implementation of the CRA Regulation as regards the reduction of overreliance in credit ratings it is still at a very early stage. The European Supervisory Authorities still need to develop the Guidelines that will inform stakeholders and national supervisory authorities how to proceed in this topic.
In view of the above, in PensionsEurope we strongly believe that the credit quality requirements for internal assessments and for the use ECAIs should be equal.
b) In those cases were an asset itself is not rated, it should be possible to assess the credit quality of the issuer.
An important part of the investment portfolio of IORPs and financial entities managing assets on their behalf is composed of government bonds, which are also exchanged as variation margin in their bilateral derivative transactions. In order to ensure the liquidity of the assets posted, often minimum ratings apply. Typically, these ratings are applied on the credit quality of the “issuer” of the security, since frequently government bonds themselves are not rated.
Therefore, in order to reduce the burden on IORPs, instead of Article 3 LEC only requiring the credit quality of “assets”, it should say also say that in case the asset itself is not rated, a valid approach would be the credit quality assessment of the “issuer”.
c) Minimum rating requirements should apply to all assets posted, irrespective of the issuer.
Contrary to what is established in Article 1 (3) LEC, we see no reason to exclude the assessment of the credit quality of government bonds issued by Member States governments, central banks, regional governments and public sector entities denominated in domestic currency. In PensionsEurope we believe that minimum rating requirements should apply to all assets posted, regardless of who is the issuer.
d) IORPs are likely to not be able to use the Internal Rating Based (IRB) model of their counterparty to assess the credit quality of collateral
When IORPs engage in OTC derivate transactions with banking institutions, traditionally the latter are not willing to share with IORPs information on the models and pricing techniques that they use to determine the credit quality of the collateral posted. Unless adequate measures are introduced to force/oblige banking institutions to share with their counterparties this information, chances are that they will continue with their current practice of not sharing such information. In case this circumstance was to persist, IORPs will not be in a position to adequately understand the IRB model of their counterparty, and therefore they will not be able to use it to assess the credit quality of collateral. This will leave IORPs in a disadvantageous position vis-à-vis their counterparties to assess the credit quality of collateral, especially if we take into account that many of the small and medium size IORPs are not sufficiently equipped to produce their own internal risk assessment models.
This point is further developed in our response to question 4 of the consultation paper.
3. Importance of government bonds for IORPs
Government bonds represent a key investment tool for IORPs and their asset managers. The imposition of concentration limits on government bonds will cause important operational disruptions to IORPs and their asset managers, not only in terms of costs but also, importantly, in terms of efficiency in the use of derivative instruments.
A very important part of the asset mix of European IORPs is composed by government bonds (in particular from the country of residence of the IORP) . Subject to credit risk, government bonds provide a certainty of return on the investment for the IORP and can be used by IORPs to hedge the interest rate risk inherent in calculating the present capital value of the obligations of the IORP to pay pensions in the future.
Historically, IORPs have been using government bonds as VM on their bilateral derivative transactions. Establishing limits to the use of government bonds in IM and VM will force IORPs to disinvest in government bonds and have in their portfolio bigger amounts of riskier assets. Decisively, concentration limits on government bonds will also bring to IORPS valuation issues of derivatives instruments, which would impact their efficiency in using derivatives; they valuation of high quality government bonds based on EONIA discounting will not be always possible due to diversification requirements.
PensionsEurope considers that concentration limits on government bonds should not apply to IORPs. Alternatively, we suggest less harmful measures for IORPs such as setting a maximum on the amount of collateral posted as a percentage of the total amount of government bonds issued by one single issuer.
In our response to question 5 the impact of concentration limits on government bonds on IORPs is further developed.
Question 4. In respect of the use of a counterparty IRB model, are the counterparties confident that they will be able to access sufficient information to ensure appropriate transparency and to allow them to demonstrate an adequate understanding to their supervisory authority?
Traditionally, banking institutions are not open to share proprietary information on the models and pricing techniques that they use. Consequently, if an IORP has to demonstrate an adequate understanding to their supervisory authorityof the Internal Rating Based (IRB) model of its counterparty, then it is likely that this option will not be able to be used; IORPs will not have sufficient information, and therefore IORPs will not be able to adequately understand the IRB model of their counterparty. Exactly the same applies to the IM model of the counterparty.
If IORPs and their asset managers would have sufficient information on the IRB model, they would be able to use the IRB model of their counterparty banking institutions and therefore both counterparties would be in equal conditions. If they lack this information, IORPs will not be able to use one or two of the three options provided in Article 3 (1) LEC, as opposed to their counterparties of bilateral derivative transactions (banking institutions) which would be able to use the three options.
In the case of small and medium size IORPs, they will not be able to use 2 of the 3 options of Article 3 (1) LEC, since it is likely that they will not have the necessary resources to produce their own internal models. Indeed, small and medium size IORPs, (which regardless of the thresholds will likely need to apply the draft RTS since banks will not be willing to adapt their business model for smaller counterparties) are frequently not equipped with sufficient resources to set up internal models and therefore it is more cost-efficient for them to apply due-diligence when using external credit ratings.
PensionsEurope believes that this situation unfair and therefore we demand that measures are adopted to force banking institutions to provide sufficient information to their IORP counterparties on their IRB model. PensionsEurope supports requiring credit institutions to disclose to their counterparties sufficient information on the structure of the models that they use as well as the data they take into account to produce these models.
The latter would allow IORPs to reduce the use of credit ratings provided by ECAIs, which would be in line with the objective of the CRA Regulation of reducing the overreliance on external credit ratings without requiring further costs for IORPs. In order to ensure that this requirement is fulfilled by the banking institutions, IORPs and financial institutions managing assets on their behalf should be able to notify such behaviour to competent authorities. In exchange, IORPs should apply due diligence aiming to understand the functioning of the model and its potential limitations when using the IRB models of their counterparties.
Moreover, and bearing in mind the limitations of using the IRB model of their counterparties, it is PensionsEurope’s strong opinion that IORPs should not be penalised for using external credit ratings from ECAIs instead of internal credit risk assessments. The credit quality requirements for internal assessments and for the use ECAIs should be equal.
On 12 May 2014 the Financial Stability Board (FSB) published a report on this matter where it recognised the particularities of pension funds in this regards and established that “the use of CRA ratings provides economies of scale in analysing credit on behalf of smaller and less sophisticated investors, and that implementation should differentiate according to size and sophistication of the firm”. Article 5 (a) (2) of Regulation (EU) No 462/2013 (CRA Regulation) also establishes that in this issue competent authorities must take into account the nature, scale and complexity of the activities of the different undertakings, which not only is not currently the case, but on the contrary, the current draft RTS would leave the weaker counterparty (the IORP) of the bilateral derivate transaction in a disadvantageous position.
Question 6. How will market participants be able to ensure the fulfilment of all the conditions for the reuse of initial margins as required in the BCBS-IOSCO framework? Can the respondents identify which companies in the EU would require reuse or re-hypothecation of collateral as an essential component of their business models?
There are different views among our members about the re-use of collateral. Some are in favour of the practice and see liquidity squeeze and systemic crisis as a consequence of its interdiction; they believe that a better approach to this matter would be to determine the prohibition of re-use of collateral on a case-by-case basis. They prefer the more flexible approach adopted on this matter by IOSCO and the BCBS. They believe that it should be up to the counterparties involved in the derivative transactions to freely decide whether to allow the re-use of the collateral that they exchange. They fear that banning the re-use of collateral could make it more difficult to access financing and the latter would also be more expensive.On the other hand, others see re-use of VM as incompatible with the segregation of their assets. In fact, VM is the value of an outstanding contract and in case of a default can be offset against outstanding positions. As the (liquidity) risk of re-use of VM lies completely with the VM receiver, VM re-use shall be allowed. It is already a current market practice for some IORPs and entities managing assets on their behalf to re-use VM collateral. VM needs to be re-used in cases when collateral needs to yield a certain return to be paid to the VM provider. Maintaining such a practice would not increase systemic risk, while restricting it would seriously impede on the pool of available collateral for IORPs which re-use VM.