Response to joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP
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Sub-funds and segmented investment funds
We welcome the ESAs view in recital 5 that the threshold relevant for the question whether or not to exchange Initial Margin contributions needs to be considered for each investment fund or sub-fund (compartment) separately. We understand that sub-funds, which are totally risk segregated, and without any solidarity between them are different entities when considering collateral requirements and thresholds.
In some cases, the investor of an investment fund (AIF) wishes that more than one asset manager manages the investment fund. This is achieved by creating segments or portfolios (e.g. one segment concerning equities and another segment concerning non-equities) each managed by a certain asset manager.
This is considered for collateralization reasons too. The collateral to be posted by the parties is determined with respect to each segment separately.
In order to maintain the possibility for investors to have their investment fund managed by more than one asset manager or to avoid the creation of legal solidarity between sub-funds, it would be helpful if the ESAs would clarify in Recital 5 that in case of segmented investment funds, each segment should be considered as a distinct entity.
This question is even more crucial for funds with sub-funds as it would force each sub-fund from a fund to deliver initial margin, even when the size of the sub-fund may be below 2 million euros.
Investment funds established in accordance with contract law (Art. 1, par.. 3 of the Directive 2009/65/EC)
As far as the ESAs determine an exemption from the rule that the threshold shall be considered for each investment funds separately, it should clarify that just the circumstance that an investment fund is established in accordance with contract law (cf. Article 1, par. 3 of EU Directive 2009/65/EC) does not mean that the threshold always needs to be applied at the level of the asset management company (“investment advisor” in Recital 5). As a matter of fact, it is the asset management company who becomes contractual party to OTC derivatives (acting for the joint account of the investors of the relevant investment fund established in accordance with contract law. It should be clear that this direct liability of the asset management company should not be understood as one of the exemptions from the general rule that the threshold is to be applied on the fund level.
First of all it needs to be pointed out that there is no incentive for the asset management company to breach the cover rule set out in Art. 51, paragraph 3, of Directive 2009/65/EC . According to the cover rule, it is not allowed to enter into derivatives that cannot be fulfilled with the assets of the fund. If the investment fund is established in accordance with contract law, whatever the asset management company receives from a transaction relating to an investment fund automatically becomes part of this investment fund. In consequence, there is no possibility of the asset management company to make own profits from any transactions being in breach of the cover rule. In case of transactions the asset management company has agreed on for the joint account of the investors of an investment fund established in accordance with contract law, any liability arising from an OTC derivative is a liability of the asset management company. The latter only has a respective claim for reimbursement against the joint group of investors of the investment fund, which is limited to the assets of the funds. Any liability exceeding the value of the investment funds assets are to be borne by the asset management company. For that reason, it is the overall interest of the asset management company to comply with the cover rule.
The above demonstrates that just the circumstance that investment funds are established in accordance with contract law gives no reason for deviating from the principle of a fund-by-fund view when applying the threshold. Since the wording in Recital 5 leaves space for interpretations, the ESAs should clarify that aspect accordingly, at least in Recital 5.
Besides the legal aspects, we would raise a second point in that context.
Since in each Member State there is always one leading practise how investment funds are established (statute, trust or contract law) which very much relates to what structure retail investors are used to, any interpretation of the RTS being in conflict with the above would mean a discrimination of the funds industry in the relevant member states. Applying IM requirements is expensive and creates costs, which are finally borne by the investors. Treating investment funds established in accordance with contract law different from those being established by statute would create unequal conditions for managing the investors’ assets.
Neither EMIR nor the UCITS directive nor BCBS/IOSCO differs between the ways an investment fund is being established. We have no reason to believe that the ESAs think otherwise. For that reason, we would welcome a clarification by the ESAs in the favoured manner either in Recital 5 and/or Art. 2 GEN, paragraph. 3
Calculation of group exposure
Moreover, the fact that a client may have concluded several mandates with different asset managers brings additional difficulties in calculating margins. It is then not possible for the asset manager of one mandate to calculate the threshold or deliver the margins, as the global exposure remains impossible to define.
2) Grand-fathering clause
We wish to insist on the necessity to fully and explicitly establish the fact that the regulation will only apply for transactions conducted after its implementation date.
It should not only be mentioned under recital 18 but also included in the text of the regulation itself. Furthermore, we consider that a clarification should be added to make sure that “genuine amendments” as referred to in the BCBS/IOSCO final report (§ 8.9 and footnote 20, p. 24) made to existing derivative contracts shall not be in the scope of the new regulation. An explicit mention in article 1 FP § 4 would bring the necessary clarification.
3) Eligible collateral
The eligible collateral should not be limited to the list of the main indices. Eligible collateral list should be extended to other indices as well.
The RTS should also provide an assessment method for the calculation of haircuts on equities.
As far as we understand, the application of two different methods by the parties to evaluate and calculate haircuts may result in discrepancies and we see no procedure in the RTS to solve those discrepancies.
4) Implementation of collateral transfer made of units or shares of UCITS
We greatly welcome the possibility for counterparties to use units or shares in UCITS as eligible collateral as it supports the need for liquidity in the markets, even if it does not benefit directly to the funds.
In order to support even more the liquidity, we would urge the ESAs to provide solutions to the following constraints that may arise in the practical use of such possibility:
- The settlement system of UCITS does not allow transfer of shares or units in a proper manner when they are not eligible to a CSD’s operations. As of today, an integrated European settlement circuit for such UCITS does not exist. This is an impediment to the implementation of such collateral transfer between counterparties when they are not located in the same country. Even if the counterparties are both located in the same country, the consent from the depositary of a given UCITS for the delivery of the shares/units as collateral is rarely granted by the depository, due to operational constraints when they are not eligible to a CSD’s operations;
- The banking regulation Capital Requirement Regulation (CRR, June 26th, 2013) has introduced two new ratios in order to ensure a better monitoring of liquidity risks: (i) the Liquidity Coverage Ratio (LCR – that measures the liquidity risk with a time horizon of 1 month, and ensures that banks own sufficient reserves and cash inflows in order to face potential cash outflows) and (ii) the Net Stable Funding Ratio (NSFR that measures the liquidity risk with a time horizon of 1 year, and ensures that the Available Stable Funding (with a maturity over 1 year) is sufficient to face the Required Stable Funding).
However, Mutual Funds have generally speaking not been taken into account in the CRR regulation n°575/2013, for the computation of liquidity ratios (LCR and NSFR).
Under a strict interpretation of CRR, funds could then be assimilated into the less liquid categories of assets and suffer from a particularly adverse processing as, in the LCR computation, funds would not be eligible at all for the computation of inflows, i.e. they could be considered assets with a maturity over one month.
Concerning this later point, we would be happy to engage with the ESAs to further elaborate on this topic and propose concrete solutions that could enable banks to hold a portfolio of funds eligible as collateral without being unduly penalized.
5) Ability to return to the liquidator unused collateral proceeds
According to the draft RTS, this capability must be included in the risk management procedure of the counterparty receiving collateral.
The issue is that current market documentation of OTC derivatives is not compliant with such possibility.
ISDA Master Agreement but also other master agreements (like the German Master Agreement for Financial Derivatives Transactions) allow the non-defaulting party to net any payment owed by this party (the defaulting party) with all amount he may have to pay to its counterparty.
The non-defaulting party can then retain any amount received as collateral provided it is inferior to the amount that results from the addition of the sums due by its counterparty.
For that reason we consider that, in some cases, unused collateral proceeds shall not be returned to the liquidator of the defaulting party. This netting should continue to apply as it reduces settlement risk between the parties.
We consider that the regulatory regime of collateral should take into account this point.
6) Ban of re-use of initial margin
We consider the ban of re-use of initial margin may trigger some adverse consequences on UCITS legal regime and furthermore will increase the cost of OTC transactions. We ask for an authorization to agree to re-use in some circumstances. See question 6 below.
7) Necessity of initial margin
As per the “Guidelines on ETFs and other UCITS issues” published by ESMA on the 18th December 2012, a UCITS is bound to invest the cash collateral it receives.
Cash collateral should be placed on deposits, invested on high quality investment bonds, used for the purpose of reverse repo or invested in short term money market funds. Such investments must be in compliance with additional security constraints. We consider this regime adequately secures transactions and avoids risk in case of default of the receiving party.
We do not share the ESAs’ opinion that it is necessary to consider initial margins in order to properly manage counterparty risks arising from certain OTC derivatives.
Therefore we would like to point the ESAs’ attention once more to the drafted initial margin requirements. Such is necessary to make the RTS an appropriate measure when building more resilient financial markets.
In summary, here are the key points we wish to draw to your attention in that respect:
- The G-20 did not impose the requirement of initial margins for non-cleared OTC derivatives. For that reason the ESAs should evaluate if setting initial margin requirements would be appropriate in all circumstances;
- Non-cleared OTC derivatives, subject to standardized Master Agreements including an automated early termination, already mitigate the risk the ESAs intend to decrease with the initial margin requirement.
Therefore, having in place respective Master Agreements should be recognized as reliable alternative to initial margins. The risk initial margins are mitigating is related to the requested portability;
- We know that BCBS and IOSCO is in favor of IM requirements. Nevertheless the ESAs should keep in mind that the goals have been set by G-20 and that the ESAs have been established with the power to draft RTS which are independent from BCBS/IOSCO`s view. Declining any and all variances from the aspects suggested by BCBS/IOSCO would place BCBS/IOSCO in the position of a legislator, which it is not.
The ESAs should consider the differences between cleared and non-cleared OTC derivatives before stipulating any initial margin requirements for non-cleared OTC derivatives.
The G-20 accepted that market participants will use non-cleared OTC derivatives in the future and that their use may bear higher risks than the use of cleared OTC derivatives.
The ESAs should consider that creating too big burdens on the use of OTC derivatives sets an incentive not to hedge existing market risks which, in turn, would have a negative impact on the G-20’s goal to building more resilient financial markets.
Therefore the ESAs should evaluate whether it is appropriate to decrease the low risk of market movement effects after the OTC derivatives counterparties default by setting initial margins requirements or, if this risk is acceptable.
For those reasons, the proposed above-mentioned rules should be applicable to counterparties entering into non-cleared derivative transactions.
8) Post capital or hold assets
According to Recital 3, a counterparty shall have the choice either to post / collect (initial) margins or hold own capital if the amount of initial margin is below the threshold.
UCITS investment funds are subject to the cover rule (cf. Art. 51 para. 3 of Directive 2009/65/EC as well as CESR consultation 10-108, Box 28). That means, they are only allowed to enter into derivatives which can be fulfilled with the assets of the investment fund.
In order to avoid any misinterpretation, the ESAs should clarify in Recital 3 that in case of investment funds, be they UCITS or FIAs, own capital is represented by the NAV of the fund.
9) Conflict in diversification rules
There are some contradiction between diversification limits resulting from the application of article 7 LEC of the RTS (pages 38-39) and the concentration limits resulting from the ESMA Guidelines on ETFs and other UCITS issues.
The proposed regulation refers to the total amount of the collateral when computing the diversification ratio. It is inconsistent to consider that there is a risk on the collateral of small amount that could be mitigated with a diversification rule; it is not workable to ask counterparties to split small amounts of collateral on several issues for even smaller amounts, uneasy to manage and costly to transfer.
The harmonization within each Member State as regards those concentration limits in UCITS implementation and in EMIR is a necessary pre-requisite to improve legal certainty, liquidity as well as the level playing field between market players.
If concentration rules were to apply, we strongly suggest that there should be a realistic threshold under which they should not, simply because it is not workable to ask for a split over different issuers of collateral on smaller amounts than 100 million-, they should be coherent with existing requirements.
10) Harmonized approach to IM calculation
From an asset managers’ viewpoint, we believe that a standardized margin schedule should be the preferred approach as UCITS’ regulations require that they set their own valuation process (in accordance with article 51 of the UCITS Directive), which must be independent and not rely on its counterparty’s valuation.
A standardized margin schedule used by both parties would also lessen the risk of disputes as compared to quantitative portfolio models developed by counterparties.
11) Different MTA for IM and VM
The proposed regulation suggests a Minimum Transfer Amount (MTA) of 500 000 €. This amount includes the net variation of IM and VM exchanged between 2 counterparties.
Many EFAMA members are monitoring IM and VM separately and we would prefer to have two MTAs of 500.000,00€ each.
For both the IRB model (eligible collateral and haircut) and the internal model of Initial Margin calculation, small and medium size player will be exposed to non-transparent models. As we fear that it might be difficult to receive the necessary information, we would consider as a good leverage that the client be recognized the possibility to seize the competent authority if he cannot obtain satisfactory explanations;
In order to avoid such comparative disadvantage for asset managers, some tools may be proposed:
capping the difference between the internal model and the standard model;
entrusting a third party for the calculation with a commitment to stability of the model;
facilitating the use of specialized models issued by professional provider such as Rating Agencies used for securities ratings and suggest they should be as often as possible public data;
excluding some OECD government debts from eligibility rating requirements to avoid the cliff risk criteria;
as regards the Initial Margin calculation, to require Banks to leave the choice for the client and for each transaction between internal model and standard.
OTC derivatives are traded between professionals. There are many arguments that limit the re-use to a very few cases when professionals willfully agree to this regime:
- the required prior explicit approval by the poster of the collateral (transaction by transaction),
- the fact that it can check that the re-use is made in conjunction with a further transaction aiming at managing the risk initially taken from the fund and not to take further exposure,
- the possibility to earmark the collateral.
If a counterparty agrees that the re-use of collateral will be positive and made for the benefit of its clients, re-use should be allowed and duly reported for information to shareholders.
However, one should note that there is currently an important discrepancy between IOSCO and ESMA’s views at it is prohibited for regulated investment funds, such as UCITS, to re-hypothecate, re-pledge or otherwise re-use collateral received. The prohibition or authorization of re-use should not be decided on a regulatory level and should rather be agreed on case by case basis within a bilateral agreement.
As written in our reply to question 5, when it is allowed under the RTS to fulfil Initial Margin requirements in cash, the default risk of the counterparty is just replaced by the default risk of the bank who maintains the account the initial margin is booked to (typically a counterparty to other OTC derivatives).
While it is not sure whether the default of the counterparty of a non-cleared OTC derivative leads to a loss at all (subject to market conditions), the insolvency of the bank, maintaining the account to which the initial margin (cash) received is booked, leads necessarily to losses for the non-defaulting counterparties.
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) Impossibility to calculate exposuresSub-funds and segmented investment funds
We welcome the ESAs view in recital 5 that the threshold relevant for the question whether or not to exchange Initial Margin contributions needs to be considered for each investment fund or sub-fund (compartment) separately. We understand that sub-funds, which are totally risk segregated, and without any solidarity between them are different entities when considering collateral requirements and thresholds.
In some cases, the investor of an investment fund (AIF) wishes that more than one asset manager manages the investment fund. This is achieved by creating segments or portfolios (e.g. one segment concerning equities and another segment concerning non-equities) each managed by a certain asset manager.
This is considered for collateralization reasons too. The collateral to be posted by the parties is determined with respect to each segment separately.
In order to maintain the possibility for investors to have their investment fund managed by more than one asset manager or to avoid the creation of legal solidarity between sub-funds, it would be helpful if the ESAs would clarify in Recital 5 that in case of segmented investment funds, each segment should be considered as a distinct entity.
This question is even more crucial for funds with sub-funds as it would force each sub-fund from a fund to deliver initial margin, even when the size of the sub-fund may be below 2 million euros.
Investment funds established in accordance with contract law (Art. 1, par.. 3 of the Directive 2009/65/EC)
As far as the ESAs determine an exemption from the rule that the threshold shall be considered for each investment funds separately, it should clarify that just the circumstance that an investment fund is established in accordance with contract law (cf. Article 1, par. 3 of EU Directive 2009/65/EC) does not mean that the threshold always needs to be applied at the level of the asset management company (“investment advisor” in Recital 5). As a matter of fact, it is the asset management company who becomes contractual party to OTC derivatives (acting for the joint account of the investors of the relevant investment fund established in accordance with contract law. It should be clear that this direct liability of the asset management company should not be understood as one of the exemptions from the general rule that the threshold is to be applied on the fund level.
First of all it needs to be pointed out that there is no incentive for the asset management company to breach the cover rule set out in Art. 51, paragraph 3, of Directive 2009/65/EC . According to the cover rule, it is not allowed to enter into derivatives that cannot be fulfilled with the assets of the fund. If the investment fund is established in accordance with contract law, whatever the asset management company receives from a transaction relating to an investment fund automatically becomes part of this investment fund. In consequence, there is no possibility of the asset management company to make own profits from any transactions being in breach of the cover rule. In case of transactions the asset management company has agreed on for the joint account of the investors of an investment fund established in accordance with contract law, any liability arising from an OTC derivative is a liability of the asset management company. The latter only has a respective claim for reimbursement against the joint group of investors of the investment fund, which is limited to the assets of the funds. Any liability exceeding the value of the investment funds assets are to be borne by the asset management company. For that reason, it is the overall interest of the asset management company to comply with the cover rule.
The above demonstrates that just the circumstance that investment funds are established in accordance with contract law gives no reason for deviating from the principle of a fund-by-fund view when applying the threshold. Since the wording in Recital 5 leaves space for interpretations, the ESAs should clarify that aspect accordingly, at least in Recital 5.
Besides the legal aspects, we would raise a second point in that context.
Since in each Member State there is always one leading practise how investment funds are established (statute, trust or contract law) which very much relates to what structure retail investors are used to, any interpretation of the RTS being in conflict with the above would mean a discrimination of the funds industry in the relevant member states. Applying IM requirements is expensive and creates costs, which are finally borne by the investors. Treating investment funds established in accordance with contract law different from those being established by statute would create unequal conditions for managing the investors’ assets.
Neither EMIR nor the UCITS directive nor BCBS/IOSCO differs between the ways an investment fund is being established. We have no reason to believe that the ESAs think otherwise. For that reason, we would welcome a clarification by the ESAs in the favoured manner either in Recital 5 and/or Art. 2 GEN, paragraph. 3
Calculation of group exposure
Moreover, the fact that a client may have concluded several mandates with different asset managers brings additional difficulties in calculating margins. It is then not possible for the asset manager of one mandate to calculate the threshold or deliver the margins, as the global exposure remains impossible to define.
2) Grand-fathering clause
We wish to insist on the necessity to fully and explicitly establish the fact that the regulation will only apply for transactions conducted after its implementation date.
It should not only be mentioned under recital 18 but also included in the text of the regulation itself. Furthermore, we consider that a clarification should be added to make sure that “genuine amendments” as referred to in the BCBS/IOSCO final report (§ 8.9 and footnote 20, p. 24) made to existing derivative contracts shall not be in the scope of the new regulation. An explicit mention in article 1 FP § 4 would bring the necessary clarification.
3) Eligible collateral
The eligible collateral should not be limited to the list of the main indices. Eligible collateral list should be extended to other indices as well.
The RTS should also provide an assessment method for the calculation of haircuts on equities.
As far as we understand, the application of two different methods by the parties to evaluate and calculate haircuts may result in discrepancies and we see no procedure in the RTS to solve those discrepancies.
4) Implementation of collateral transfer made of units or shares of UCITS
We greatly welcome the possibility for counterparties to use units or shares in UCITS as eligible collateral as it supports the need for liquidity in the markets, even if it does not benefit directly to the funds.
In order to support even more the liquidity, we would urge the ESAs to provide solutions to the following constraints that may arise in the practical use of such possibility:
- The settlement system of UCITS does not allow transfer of shares or units in a proper manner when they are not eligible to a CSD’s operations. As of today, an integrated European settlement circuit for such UCITS does not exist. This is an impediment to the implementation of such collateral transfer between counterparties when they are not located in the same country. Even if the counterparties are both located in the same country, the consent from the depositary of a given UCITS for the delivery of the shares/units as collateral is rarely granted by the depository, due to operational constraints when they are not eligible to a CSD’s operations;
- The banking regulation Capital Requirement Regulation (CRR, June 26th, 2013) has introduced two new ratios in order to ensure a better monitoring of liquidity risks: (i) the Liquidity Coverage Ratio (LCR – that measures the liquidity risk with a time horizon of 1 month, and ensures that banks own sufficient reserves and cash inflows in order to face potential cash outflows) and (ii) the Net Stable Funding Ratio (NSFR that measures the liquidity risk with a time horizon of 1 year, and ensures that the Available Stable Funding (with a maturity over 1 year) is sufficient to face the Required Stable Funding).
However, Mutual Funds have generally speaking not been taken into account in the CRR regulation n°575/2013, for the computation of liquidity ratios (LCR and NSFR).
Under a strict interpretation of CRR, funds could then be assimilated into the less liquid categories of assets and suffer from a particularly adverse processing as, in the LCR computation, funds would not be eligible at all for the computation of inflows, i.e. they could be considered assets with a maturity over one month.
Concerning this later point, we would be happy to engage with the ESAs to further elaborate on this topic and propose concrete solutions that could enable banks to hold a portfolio of funds eligible as collateral without being unduly penalized.
5) Ability to return to the liquidator unused collateral proceeds
According to the draft RTS, this capability must be included in the risk management procedure of the counterparty receiving collateral.
The issue is that current market documentation of OTC derivatives is not compliant with such possibility.
ISDA Master Agreement but also other master agreements (like the German Master Agreement for Financial Derivatives Transactions) allow the non-defaulting party to net any payment owed by this party (the defaulting party) with all amount he may have to pay to its counterparty.
The non-defaulting party can then retain any amount received as collateral provided it is inferior to the amount that results from the addition of the sums due by its counterparty.
For that reason we consider that, in some cases, unused collateral proceeds shall not be returned to the liquidator of the defaulting party. This netting should continue to apply as it reduces settlement risk between the parties.
We consider that the regulatory regime of collateral should take into account this point.
6) Ban of re-use of initial margin
We consider the ban of re-use of initial margin may trigger some adverse consequences on UCITS legal regime and furthermore will increase the cost of OTC transactions. We ask for an authorization to agree to re-use in some circumstances. See question 6 below.
7) Necessity of initial margin
As per the “Guidelines on ETFs and other UCITS issues” published by ESMA on the 18th December 2012, a UCITS is bound to invest the cash collateral it receives.
Cash collateral should be placed on deposits, invested on high quality investment bonds, used for the purpose of reverse repo or invested in short term money market funds. Such investments must be in compliance with additional security constraints. We consider this regime adequately secures transactions and avoids risk in case of default of the receiving party.
We do not share the ESAs’ opinion that it is necessary to consider initial margins in order to properly manage counterparty risks arising from certain OTC derivatives.
Therefore we would like to point the ESAs’ attention once more to the drafted initial margin requirements. Such is necessary to make the RTS an appropriate measure when building more resilient financial markets.
In summary, here are the key points we wish to draw to your attention in that respect:
- The G-20 did not impose the requirement of initial margins for non-cleared OTC derivatives. For that reason the ESAs should evaluate if setting initial margin requirements would be appropriate in all circumstances;
- Non-cleared OTC derivatives, subject to standardized Master Agreements including an automated early termination, already mitigate the risk the ESAs intend to decrease with the initial margin requirement.
Therefore, having in place respective Master Agreements should be recognized as reliable alternative to initial margins. The risk initial margins are mitigating is related to the requested portability;
- We know that BCBS and IOSCO is in favor of IM requirements. Nevertheless the ESAs should keep in mind that the goals have been set by G-20 and that the ESAs have been established with the power to draft RTS which are independent from BCBS/IOSCO`s view. Declining any and all variances from the aspects suggested by BCBS/IOSCO would place BCBS/IOSCO in the position of a legislator, which it is not.
The ESAs should consider the differences between cleared and non-cleared OTC derivatives before stipulating any initial margin requirements for non-cleared OTC derivatives.
The G-20 accepted that market participants will use non-cleared OTC derivatives in the future and that their use may bear higher risks than the use of cleared OTC derivatives.
The ESAs should consider that creating too big burdens on the use of OTC derivatives sets an incentive not to hedge existing market risks which, in turn, would have a negative impact on the G-20’s goal to building more resilient financial markets.
Therefore the ESAs should evaluate whether it is appropriate to decrease the low risk of market movement effects after the OTC derivatives counterparties default by setting initial margins requirements or, if this risk is acceptable.
For those reasons, the proposed above-mentioned rules should be applicable to counterparties entering into non-cleared derivative transactions.
8) Post capital or hold assets
According to Recital 3, a counterparty shall have the choice either to post / collect (initial) margins or hold own capital if the amount of initial margin is below the threshold.
UCITS investment funds are subject to the cover rule (cf. Art. 51 para. 3 of Directive 2009/65/EC as well as CESR consultation 10-108, Box 28). That means, they are only allowed to enter into derivatives which can be fulfilled with the assets of the investment fund.
In order to avoid any misinterpretation, the ESAs should clarify in Recital 3 that in case of investment funds, be they UCITS or FIAs, own capital is represented by the NAV of the fund.
9) Conflict in diversification rules
There are some contradiction between diversification limits resulting from the application of article 7 LEC of the RTS (pages 38-39) and the concentration limits resulting from the ESMA Guidelines on ETFs and other UCITS issues.
The proposed regulation refers to the total amount of the collateral when computing the diversification ratio. It is inconsistent to consider that there is a risk on the collateral of small amount that could be mitigated with a diversification rule; it is not workable to ask counterparties to split small amounts of collateral on several issues for even smaller amounts, uneasy to manage and costly to transfer.
The harmonization within each Member State as regards those concentration limits in UCITS implementation and in EMIR is a necessary pre-requisite to improve legal certainty, liquidity as well as the level playing field between market players.
If concentration rules were to apply, we strongly suggest that there should be a realistic threshold under which they should not, simply because it is not workable to ask for a split over different issuers of collateral on smaller amounts than 100 million-, they should be coherent with existing requirements.
10) Harmonized approach to IM calculation
From an asset managers’ viewpoint, we believe that a standardized margin schedule should be the preferred approach as UCITS’ regulations require that they set their own valuation process (in accordance with article 51 of the UCITS Directive), which must be independent and not rely on its counterparty’s valuation.
A standardized margin schedule used by both parties would also lessen the risk of disputes as compared to quantitative portfolio models developed by counterparties.
11) Different MTA for IM and VM
The proposed regulation suggests a Minimum Transfer Amount (MTA) of 500 000 €. This amount includes the net variation of IM and VM exchanged between 2 counterparties.
Many EFAMA members are monitoring IM and VM separately and we would prefer to have two MTAs of 500.000,00€ each.
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?
We approve the requirement that banks communicate on the models that they use and the data that they take into account when running these models. From the perspective of the asset managers, our responsibility towards our clients includes the verification of the prices of the financial instruments that we use and the level of collateral is within the scope of our controls.For both the IRB model (eligible collateral and haircut) and the internal model of Initial Margin calculation, small and medium size player will be exposed to non-transparent models. As we fear that it might be difficult to receive the necessary information, we would consider as a good leverage that the client be recognized the possibility to seize the competent authority if he cannot obtain satisfactory explanations;
In order to avoid such comparative disadvantage for asset managers, some tools may be proposed:
capping the difference between the internal model and the standard model;
entrusting a third party for the calculation with a commitment to stability of the model;
facilitating the use of specialized models issued by professional provider such as Rating Agencies used for securities ratings and suggest they should be as often as possible public data;
excluding some OECD government debts from eligibility rating requirements to avoid the cliff risk criteria;
as regards the Initial Margin calculation, to require Banks to leave the choice for the client and for each transaction between internal model and standard.
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?
EFAMA’s view is that BCBS/IOSCO principles have taken a prudent and pragmatic approach when authorizing under strict limitations the possibility to re-use or re-hypothecate received collateral. We think that there is no reason for the ESAs not to follow these principles.OTC derivatives are traded between professionals. There are many arguments that limit the re-use to a very few cases when professionals willfully agree to this regime:
- the required prior explicit approval by the poster of the collateral (transaction by transaction),
- the fact that it can check that the re-use is made in conjunction with a further transaction aiming at managing the risk initially taken from the fund and not to take further exposure,
- the possibility to earmark the collateral.
If a counterparty agrees that the re-use of collateral will be positive and made for the benefit of its clients, re-use should be allowed and duly reported for information to shareholders.
However, one should note that there is currently an important discrepancy between IOSCO and ESMA’s views at it is prohibited for regulated investment funds, such as UCITS, to re-hypothecate, re-pledge or otherwise re-use collateral received. The prohibition or authorization of re-use should not be decided on a regulatory level and should rather be agreed on case by case basis within a bilateral agreement.
As written in our reply to question 5, when it is allowed under the RTS to fulfil Initial Margin requirements in cash, the default risk of the counterparty is just replaced by the default risk of the bank who maintains the account the initial margin is booked to (typically a counterparty to other OTC derivatives).
While it is not sure whether the default of the counterparty of a non-cleared OTC derivative leads to a loss at all (subject to market conditions), the insolvency of the bank, maintaining the account to which the initial margin (cash) received is booked, leads necessarily to losses for the non-defaulting counterparties.