Response to joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP
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Here is a brief summary of our thoughts:
Requirement for initial margin will apply subject to a threshold value of EUR 8 billion for gross notional outstanding of OTC derivatives. In the scenario where a party to OTC transaction is below the threshold, but the other is above will result in a two way payment Initial Margin. The party below the threshold should not support the same rules as its counterparts and should not be forced to post initial margin. Otherwise, costs may still fall disproportionately on smaller market participants.
The requirement for the implementation of internal initial margin models and the resulting obligation to agree on the outcomes of different models will lead to a sub-optimal situation. We would rather recommend the use of the standardized method or the election of a single initial margin model (market best practice) that would only need to be validated once by a third party and / or the regulator.
One should emphasise that small and medium size players should not suffer from decisions taken by larger players or support substantial costs to mitigate systematic risk inferred by those larger players.
Grand fathering clause: Exchange of collateral requirement as of 1st December 2015 for new contract should be reinforced; 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 shall bring the necessary clarification. As a matter of fact, investment funds often amend existing contracts to reduce their notional amount to adjust their exposure, as a consequence of redemptions. Thus, it is very important for them to keep these existing contracts outside the scope of the regulation.
Reverse the presumption that IM will not be collected: in article 1FP §3, the current wording says that the possibility to exempt transactions between counterparties under the threshold requires a prior formal agreement. The default rule should be that, in the absence of a specific agreement between the parties, there is no IM posted. Legal services are overworked and this suggestion would simply make things workable.
100 million euros of collateral as Threshold for concentration rules; alignment with UCITS collateral diversification rules: if concentration rules were to apply, they should be coherent with existing requirements. ESMA guidelines require UCITS to spread received collateral in order not to exceed an exposure higher than 20% of the NAV of the fund on one single issuer. The denominator of the ratio is what is important in the fund, i.e. the net asset value or the net capital available in the fund. 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 issuers for even smaller amounts, uneasy to manage and costly to transfer.
Group consolidated eligibility thresholds: It would be impossible for an asset manager to calculate group consolidated eligibility thresholds on behalf of its client. In addition, the fact that a client may have signed several mandates with several Asset Managers brings additional difficulties in calculating such margin. Which entities will be responsible for calculating and paying the required amount of margin on behalf of the client? The application of two different methods by the parties to evaluate and calculate haircuts may result in discrepancies. It seems that there is no procedure in the RTS to solve those discrepancies. We believe that a standardized margin schedule may be the preferred approach as a standardized margin schedule used by both parties would lessen the risk of disputes as compared to quantitative portfolio models developed by counterparties.
In order to avoid such comparative disadvantage faced by Asset Manager some tools may be proposed:
- To cap the difference between the internal model and the standard model;
- To entrust a third party for the calculation with a commitment to stability of the model;
- The possibility to use specialized models issued by professional provider such as Agencies Rating used for securities ratings;
- To exclude OECD Government Bonds from eligibility rating agencies to avoid the cliff risk criteria;
- As regard to Initial Margin calculation, require Banks to leave the choice for the client and for each transaction between internal model and standard.
We are of the opinion that BCBS/IOSCO principles have taken a prudent and pragmatic approach when strongly limiting the possibility to re-use or rehypothecate received collateral. We think that there is no reason not to follow these principles. OTC derivatives are traded between professionals. If counterparty agrees that the re-use of collateral will be positive and made for the benefit of its clients, re-use should not be prohibited.
AIFs are currently permitted to re-use collateral (certain disclosure requirements are necessary). These new rules are therefore inconsistent with the rules applying to AIFs and with the way existing AIFs have been structured.
The prohibition of collateral re-use would pose a business problem for some types of funds. If prime brokers are unable to re-use the collateral they receive, access to financing will become more difficult for these funds, and much more expensive.
Another negative effect of this prohibition is that it would deprive the collecting party of a way to generate interests that must be paid to the posting party. How will the collecting party be able to pay interest on collateral that it may not reinvest? In addition and depending of the margin method used, UCITS may be required to post more IM than they may receive from banks. Consequently they would receive less remuneration for such asset transfer.
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.
Particular requirements may be addressed in a more appropriate manner, or still need to be clarified, in order to reduce the costs and avoid any comparative disadvantage for small and medium size players.Here is a brief summary of our thoughts:
Requirement for initial margin will apply subject to a threshold value of EUR 8 billion for gross notional outstanding of OTC derivatives. In the scenario where a party to OTC transaction is below the threshold, but the other is above will result in a two way payment Initial Margin. The party below the threshold should not support the same rules as its counterparts and should not be forced to post initial margin. Otherwise, costs may still fall disproportionately on smaller market participants.
The requirement for the implementation of internal initial margin models and the resulting obligation to agree on the outcomes of different models will lead to a sub-optimal situation. We would rather recommend the use of the standardized method or the election of a single initial margin model (market best practice) that would only need to be validated once by a third party and / or the regulator.
One should emphasise that small and medium size players should not suffer from decisions taken by larger players or support substantial costs to mitigate systematic risk inferred by those larger players.
Grand fathering clause: Exchange of collateral requirement as of 1st December 2015 for new contract should be reinforced; 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 shall bring the necessary clarification. As a matter of fact, investment funds often amend existing contracts to reduce their notional amount to adjust their exposure, as a consequence of redemptions. Thus, it is very important for them to keep these existing contracts outside the scope of the regulation.
Reverse the presumption that IM will not be collected: in article 1FP §3, the current wording says that the possibility to exempt transactions between counterparties under the threshold requires a prior formal agreement. The default rule should be that, in the absence of a specific agreement between the parties, there is no IM posted. Legal services are overworked and this suggestion would simply make things workable.
100 million euros of collateral as Threshold for concentration rules; alignment with UCITS collateral diversification rules: if concentration rules were to apply, they should be coherent with existing requirements. ESMA guidelines require UCITS to spread received collateral in order not to exceed an exposure higher than 20% of the NAV of the fund on one single issuer. The denominator of the ratio is what is important in the fund, i.e. the net asset value or the net capital available in the fund. 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 issuers for even smaller amounts, uneasy to manage and costly to transfer.
Group consolidated eligibility thresholds: It would be impossible for an asset manager to calculate group consolidated eligibility thresholds on behalf of its client. In addition, the fact that a client may have signed several mandates with several Asset Managers brings additional difficulties in calculating such margin. Which entities will be responsible for calculating and paying the required amount of margin on behalf of the client? The application of two different methods by the parties to evaluate and calculate haircuts may result in discrepancies. It seems that there is no procedure in the RTS to solve those discrepancies. We believe that a standardized margin schedule may be the preferred approach as a standardized margin schedule used by both parties would lessen the risk of disputes as compared to quantitative portfolio models developed by counterparties.
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?
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 of the Banks.In order to avoid such comparative disadvantage faced by Asset Manager some tools may be proposed:
- To cap the difference between the internal model and the standard model;
- To entrust a third party for the calculation with a commitment to stability of the model;
- The possibility to use specialized models issued by professional provider such as Agencies Rating used for securities ratings;
- To exclude OECD Government Bonds from eligibility rating agencies to avoid the cliff risk criteria;
- As regard to Initial Margin calculation, 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?
We believe that the prohibition or authorization of re-use should not be determine on a regulatory level but on case by case basis within a bilateral agreement between the parties.We are of the opinion that BCBS/IOSCO principles have taken a prudent and pragmatic approach when strongly limiting the possibility to re-use or rehypothecate received collateral. We think that there is no reason not to follow these principles. OTC derivatives are traded between professionals. If counterparty agrees that the re-use of collateral will be positive and made for the benefit of its clients, re-use should not be prohibited.
AIFs are currently permitted to re-use collateral (certain disclosure requirements are necessary). These new rules are therefore inconsistent with the rules applying to AIFs and with the way existing AIFs have been structured.
The prohibition of collateral re-use would pose a business problem for some types of funds. If prime brokers are unable to re-use the collateral they receive, access to financing will become more difficult for these funds, and much more expensive.
Another negative effect of this prohibition is that it would deprive the collecting party of a way to generate interests that must be paid to the posting party. How will the collecting party be able to pay interest on collateral that it may not reinvest? In addition and depending of the margin method used, UCITS may be required to post more IM than they may receive from banks. Consequently they would receive less remuneration for such asset transfer.