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European Covered Bond Council (ECBC)

The ECBC welcomes the fact that the ESAs have acknowledged the special features of covered bond-related derivatives and allowed for such derivatives to be excluded bilateral collateral posting of initial and variation margins, while ensuring the derivative counterparties a degree of protection by outlining specific conditions that have to be met.

We consider that the proposal adequately addresses the risks faced by a counterparty to a covered bond issuer/cover pool default and that, overall, the requirements specified in paragraph 1 of Article 3 GEN are necessary for the mitigation of such risks (see Sections 2.1-2.3 of our attached response). In particular, we support the idea of using an EU-harmonised classification of covered bonds, as it ensures equal privileges for this class of financial instruments. However, as covered bonds which are based on strong national legal frameworks and fulfil Art. 52 (4) UCITS but whose cover assets are not listed in Art. 129 CRR offer the same credit protection to swap counterparts, we suggest that the classification of covered bonds should be based on Art. 52 (4) UCITS (see Section 2.2 of our attached response).

We agree with the view that covered bond programmes should be subject to a minimum overcollateralization requirement, although we would encourage the ESAs to set the same minimum requirement across the different regulatory files that are currently addressing this topic. In addition, considering the timing implications if the various national covered bond legislations need to be amended to include a minimum OC, we would strongly suggest a grandfathering period before this requirement becomes mandatory (see Section 2.3 of our attached response).

There are a number of other issues that the ECBC would also like to invite the ESAs to take into consideration. In the first place, we would propose to add the words “insolvency-related” before “default” in paragraph 1(a) of Article 3 GEN. It is important that this requirement is limited to insolvency related defaults only, as the purpose of this restriction should be to avoid that the derivative is terminated as a result of the issuer’s insolvency, not to prevent the counterparty from terminating upon other limited non-insolvency- related defaults (see Section 2.1 of our attached response). Moreover, the scope of the contemplated carve out regime to the benefit of covered bonds should be broadened in order to take into account issues raised by bespoke derivatives performed for hedging purposes, such as Back to Back Swaps (see Section 2.6 of our attached response).

Furthermore, we believe that derivatives that satisfy the requirements in Article 3 GEN and that are, therefore, excluded from the bilateral collateral posting of initial and variation margins, due to their special features, should be also excluded when calculating the group thresholds for non-centrally cleared derivatives in Article 1 FP “Final provisions”. The unilateral posting is an inherent feature of covered bonds and, thus, cannot be reduced over time (see Section 1 of our attached response).

In addition, the relief for covered bond derivatives should be two-way, i.e. also apply to covered bond derivative counterparties. The collected collateral must be segregated based on Article 1 SEG “Segregation of initial margins” so that the covered bond issuer’s derivative counterparty has sufficient protection if the covered bond issuer enters into bankruptcy or other insolvency proceedings. However, in Article 1 REU – “Treatment of collected initial margins” it is stipulated that the collecting counterparty, i.e. the covered bond issuer, should not re-hypothecate, re-pledge or otherwise re-use the collateral collected as initial margin. These various conditions and requirements are impossible or at least extremely problematic to comply with in many covered bond jurisdictions given the fact that when the covered bond issuer receives the initial margin, it legally must be registered as part of the cover pool assets and, hence, it is no longer “segregated” from the rest of the pool in the case of the insolvency of the issuer. Moreover, we consider the segregation of such initial margin collateral from other assets of the covered bond issuer unnecessary when a covered bond legislation gives the collateral provider a prioritized claim on the covered bond issuer. The risk associated with a segregated cash account held with a third party institution is typically commensurate with an unsecured claim on such third party institution which, in turn, is typically a worse risk than a prioritized claim on a covered bond issuer (see Section 1 of our attached response).

Finally, with regard to the Alternatives proposed on pages 59 and 60, we would like to highlight that Alternative 1 (one-way margin requirement) seems to be the most sensible way to proceed, although the current practice with the one-way margining should also be maintained. The market-based solution (Alternative 2), as outlined in the cost-benefit analysis section of the ESAs Consultation Paper, is not a particularly adequate alternative for covered bonds, as it represents a transfer of risks to a third-party which then brings additional counterparty risks to the cover pool (see Sections 2.4-2.5 of our attached response).

The ECBC stands ready to assist the ESAs in its role of market catalyst and think-tank. We very much hope that you will take our remarks into consideration. Please, do not hesitate to contact us, if we can be of any assistance or if you would like further clarification or elaboration on our views.
Luca Bertalot
+32 22 85 40 30