Response to joint Consultation on draft RTS on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP

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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.

We believe that the operational nature of the real estate fund and MIV sectors have not been addressed in an appropriate manner.

Real Estate Funds
The real estate sector invests in real assets which are illiquid by their very nature and which support jobs in the real economy. Unlike other “financial counterparties”, real estate funds raise capital for the sole purpose of building and investing in these physical assets. They do not hold cash or liquid securities that could be pledged as collateral. A variation margin requirement will represent a significant, disproportionate and extremely expensive new burden.

Real estate funds raise capital from a range of sources and invest those funds as equity or debt in real property. They hold investments (e.g., buildings) in special purpose vehicles (SPVs) that also serve as party to debt and interest rate derivatives used to hedge the debt. These SPVs are typically non-financial counterparties under EU law that are exempt from central clearing and margin requirements under EMIR.

However, as a real estate investment company, they are subject to the authorization requirements under the AIFMD. The fund itself is therefore considered a “financial counterparty” under Article 2(1)(8) EMIR due to a cross-reference to the AIFMD in this article. Currency risk is often addressed at the fund level when a real estate fund purchases assets. We refer to our answer in Question 1 for an example of how real estate funds use FX forwards to hedge currency risk at the fund level.

Per our answer to Question 1 of this consultation, we believe that this problem could be mitigated by introducing thresholds for variation margin for non-systemically important financial counterparties.

Microfinance Investment Vehicles
Microfinance Investment Vehicles (MIVs) serve as a source of capital for microfinance institutions that provide loans to small business and entrepreneurs who lack access to traditional banking or related financial services. Microcredit is an essential resource for entrepreneurs and small businesses that lack access to traditional banking services, especially in the third world. It has proven a highly effective tool in efforts to alleviate poverty in poor and developing countries.

MIVs raise funds from public sector entities such as development finance institutions, institutional investors such as pension funds, and non-profit organizations. Their investors are typically highly risk averse and seek modest financial returns coupled with measurable social improvements in low income areas. They are subject to the authorization requirements under the AIFMD and for that reason they are considered “financial counterparties” under Article 2(1)(8) EMIR.

As MIVs provide loans to microfinance institutions in the local emerging or frontier market currencies, they encounter significant exposure to currency risk. This is hedged through bespoke products in the OTC derivatives markets. In order to fulfill their social role, they prefer to take on the currency risk at the fund level so as not to overburden and expose the microfinance institutions or their clients to the risk. In addition, they also use interest rate hedging products to mitigate the risk associated with lending to microfinance institutions at fixed rates while providing floating rate returns to investors.

MIVs do not hold cash reserves, and do not have access to pools of highly liquid securities to pledge as collateral for their OTC derivatives. A variation margin requirement will require them to choose either to reduce their investments in microfinance institutions in order to reserve cash to meet collateral requirements or to stop hedging and pass the currency exposure to the microfinance institutions and their borrowers. These microfinance institutions and individual borrowers are far less equipped to handle currency risk exposures. Either of these outcomes will reduce the significant benefits that microfinance funds provide to low-income communities around the world.

As indicated in our answer to Question 1, we believe that the problem posed by variation margin to the microfinance sector can be mitigated by introducing thresholds for variation margin for non-systemically important financial 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?

Non-Applicable

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?

Non-Applicable

Name of organisation

Chatham Financial Europe Limited