AFG welcomes the attempt for a harmonization at international level of the regulations. Having homogeneous international framework is of utmost importance in order to avoid market fragmentation, disruptions and increasing risks of squeeze of liquidity in the market which would be detrimental to all market participants for which the main objective is to use OTC derivatives for risk management purposes.
However we believe that harmonized and consistent regulation should proceed from effectively enforceable requirements and cannot rely on suggestions to extend unilaterally domestic provisions to third country entities. We doubt that article 3 GEN will be applicable and fear it will lead to more complexity and uncertainty as an EU firm will not be in a position to impose its requirement to exchange collateral to an entity which shall not be subject to a similar requirement in its own state. If the result is to exclude this entity from the list of counterparties it might create a great disadvantage for the EU firm and, in the case of funds, for the end client-investor.
However, if some exemptions are finally issued for third country entities, this is important to give mandate to an independent European authority (such as ESMA) to provide technical advice on the equivalence between the EU regulatory regime and the third country regime for which exemptions have been decided.
The equivalence assessment conducted by the independent European authority must follow an objective-based approach, where the capability of the regime in the third country to meet the objectives of the EU Regulation is assessed from a holistic perspective. The analysis of the differences and similarities has been conducted as factually as possible. The advice has to be based on factual assessments but has also taken into account the analysis of the consequences for the stability and protection of EU entities and investors that an equivalence decision would have in those specific areas where the legally binding requirements are not considered equivalent.
The draft differentiates between VM and IM. For VM, article 1VM provides for a delay of 3 days to collect margins when the delay is reduced to 1 day for IM and for VM in case of absence of IM. The time schedule is not practical: we reckon that it is possible to calculate on D+1 (i.e. one day) the valuation of the positions and the amount of margin to be collected or posted; that being done, it is important to reconcile this amount with the counterparty and to accept it; afterwards both firms have to agree on eligibility, haircuts and diversification in the case of securities collateral before giving instructions to post or collect collateral; all of that can lead to an instruction at the end of the day and, allowing for time zone differences, to a settlement in the following couple of days. D+1 is too short in practice, except if it is considered as the delay to calculate, reconcile and instruct, knowing that a technical delay will apply to effectively deliver or transfer cash or securities. In such a case, it will nevertheless be very tight and demanding when divergences appear and models and data have to be discussed between experts.
We would like to outline that the D+1 time schedule will lead the counterparties to exchange cash only to satisfy IM calls. Excluding securities from the IM isn’t efficient neither from a risk nor from a business perspective. Instead of D+1, having a D+2 business days period for posting margin could procure flexibility to the parties and preserve the derivatives market from systemic risk.
AFG considers that the common practice on the market is to assess risk according to sensitivities to the applicable risk factors.
We recommend with the intention to reduce disputes and related settlement delays on collateral that asset managers be granted the possibility to negotiate, on a bilateral basis and to implement upon mutual agreement alternative methodology for the purpose of collecting collateral. We further agree that revisions and modifications of their internal models should be announced and explained by counterparties ahead of time with a possibility to discuss them and get a fair account of the rationale and consequences of these changes in methodology or principles.
When the manager concludes an OTC derivative, he knows that there are 4 levels of risk :
- The risk of the underlying and its volatility which should eventually make the profit or loss of the position
- The counterparty risk that may jeopardize the expected profit if the counterparty cannot pay
- This CP risk is mitigated through collateral, be it variation margin calls or IM; the third level of risk relates to the accessibility to the collateral and its value and easiness to sell on the market (high quality and liquidity tests)
- This risk can be mitigated through appropriate haircuts and diversification but could not be completely eliminated.
The impact of the diversification is remote from the initial risk and it should be given its appropriate level of significance.
With regard to funds, it is not appropriate to refer any limit to a percentage of the collateral. The relevant amount is the asset under management which is the basis for risk taking and is far less volatile than the collateral. From a practical point of view it is a nightmare to require eleven different issuers for collateral that will amount to a couple of millions or even less. This is about the size of collateral in the vast majority of funds. ESMA published in December 2012 guidelines on ETF and other UCITS issues where it asked for diversification of collateral and introduced the figure of 20% per issuer with reference to the total asset of the UICTS. The lack of threshold made this regulation burdensome and disputable in terms of financial stability but nevertheless it proved workable thanks to the reference to AUM to calculate the percentage.
Equity funds have only equities in their portfolios. The suggestion to limit the collateral that can be posted or collected to 40% in equities will make it very difficult for them to sign OTC derivative contracts. It is an unexpected and hopefully unintended consequence of the proposed RTS and we strongly oppose this view. The 40% limit is also a major issue also for funds of funds. This type of funds held shares of other funds that could not be UCITS. For that reason, funds of fund won’t be able to comply with the diversification limit that will prevent them to enter into OTC derivatives. Funds of funds should be allowed to transfer share of non UCITS funds provided these non UCITS are compliant with 5 LEC (a) and (b).
With regards to mandates and multi-delegated funds, AFG would highlight that it would not be feasible operationally for an asset management company to calculate group consolidated eligibility thresholds on behalf of its clients as we would not have access to the global investment portfolio. There is also to be mentioned the case of a mandate signed with several asset management companies.
AFG would also highlight that some investors could have to use derivatives only in specific country or monetary area and that the entity could hold only domestic assets for risk, accounting or regulatory constraints. In that case, to respect some diversification rules, the investor will have to monetize part of its assets through repo to post IM in cash and will so increase its leverage and the interconnectedness.
From a general perspective, AFG would strongly highlight that despite large diversification of eligible assets for collateral, banking regulation (Basel 3) favors use of cash collateral for Initial Margins (no netting recognized between expected current and future exposures for non-cash collateral IV and VM) which could increase systemic risks in the financial system.
By forcing counterparties to impose asset managers the use of cash collateral, the banking regulation would increase the use of repo by asset managers and will also increase the banking risk in funds and mandates as, except if the IM could be posted to Central Bank (with appropriate segregation infrastructure at Central Bank level) at a punitive remuneration rate, the investor keep the risk of default on the bank where the cash is posted.
AFG insists on the necessity:
1. To suppress the limitation of 40% on the total of equities as it is a limitation of eligibility which is contrary to level one text more than a measure of diversification.
2. To suppress diversification rules for mandates, multi-delegated funds and for partial delegation concerning funds.
According to the draft of RTS, “counterparty shall perform an independent legal review at least on an annual basis in order to verify the legal enforceability of the bilateral netting arrangements and always be able to provide documentation supporting the legal basis for compliance of the arrangements in each jurisdiction”.
We would like to highlight that obtaining an independent legal opinion on the effectiveness of the netting arrangements would result in an onerous process.
The netting mechanism are, most of the time, included in the standard derivatives documentations in place between derivatives counterparty (such as ISDA or FBF standard documentation) meaning that the enforceability of these derivatives documentations from a netting perspective can rely on the legal opinions issued by these associations (ISDA or FBF).
For instance, the scope of the ISDA opinions address the enforceability of the termination, bilateral close-out netting and multibranch netting provisions of the 1992 and 2002 Master Agreements. Opinions are updated annually to comply with requests from various central banks. In addition, ISDA also solicits legal opinions on the enforceability of the ISDA Credit Support Documents in various jurisdictions, also updated on an annual basis.
It could be beneficial for all market participants if these RTS could consider as sufficient to rely on these standard opinions as they offer satisfactory level of independence.
In addition, as per our response in question 3, we believe counterparties should have the right on a bilateral basis to agree on a methodology to determine pricing and IM for the determination of the collateral amounts to be posted with respect to IM and VM and that such methodology shall be documented accordingly.
The segregation of IM is of paramount importance in AFG’s view in order to best ensure investors protection. However the segregation of cash which is fungible by nature is a tricky concept and we see the possibility to establish individual accounts for different purposes for a same fund, we do not believe that this money will be protected in case of insolvency of the depository. We need the RTS to be workable and to clarify that individual segregation for cash does not mean bankruptcy remote, which a further motive to impose strict limitations on the entities that can act as depository for funds. In addition, regulation should allow for bankruptcy remote solution for cash deposits (i.e. ultimately allow for cash do be deposited at central banks if possible).
We want to highlight that under French law, cash isn’t segregated from the assets of the custodian. This segregation should be achieved through specific ringfencing measures similar to the one already applicable to the French credit institutions. For that reason we propose to delete the obligation to segregate IM from the asset of the custodian as long as no further regulatory step is completed.
Regarding the need to obtain an independent legal review at least on an annual basis in order to verify that the segregation arrangements meet the requirements referred to in paragraphs 3 and 4 in each jurisdiction will clearly involve a lot of work and costs for both counterparties to derivatives transactions.
It would be really realistic to permit that these independent legal reviews can be internal provided it is carried out with sufficient independence.
Moreover, it would desirable, as it is already the case under article 39 of EMIR for the centrally cleared OTC transactions that the collecting party is in charge of this legal analysis validating the effectiveness of each type of segregation models.
AFG agrees that when cash is posted as initial margin, the collector should maintain it with a view to protect the collateral poster to whom it should be returned at the end of the transaction. We consider that the collected cash should be re invested in low risk liquid instruments. We think that the segregation out of its trade is essential.
Still, we would like to draw attention to the fact that constituting IM in assets rather than cash ensures better protection of collateral and enable to reduce systemic risk. Use of cash collateral for IM could be a factor contributing to systemic risk : although re-use of cash to protect IM collateral is permitted, re-use shall essentially be achieved through low risk liquid investments, namely short term banking deposits which overall will increase exposure to banks and interconnectedness.
Although the scope of instruments eligible instruments proposed for the purpose of collecting margins is large, banking regulation such as Basel 3 only allows for cash collateral to benefit from netting effects and capital relief. As a consequence, there shall be a strong incentive imposed by banking regulation to favor cash collateral for IM, and asset managers may experience difficulties in negotiating with their banking counterparties the possibility to use assets other than cash although the scope of instruments permitted by regulation is wider.
We believe banking regulation should allow for netting and capital relief for VM and IM posted in assets in order to avoid increasing requirements for cash deposits and increase use of repo for the purpose of collateral management which will ultimately increase systemic risk.
If not generated via repo, cash buffers mobilized for IM would penalize funds performances. To avoid such impact, asset managers may seek to gain synthetic exposure to assets via derivatives which would contribute to increase derivatives volumes and systemic risk as well.
As an alternative to the evolution of banking regulation on assets as collateral, we require that asset managers be granted on behalf the funds and client mandates effective possibility to access to central banks for repo and cash deposits, with appropriate segregation infrastructure at Central Bank level, to secure management of cash for the purpose of collateralization of OTC derivatives without increasing systemic risk.
For the re-use of securities collected as collateral, the recent discussion about the SFT regulation has shown that it is difficult not to presume the explicit agreement of the counterparty to re-use if a transfer of collateral was executed through a total transfer of property. Thus we accept the protective ban of any re-use as a good initiative but we are worried that it could create a problem of international competition and even playing field if this restriction is specific to the EU.
The concept of “transfer currency” is not defined by ISDA, its definition being left to the counterparties. It makes it difficult to assess the consequences of the proposed RTS in that subject. Anyway, the 8% additional haircut is in itself very penalizing. The more so because it simply applies to securities and not cash. We expect internal models will show a much lower impact for currency mismatch. As a matter of fact, currency movements are very sharp when specific events occur and in that case 8% might just not be sufficient to offer protection and they are very slow most of the time on a day to day basis. Calibration at 8% is far too high in our view, by 4 to 8 times. Furthermore, such a high percentage would incentivize counterparties to post securities denominated in the basis currency and might reduce their ability to provide highly liquid securities of very high quality.