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Association of Global Custodians, European Focus Committee

The members of the Association of Global Custodians’ (the “AGC”) European Focus Committee (the “Committee”) are grateful for the opportunity to provide comments in response to the second consultation paper issued by the European Supervisory Authorities (“ESAs”) on their Draft Regulatory Technical Standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 (the “draft RTS”). The members of the Association of Global Custodians are: BNY Mellon; Brown Brothers Harriman & Co; Citibank, N.A.; Deutsche Bank; HSBC Securities Services; JP Morgan; Northern Trust; RBC Investor & Treasury Services; Skandinaviska Enskilda Banken; Standard Chartered Bank; and State Street Bank and Trust Company.

The member banks of the Committee support efforts to reduce systemic risk in the OTC derivatives markets, including the ESAs’ initiative to adopt risk-mitigation techniques for OTC-derivative contracts that are not cleared by a CCP. However, we have noted the draft RTS proposals on treatment of cash collateral and wish to call to your attention our very significant concerns about them.

We understand that the ESA’s draft RTS were revised to permit cash collateral to be reinvested in other eligible collateral as agreed between two swap counterparties, however, the draft RTS require further revision to ensure cash collateral remains viable in the context third-party custodian arrangements.

The final Basel/IOSCO agreement on margin for uncleared derivatives pointed out, “the use of third-party custodians is generally considered to offer the most robust protection” for collateral posted in uncleared derivatives transactions. While not mandated by the ESAs draft RTS, we agree with the industry consensus that third-party custodians are likely to be the preferred alternative for protecting collateral posted by counterparties under the final RTS. We also regrettably agree with the emerging consensus that the draft RTS will make these third-party custody arrangements impractical if not impossible in practice.

Eligible collateral includes both cash and non-cash: third-party custody arrangements must be able to accept both types, as agreed by the counterparties. Furthermore, a critically important inherent attribute of non-cash collateral is that it, too, generates cash: dividends and income, proceeds from repayment of principal from maturing bonds, proceeds of repurchase agreements and proceeds of sale all are received into linked cash accounts held with the custodian. A custody arrangement inherently must be able to maintain holdings of both securities and cash, even in cases where “cash” collateral is not “delivered” by the collateral poster.

Securities held in custody are held “off balance sheet” in bankruptcy-remote custodial accounts. Cash, in contrast, is held either in specie or as a claim on a bank as a deposit: banks reflect deposit obligations as liabilities on their balance sheets. This cash can of course be invested as the swap counterparties agree, in which case the investment is removed from the balance sheet of the bank (no liability of the bank exists). This treatment of cash is common to all custody arrangements, including mutual funds, pension funds, etc., and is not limited to the swaps margin accounts that are the subject of the draft RTS.

Cash is held on deposit with a bank naturally equates to credit exposure to that bank. As suggested above, cash and other collateral placed with a custodian bank acting under a tri-party custody agreement provides additional protection because the custody bank will only move assets (including the cash) on receipt of proper instructions as agreed between the counterparties, rather than at the discretion of just one counter-party. These arrangements are widely used in the financial markets and among all kinds of participants in the industry: a key factor is the creditworthiness of the custodian bank, the integrity of its records and controls and the prudential regulation and supervisory framework to which it is subject. Custodian banks tend to be subject to the highest prudential standards, including those relating to leverage capital, risk-weighted capital, liquidity, large exposures/credit concentration limits, stress testing, living wills, and resolution planning.

In addition, institutional customers generally minimise cash left on deposit with the custody bank in order to manage credit exposure to the custody bank and to generate higher yields than is available on custody deposits. Custody banks have an interest in minimizing such deposits as well, due to the negative impact of such deposits on the bank’s leverage ratio and other regulatory limitations. It should be noted that a longstanding tool used to manage credit exposure to bank custodians is commonly referred to as sweep": end-of-day cash balances are "swept" for short-term investment in "off-balance sheet" investments such as money market funds and repo or in "on-balance sheet" investments such as interest-paying deposits maintained with other banks (i.e., banks other than the third-party custodian bank). We emphasise that, due to the inherent nature of cash arising in connection with securities accounts (as discussed above), it is not possible to “sweep” all cash to banks other than the third-party custodian bank.

The broader context is that a third-party custodian, who is not a party to the trade, has no economic interest in the derivative contract. The custodian’s sole purpose is to provide safekeeping of posted collateral. The custodian’s actions are dictated solely by the direction of the counterparties subject to the rules prescribed in the custody agreement, and it has no discretion over the collateral. Assets held by the custodian under a tri-party custody agreement, whether in cash or securities, are bankruptcy-remote from both the posting and collecting counterparties – the parties in interest to the transaction. The ability of custodian to protect the interests of both counterparties under the contractual custody agreement is one of the key factors in making third-party custody the preferred option for many collateral posters.

Our specific concerns regarding the unintended consequences of the draft RTS treatment of cash used as initial margin are set out below."
In both the direct model and the alternative model, a third party custodian or holder is likely to be involved in the arrangement (as described above). Such custodians will need to be adequately protected and incentivised to offer services in relation to IM arrangements and will need to charge fees for their services. A custodian would normally be secured by a custodial lien. Article 2 LEC (1)(g) (p. 40) and the Recitals should therefore permit custodial or third party liens and security interests. If all such liens or security interests are prohibited, there may be reluctance on the part of the custodians to provide the necessary custodial services to facilitate the posting of IM.
As noted above, because of the proposed treatment of cash used for initial margin, the members of the Committee believe that the draft RTS will make third-party custody arrangements impractical if not impossible in practice. The members of the Committee are concerned that the draft RTS do not properly accommodate the third-party custody business model: they seem to assume that conditions imposed on segregation by collecting counterparties can be applied without adjustment to third-party custodians. The draft RTS should take account of the important differences between cash and non-cash posted to third-party custodians so that cash remains viable as posted collateral and complications with no-cash collateral are prevented (since non-cash collateral generates cash, as discussed above).

In particular, the Members of the Committee urge the ESAs to clarify that cash posted with third-party custodians may be placed on deposit with the custody bank. Since such deposits necessarily result in credit risk to custodians, we also recommend that the ESAs require the collateral poster and the collecting counterparty to manage such credit risk by, for example, availing themselves of the option under 1 REU (2) to reinvest cash collateral in other eligible assets. (Some cash, as noted above, can be “swept” to third-party banks: similar to other EU legislation (such as UCITS) intending to protect investor or customer interests, therefore, provision should be made to permit deposits to be allocated to banks other than the third-party custodian bank as “eligible collateral”.)

Our specific concerns and recommendations on these issues, as well as several suggested technical corrections, follow below.


1) Clarify that cash accounts will hold all cash flows connected to posted collateral

Article 2 LEC (g) of the draft RTS requires risk management procedures of the collecting counterparty to ensure that cash accounts are maintained to accept “collateral collected as initial margin and for crediting the proceeds of repurchase agreements on the collateral.”

As noted above, cash flows connected to posted collateral could result from numerous sources in addition to the two referenced in Article 2 LEC (g), including dividends paid on held securities, payouts of principal on maturity of bonds, or other sources. The cash account established pursuant to a collateral arrangement must be able to accept cash from any of these sources. As a result, we recommend Article 2 LEG (g) be amended as indicated in the uploaded attachment.

2) Require the swaps counterparties to manage credit risk resulting from a bank holding cash collateral

The Members of the Committee acknowledge that the credit exposure resulting from placing cash collateral on deposit with a custodian should be managed by swaps counterparties. Generally, the management of such credit risk will be accomplished by reinvestment of cash collateral in other eligible collateral, as is common practice today, and is permitted by the revision of Article 1 REU proposed by the ESAs in the second consultation on the draft RTS. We suggest such risk management be addressed in the final RTS in a new section added to Article 2 LEC, as indicated in the uploaded attachment.

3) Clarify that cash maintained by third-party custodians may be placed on deposit

As described above, cash, whether posted margin or operational cash flows, held in third-party custody arrangements is placed on deposit with the custody bank. The draft RTS does not clearly reflect this practice, and fails to distinguish between the treatment of cash held by a collecting counterparty and cash held by a custodian. As a result, we suggest Article 1 SEG (3) be amended as indicated in the uploaded attachment.

4) Clarify that cash may only be reinvested by the custodian at the direction of the counterparties

New Section 2 of Article 1 REU helpfully permits cash collateral to be reinvested in other eligible assets upon agreement of the counterparties. This provision is consistent with current market practice, and will allow counterparties to minimize their credit risk to the custodian or collecting counterparty.

For a custodian, such reinvestment would involve facilitating the reinvestment of cash on deposit into other eligible securities. A custodian, however, would only do so at the direction of the swap counterparties, and not at its own discretion. We suggest clarification of the directed nature of the custodian’s duties, as indicated in the uploaded attachment.

5) Clarify differences between cash and non-cash collateral

As described above, the treatment of cash and non-cash collateral differs considerably under traditional custodial arrangements. In several instances, the draft RTS applies concepts suitable to non-cash collateral (i.e. securities) to all collateral, including cash. We suggest the draft RTS be amended to correct these inappropriate references, as follows:

A) Article 2 LEC (g) –

Section (g) of Article 2 LEC requires collateral to be transferable without regulatory, legal, or third-party constraints. This concept is entirely appropriate for securities collateral, but not consistent with cash placed on deposit, where the collateral holder is a general unsecured creditor of the bank. As mentioned above, the presence of such credit risk has led the Members of the Committee to recommend a specific provision in the RTS requiring counterparties to manage such risk. The requirement of Section (g), though, should be limited solely to securities collateral, as indicated in the uploaded attachment.

B) Article 1 SEG (1) –

Similarly, Section (1) of Article 1 SEG would require all collateral to be held in a manner which protects the collateral from default or insolvency of the custodian. As described above, cash held in third-party custody arrangements necessarily creates credit exposure to the custodian. Such exposures should be managed by the counterparties, but cash (either margin or operational) cannot be accepted by the custodian if no such credit exposure is permitted. Article 1 SEG (1) should be amended as indicated in the uploaded attachment.
John Siena
+442076148788