Sandy McFadzean of Catalyst explores the areas of the ESMA consultation paper on OTC derivatives regulation that will have the greatest impact on market participants. (Comments from Catalyst Report “Synopsis of EMIR & the ESMA Technical Standards”)
Q. 1 You highlight the paper’s proposals of client of client or ‘indirect’ client clearing as potentially controversial. Can you explain what the paper states and why the wording may cause concern?
The new EU Regulation, European Market Infrastructure Regulation (EMIR) talks about ‘indirect client clearing’, but the legislators left it to European Securities and Markets Authority (ESMA), the European ‘super-regulator’, to define exactly what it means. Now, in their recent consultation paper, ESMA goes a little further than just specifying the arrangements. They’ve created a mandate for clearing members to provide indirect clearing whereby clients of the clearing members would be able to clear for their own clients. Indirect clearing adds another link in the ‘clearing chain’. While not in itself controversial, the wording is odd: it states that all central counterparty (CCP) clearing members will be mandated to offer this indirect client clearing service, whether or not they offer normal ‘direct’ client clearing services, which is not itself mandated.
In other words, even the clearing members who do not intend to offer client-clearing services will be mandated to offer indirect clearing services, which doesn’t make much sense. Even if we assume that the mandate implicitly only applies to clearing members who elect to provide client-clearing services, it’s still significant that these firms are also mandated to offer indirect clearing services, which they may neither want, nor be able, to do.
Looking at the primary text, we can deduce that the intention behind this mandate is to make sure all counterparties have access to clearing. Indirect clearing would enable Tier 2 banks to clear for their clients without becoming a clearing member of a CCP, so there would be a wider range of banks able to offer client clearing services. The aim may also be to try to prevent any perception of regulators favouring larger banks, alleviating competition objections from smaller banks that fear they may lose execution clients to larger firms who can also offer clearing.
But there is a danger of unintended consequences that may do exactly the opposite. Some banks may be dissuaded from becoming CCP members or, if they do, from offering client clearing services because they would also have to offer indirect client clearing. When you dive into the technical aspect of indirect clearing it appears to force the clearing member to take on the credit risk of the indirect client, yet at the same time the clearing member is prevented from having full disclosure of who that client is. This isn’t a position many banks want to be in, so some may withdraw from clearing altogether. Many industry participants have raised this concern, and industry associations including The International Swaps and Derivatives Association (ISDA) and The Association for Financial Markets in Europe (AFME) have communicated detailed concerns to regulators.
Q. 2 What does the ESMA paper state about clearing obligations and what are the potentially problematic elements of what is proposed?
The EMIR ‘primary text’ creates the Clearing Obligation in line with the G20 Leaders’ statement calling for CCP clearing of OTC derivatives. The regulation also defines the ‘Clearing Obligation Procedure’ – the process by which products become eligible for central clearing.
ESMA has specified two separate processes that can trigger the clearing obligation for a particular product: the ‘bottom up’ and ‘top down’ approaches.
The bottom up approach is where a CCP choosing to clear a particular product applies for authorisation to do so via their regulator. ESMA then reviews the application and decides whether or not the clearing obligation applies. The likely result is that the product will become eligible for mandatory clearing after a period of consultation. Obviously this process does not allow for overall clarity on the timing of the mandate nor the order of adoption of products.
The top down approach could be considered more controversial if you read that it implies that regulators would decide what products a CCP should clear. Most participants would query whether this is a good thing. In fact the wording of the technical standards text states that ‘no CCP will be forced to clear a product that it is not able to manage’ but does require ESMA, on its own initiative, to identify derivatives products that should be subject to the clearing obligation but for which no CCP has yet received authorisation. Exactly what happens next is unclear. ESMA is supposed to issue a ‘call for development proposals for the clearing of those classes of derivatives products’. The nature of this call, and the level of coercion that regulators can apply if no CCP responds, isn’t made clear.
The inclusion of the top down approach in the paper creates a mechanism, albeit not a fully formed one, for ESMA to influence the selection of products by CCPs, which may help prevent products being overlooked.
The level of uncertainty in the timeline and in the extent to which regulators can force the clearing of products, makes it very difficult for market participants to understand when and how to make investment decisions in order to comply with new obligations. The regulators can ease this problem by offering more certainty around the phasing and timeline for products to enable cost conscious participants to allocate their investment in the most efficient way.
Q. 3 What does the ESMA consultation propose around exemptions of corporate and non-financial organisations for CCP clearing obligations and are there areas of the proposal which may cause concern to market participants?
One of the exemptions from the clearing obligation is for non-financial counterparties, such as corporate treasuries, who trade derivatives to hedge business risk. ESMA has introduced a ‘Clearing Threshold’ – a limit to the gross notion of the derivatives positions that are not ‘objectively measurable as risk reducing’. This is a mechanism to guard against the abuse of the exemption, for example to prevent a speculator from setting up a corporate entity whose sole purpose is trading swaps, avoiding the need to clear.
We don’t think anyone has an issue with the principle of the threshold but there are a number of areas where we question the specific ways it is being implemented. For example, the metric being used – gross notional – isn’t necessarily a good measure of the risk of the portfolio. The mark-to-market of the portfolio may be a more sensible way of setting the limit.
Another area of concern is how to identify the trades which are risk reducing and who is ultimately responsible for reporting breaches of the threshold. Non-financial entities may not be regulated by the financial authorities who would therefore have to rely on banks to police their clients. Yet it’s difficult to see how the bank can be held responsible without an overall view of the non-financial counterparty’s portfolio. Banks would presumably have to rely on assurances from their clients but those clients are not likely to have the complex technology required to carve out risk reducing trades from non-reducing trades.
Though the principles here seem sound enough, we think the practicalities still need to be ironed out.
Q. 4 And what about the pension fund exemptions as stated in the ESMA paper?
For three years after EMIR’s entry into force, the clearing obligation will not apply to OTC derivatives entered into by pension funds for hedging purposes. The thinking here is that pension funds are investors, and don’t hold a lot of cash. Most clearinghouses do not currently accept non-cash collateral against variation margin. Forcing funds to liquidate their investments or otherwise raise cash may reduce their return, and hence hurt pension savers. This is an unpalatable scenario for regulators but nevertheless they have shied away from an outright exemption. The purpose of the temporary derogation is to allow time for technical solutions to be found allowing pension funds to post non-cash collateral to cover variation margin.
Q. 5 What are the areas of concern with regards to the proposals for the calculation of initial margin as identified by ESMA and potential impact on the market?
EMIR identifies three quantities to be used calculating initial margin: percentage confidence level, time horizon for historical volatility and close-out period. They have specified minimum values for these, which may be controversial. The confidence level, for example, for OTC derivatives is mandated at 99.5percent. Our understanding is that the equivalent in the US is 99percent. What we are hearing from risk experts is that this half point makes a considerable difference and could make European CCPs less competitive than CCPs elsewhere. In our opinion, the appropriate figure will vary by product: in some cases 99.5percent or higher is appropriate, but a ‘one size fits all’ figure is not the best way to ensure either good risk management or a level playing field internationally. We suggest it would be better, to leave such decisions to qualified risk managers in CCPs themselves.
The global OTC derivatives market needs harmonised regulation globally, in the spirit of the G20 leaders’ statement. In general, not all OTC derivatives are alike; there is a wide spectrum of products and not all solutions are appropriate for all classes of derivatives. In short, one size does not fit all. So, we would suggest that it is best left to the market to devise solutions to support the right products, within a regulated framework.
Q.6 ESMA calls for the clearinghouses to have some skin on the game going forward? Is this an idea well supported by the market participants and are there any concerns about what is proposed?
EMIR specifies the default waterfall within a CCP, in other words the order in which different layers of protection should be used to cover the losses of the CCP when a member defaults. The waterfall structure starts with the initial margin of the defaulting counterparty. If this runs out, then the default fund contributions of that defaulting counterparty are used. Only when the defaulting counterparty’s resources are exhausted can the CCP use the other members’ resources in the form of the mutualised default fund. In order to incentivise the CCP to get the balance right in terms of initial margin versus default fund contributions, members generally prefer the CCP to have some ‘skin in the game’ by having a layer of CCP capital available to be used before they, the members, start taking losses. Regulators also like this structure, and the incentives for CCPs to manage risk appropriately, hence it mandating in EMIR. In the technical standards ESMA has specified 50 percent as an appropriate amount of equity capital, to be reserved for this purpose.
Generally we would expect broad support from market participants for this measure, which will mitigate concerns around a ‘race to the bottom’ in risk management if CCPs are incentivised solely on winning business. However, the 50percent level does seem high. For example, in a multiple default scenario where 50percent is used for the first, there is a much reduced amount available for subsequent defaults. Such a high figure could be perceived as contributing to CCP default risk during market stress, which defies the whole point of having the clearinghouse in the first place. Mechanisms for capital replenishment by shareholders are necessary, but the 50percent level could create a significant, and potentially unlimited, liability on shareholders during times of stress.
Various suggestions have been mooted around the industry. One CCP has suggested that 10percent of the equity capital is appropriate. It is important to remember that CCPs generally will not have that much capital of their own, despite their often huge balance sheets. They are not capitalised by their shareholders, in the same way that a normal company would be, so this isn’t about the CCP finding resources to have a material effect on loss absorption, It about incentivising behavior pre-default.
Overall, our understanding is that many market participants would support 10percent. It is sometimes the members themselves that are the shareholders, so this is all about incentivising the CCP management to manage risk effectively – which is of course the fundamental function of central clearing.
Q. 7 The ESMA paper also dictates investment policies for the assets CCPs will hold. What does ESMA propose in the consultation paper?
CCPs take large amounts of collateral in the form of cash. It would make little sense for this cash to be held as unsecured bank deposits – the credit risk would just be transferred to the deposit bank – so, CCPs must secure cash away from the banking system. This is usually achieved through outright purchases of high credit quality securities, or reverse repo transactions backed by those securities. The issuers, maturities and quantities of the securities that can be used for this purpose are defined in the CCPs’ investment policy. This is the policy that the regulators are seeking to specify, basically limiting eligible securities to quite a small set of assets, which are perceived to be the safest. One of the drivers for this is to prevent CCPs from taking too much risk in their investments to generate return. The flip side is that policies that are very restrictive could limit return too much, increasing the cost of clearing. There is already concern in the market that the demand for high quality securities for collateralising cleared OTC derivatives could squeeze liquidity. Restricting CCP investment policies too much could aggravate this problem.
Q. 8 Do you have any recommendations as to the best solutions for some of the issues raised?
The most important outcome is that the right measures are put in place for the right product types and that those measures are equivalent across different jurisdictions. Regulators need to be conscious of the spirit of the G20 leader’s statement that there should be global consistency in its implementation. Market participants need to provide constant feedback, evidenced with data where possible, to help regulators reach the conclusions that will ultimately drive regulation down a workable path. Ultimately, collaboration is absolutely crucial.
