Institutional investors have urged European regulators to reconsider the types of collateral that will be acceptable under new OTC derivatives rules and have also raised concerns about clearing house stability.
Criticisms were levelled in response to a consultation by the European Securities and Markets Authority (ESMA), on the technical standards for the European market infrastructure regulation (EMIR).
Many buy-side firms warned ESMA’s proposal for central counterparties to require a minimum proportion of cash as collateral – to limit the pro-cyclical effects of haircuts on financial instruments – would damage clients.
“A cash requirement, if passed onto the end investor, would require a very significant proportion of investment portfolios to sell portfolio holdings to raise cash resulting in lower returns – and hence savings and pensions – for European citizens,” wrote BlackRock in its consultation response.
UK based buy-side trade body the Investment Management Association (IMA), whose members manage around £4 trillion in assets, added that cash would be most suited for use in meeting variation margin, rather than for initial margin, where it said lower-grade collateral should be considered.
“The list of eligible assets should include corporate bonds of high quality in addition to the assets mentioned by ESMA,” said the IMA.
Collateral standards
EMIR will require OTC derivatives to be standardised, where possible, so they can be centrally cleared and traded on exchange-like platforms. The formal clearing obligations of the new regime will require collateralisation of swap transactions with specific types of high-grade collateral – something that is not currently required under bilateral swaps deals.
ESMA, in conjunction with the European Banking Association and European System for Central Banks, is required to develop draft regulatory technical standards specifying the type of collateral that could be considered highly liquid and therefore suitable for use against swaps exposure.
While ESMA has mentioned that gold and commercial bank guarantees may be suitable as collateral, Insight Investment, a UK-based asset manager owned by BNY Mellon, said it did not consider these assets to meet EMIR’s requirements of “highly liquid collateral with minimal credit and market risk”.
Investors also queried ESMA’s CCP-centric approach for deciding eligibility of OTC instruments for central clearing. Under EMIR, CCPs will be responsible for deciding which instruments are best suited for central clearing under a so-called ‘bottom-up’ approach.
“We note that there are no specific criteria addressing whether counterparties are operationally ready to clear certain classes of derivatives,” said the IMA. “The focus appears to be on the readiness of CCPs. CCPs do not operate in a vacuum.”
Stability doubts
A number of organisations, including French asset management body the Association Française de la Gestion Financière (AFG), proposed that clearing houses should be identified as ‘systemically important financial institutions’ (SIFIs).
“The mandatory usage of CCPs will reduce the diversity of counterparties and may increase the risk if CCPs are not totally safe for investors…we would appreciate that CCPs be identified as SIFIs, with specific capital requirements and controls that it implies, and have access to central bank money,” it said.
But BlackRock added that of a “small number” of CCPs, would ensure buy-side costs are kept low and limit the inefficiencies caused by excessive liquidity fragmentation.
There was also some disquiet among investment managers at the low level of buy-side engagement within ESMA’s consultation.
Trade body the European Fund and Asset Management Association (EFAMA), argued that “there is no recognition of the agents/fund managers and other intermediaries acting for clients roles and responsibilities and the only focus would seem to be on the position of CCPs”.
For instance, EFAMA said that issues around haircuts and eligible collateral rest solely on the interpretation and model applied by a CCP.
“Given the wide range of market participants, perhaps ESMA could consider who is the client and who is the service provider as opposed to who is financial or non-financial,” added the Association of British Insurers in its response.
ESMA will now write EMIR’s 30 final draft technical standards. The watchdog will then hold a further, more detailed, consultation during the summer before sending its final technical standards to the European Commission for approval, expected in September. Implementation of EMIR is currently scheduled for the start of next year, as per guidelines laid out by the Group of 20.