Sovereign concentration rule to hit UK buy-siders

Rule set to expose investors to currency risks in derivatives transactions.

A controversial rule which will expose investors to increased currency risks in derivatives transactions has been rubber-stamped by the European Securities and Markets Authority (ESMA).

European non-cleared derivatives regulations are set to severely impact pension funds and buy-side traders handling sovereign debt on their behalf.

The sovereign concentration rule – first outlined in the European Systemic Risk Board’s report on sovereign debt exposures – will require large derivatives users to diversify their collateral across two sovereign bonds.

For UK-based asset managers this will mean posting another sovereign bond alongside GILTs which will introduce currency risk into the transaction.

“It really doesn’t make sense as you are being forced to introduce currency risk in the equation,” said Vanaja Indra, market and regulatory reform policy at Insight Investment.

“We are really scratching our heads to see where this has come from because usually there is a legitimate desire to mitigate risk by regulators when they propose rules.”

Under the new rules, a UK-based pension fund, for example, would use inflation and interest rate swaps to manage liabilities in sterling. So those users would typically hold UK GILTs and post them as collateral to support margins on derivatives contracts

With the proposed sovereign concentration rule, a large user of derivatives would not be able to do that once past a certain threshold, they would also have to diversify across two different sovereigns.

“The issue with the Sovereign concentration rules has always been a concern to us,” added Indra.

“I can see how for end-users in the Eurozone it makes sense because they have more than one sovereign issuer of government bonds. But not all 27 member states are in the Eurozone.”

New rules for non-cleared derivatives are enforcing stricter margin requirements for those products not being clearing through a central counterparty.

European regulators published their final draft rules on the requirement last week containing the controversial rule, much to the displeasure of the UK’s buy-side derivatives users.

“We have raised this issue with the regulators, and although it doesn’t just affect the UK, we are the largest users of derivatives, so we are being the most vocal,” added Indra.

“The gut feeling I am getting is that they are looking at this as a UK issue, therefore they have tried to make the rules work a bit better but fundamentally the issue is still there.

“They have tried to make the rules work a bit better, by saying the rule, only applies to initial margin and not variation margin. That’s an improvement as they have raised the bar on how the triggers work.”

The European Securities and Markets Authority (ESMA) submitted the final draft rules to the European Commission last week. The Commission now has to approve the final rules before they come into force.