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EFAMA Response to ESMA Discussion Paper on UCITS OTC

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EFAMA Response to ESMA Discussion Paper on UCITS OTC EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations (ESMA/2014/876) EFAMA is the representative association for the European investment management industry. EFAMA represents through its 27 member associations and 63 corporate members almost EUR 17 trillion in assets under management of which EUR 10.6 trillion managed by 55,000 investment funds at end June 2014. Just under 36,000 of these funds were UCITS (Undertakings for Collective Investments in Transferable Securities) funds. For more information about EFAMA, please visit www.efama.org Preliminary Remarks EFAMA welcomes the opportunity to respond to the ESMA Discussion paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations (ESMA/2014/876). We understand that the contributions sought will concur to refine the “working assumptions” presented in the discussion paper in view of a further consultation and possibly further recommendations to the European Commission for amendments to the relevant parts of the UCITS directive. Considering the clearing options potentially available to UCITS as “financial counterparties” under EMIR - i.e. (i) become a direct member of a CCP, (ii) become client to a Clearing Member (CM), and (iii) enter into an indirect clearing arrangement – and the prevailing market practices, we acknowledge that, at this stage, option (ii) is certainly the most viable one. Already in its revised Q&A on Risk Management and Calculation of Global Exposure and Counterparty Risk for UCITS in December 2013, we took note of ESMA’s choice to not be too prescriptive on the clearing model chosen by UCITS and the recent discussion paper further reflects this by well illustrating the pros and cons behind direct and indirect clearing arrangements. By replying to this discussion paper, EFAMA would also like to emphasise that from a strict UCITS fund’s perspective there is a significant difference between bilateral OTC and the central clearing environment proper of a CCP. The former is clearly easier to monitor, whereas with trades cleared through a CCP the number of operations to be monitored increases significantly implying, inter alia additional operational and transfer risks that greatly complicate the task of reducing UCITS risk exposures down to a specific percentage term. Furthermore, in a bilateral OTC environment, UCITS funds would pay no upfront initial margin, where the only collateral being posted takes the form of variation margin, alongside minimum transfer rue Montoyer 47, B-1000 Bruxelles +32 2 513 39 69 Fax +32 2 513 26 43 e-mail : [email protected] www.efama.org 2 EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations amounts. On the other hand, with central clearing (and subject to the relevant clearing thresholds), costs are certainly to rise given the need to deal with multi-party (initial and variation) margin requirements and more in-depth risk analysis, confirming the difficulty of reducing UCITS risk to a precise percentage term. More broadly, agreeing that by moving OTC derivatives to central clearing can better address market-wide risks, EFAMA would additionally like to highlight that it is the responsibility of regulators and supervisors to ensure that CCPs are well-capitalised, that their risks is well-managed and that their recovery and resolution are adequately addressed, while continuing to grant access for UCITS to derivative markets through a large definition of eligible collateral in line with the relevant recent ESMA Guidelines1. With regard to possible future amendments to the UCITS directive as envisaged in the discussion paper, EFAMA would also like to re-iterate the need to urgently review the relevant paragraph - §43, letter j) - of the ESMA Guidelines on ETFs and other UCITS issues, as last updated in August 2014. In this regard, a majority of our Members deems that the prohibition to re-use cash collateral as margin – not included in the limited uses prescribed under the aforementioned paragraph – would seriously hamper the benefits of central clearing for UCITS funds by further restricting the choice of “highly liquid” collateral to be posted under a CM/CCP agreement2. Other issues that would require further clarification from ESMA, always in the light of possible revisions to the UCITS directive, include the application of the directive’s Article 52 counterparty risk limits to a U.S. CCP (based on an “agent” clearing model and different from the “principal to principal” one assumed in the discussion paper), as well as close-out requirements (i.e. whether a UCITS will be effectively able to close, sell or liquidate a derivative position at a “fair value” at any time – under Article 50(1)(g)(iii) of the directive – vis-à-vis a U.S. CM). Responses to the questions 1. Do you agree with the working assumptions above? We agree with ESMA’s working assumptions that the limits under Article 52 of the UCITS directive should be considered in the light of a potential default of a CM (or even of a client of a CM in the case of an indirect clearing arrangement), rather than that of a CCP itself. It is our view that direct exposures to the latter present a negligible level of risk and that, accordingly, the relevant UCITS risk limits under Article 52 of the directive should not apply. 1 See ESMA Guidelines on ETFs and other UCITS issues (ESMA/2014/937), available at: http://www.esma.europa.eu/system/files/esma-2014-0011-01-00_en_0.pdf 2 In this regard, please also refer to EFAMA’s reply in September 2012 to the ESMA Consultation on recallability of repo and reverse repo arrangements: http://www.efama.org/Publications/Public/UCITS/12- 4043_EFAMA%20reply%20ESMA%20consultation%20on%20the%20treatment%20of%20repo%20and%20rever se%20repo%20agreements.pdf 3 EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations 2. In particular, do you agree that UCITS should regard the counterparty risk of all ESMA-recognised CCPs as being relatively low? Are there some ESMA-recognised CCPs for which counterparty risk may not be low? If so, please explain. Yes, we believe that the counterparty risk of ESMA-recognised CCPs is and will remain low, if not null, given that a UCITS typically has no direct trading exposure to a CCP and where the latter's resilience is enhanced via margins, capital requirements, risk management framework, etc.3 . As a matter of note, recognised non-EU CCPs (and a fortiori those non-recognised non-EU CCPs) will inevitably be governed by a third-country resolution regime that could imply additional legal risks in the event of a failure. Also, risk conditions may change where responsibility for CCP resolution is extended beyond that CCP’s members. We would therefore caution against the extension of the responsibility for CCP resolution to UCITS investors and where UCITS funds are clearing by abiding to their regulatory obligations under EMIR. There may be isolated cases where a UCITS becomes a direct counterparty to an ESMA-authorised CCP, provided that the relative asset management company meet the necessary requirements to register directly as a CM with the relevant CCP. Overall, however, it is safe to assume that –for a UCITS - the above requirements would be overly costly for the choice to make business sense. 3. Do you think that UCITS should apply any counterparty risk limits to ESMA-recognised CCPs? What should be the limits? No, we do not believe that the UCITS counterparty risk limits under Article 52 should apply. There is no requirement at present to have limits vis-à-vis clearers for ETD trading, so we do not see why such limits would be required for CCPs which clear OTC derivatives. If limits were to be applied to such CCPs, this would result in a number of issues, e.g. the loss of effective margining, the need to have relationships with more CCPs, and possibly even force the UCITS to use untested clearing institutions. 4. Do you agree that the assessment of counterparty risk vis-à-vis the CM and the client should distinguish between the different types of segregation arrangement? If not, please justify your position. Yes, we agree with the above statement, bearing in mind that ensuring adequate client asset protection is of paramount importance to UCITS funds, especially from an investor protection standpoint. In this respect, it is important to ensure that each and every authorised CCP offer CMs the option of full individual client segregation packages4 and that each and every authorized CM offer the option of full individual client segregation packages to UCITS funds, alongside their offer of omnibus 3 In this regard, please refer to the delegated regulation 152/2013 of 19 December 2012, supplementing EMIR concerning technical standards on capital requirements for central counterparties. 4 Because the notion of “individual client segregation” under EMIR regulation is imprecise and can therefore lead to different interpretations across European countries and/or CCPs, EFAMA would note that individual client segregation consists in allowing for a cash and securities account of a clearing member to be opened for the account of a UCITS, or a UCITS compartment, within the CCP. This structure offers real portability to the UCITS. 4 EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations legally segregated, but jointly managed assets. The former type of segregation would ensure the portability of a UCITS client’s positions in the event of a CM’s default, as well as ensure the protection of the client’s margin collateral per single fund (including that of eventual sub-funds) that is ring-fenced from that of the CM and from that of its other clients.
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