EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty by UCITS for OTC financial derivative transactions subject to clearing obligations (ESMA/2014/876)

EFAMA is the representative association for the European 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 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 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 , where the only collateral being posted takes the form of variation margin, alongside minimum transfer

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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 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. Another important point in our view is that the use of individual client segregation should come at little or no additional cost to the end-investor, although difficult and likely to be disproportionate compared to the additional layer of protection implied5.

Of the different types of segregation arrangements presented in the discussion paper and although the advantages of the individual segregation model are easy to see, the latter may not work for specific asset classes, e.g. exchange traded futures. Also, another aspect to look more into when choosing the appropriate segregation for UCITS is the protection of client money.

Certain EFAMA Members have moreover encouraged either ESMA or the National Competent Authorities (NCAs) to clarify which of the available segregation models implies lower risks for UCITS, thereby removing the incentive for certain managers to choose the cheapest over the safest segregation model. To a certain extent, some CCPs may be open to discuss changes in their structures, as well as a possible tailoring of their offer to meet the needs of the buy-side. However, it is important to bear in mind that, in the vast majority of situations, these offers should increasingly come from the CMs as they in the majority of cases are the natural counterparties to UCITS funds.

The individual segregation requirement would also impose itself from an accountancy perspective with regard to compartmentalised sub-funds, i.e. it would be illegal if for instance a bond-only sub-fund was used to source collateral for the needs of another sub-fund investing in high-yield debt (i.e. no cross- subsidisation between funds or sub-funds thereof).

5. When assessing the counterparty risk for centrally-cleared OTC derivative transactions, do you think that UCITS should look at other factors than the segregation arrangements? If yes, what are those factors?

Apart from the type of segregation arrangement, the UCITS manager may also want to consider other factors like for instance (i) the market model of the chosen CCP (although in most cases the UCITS does not have the CCP as its direct counterparty, the U.S. “sponsored principal” or “agent” model remains the exception; e.g. ICE); (ii) that the model allows for segregation at the sub-fund level (i.e. in the case of UCITS “umbrella funds”); (iii) the specifics of a CCP’s rulebook that may lead UCITS managers and their CM to amend their mutual clearing agreement; (iv) the specifics of the clearing agreement (e.g. concerning the treatment of over-collateralisations at the CM level and margining requirements); (v) the availability and recognition of additional provisions governing the termination of credit derivatives; (vi) any relevant provisions of the local legislation/regulation applying in case of the CCP’s or the CM’s

5 We acknowledge however that individual segregation packages will inevitably entail higher costs for UCITS in terms of higher collateral requirements and of greater operational complexity, including more frequent intra- day margin calls. 5 EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations

insolvency; and (vii) the CM’s financial strength, business model and collateral management capabilities. We encourage ESMA to therefore consider the actual level of counterparty risk in this broader context, aside from pure segregation factors.

6. Do you agree that under an individual client segregation UCITS have a low counter-party risk vis- à-vis the CM for all the assets posted (initial margins, variation margin and excess margin if applicable)? If not, please justify your position.

Yes, we agree with the above. Additionally, we feel that it is important for excess margin to be afforded the same protection as initial margin and variation margin under this scenario.

7. Do you think that UCITS should apply any counterparty risk limits to the CM under individual client segregation? What should be the limits?

We do not think that a UCITS should apply counterparty risk limits vis-à-vis the CM under individual client segregation; otherwise, this would limit the amount of clearing that a CM would be able to undertake for the UCITS. The same principles should apply to AIFs as well. Additionally, Individual segregation implies that all assets will be deposited with the CCP and that none will be kept by the CM, including excess margin.

8. To what extent do you think that the liquidation of derivative positions by a CCP in respect of a defaulting CM (and the associated ) is a significantly likely scenario that should be taken into account by the UCITS?

We believe that there should be a distinction between the default of a UCITS derivative counterparty and that of the CM. With regard to the latter instance, the risk to the UCITS would very much depend on the availability of alternative CMs with an offer to clear the same type of product, thereby ensuring portability; as well as on the recovery of the UCITS’s collateral to re-establish its positions and the development of robust, tried and tested portability arrangements to move from a defaulting CM to a new CM. Depending on the segregation model, the collateral may not always be available, depending also on whether its nature is cash or securities. In the first case, cash collateral carries greater risk of not being returned. We note, however, that whilst being mindful of this situation, there would need to be significant market dislocation for such a scenario to arise.

9. Do you agree that UCITS should apply the same counterparty risk limits to CMs under individual client segregation for both OTCs and ETDs? If not, please justify your position.

We do not believe that the counterparty risk limits should apply to either ETDs or to OTC centrally- cleared derivatives under individual client segregation. As ETDs are cleared through an exchange where delivery-versus-payment (DVP) also applies, qualitative controls in terms of risk management should apply instead of the quantitative limits. On its part, central clearing for OTC ensures the same architecture as for ETDs, with UCITS managers applying the same qualitative risk control measures in selecting their CMs and CCPs as for ETDs. We deem, however, that setting up individually segregated 6 EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations

accounts with a CM for clearing OTC trades would much depend on the available offer and imply higher costs.

From an operational perspective, the prescribed move from bilateral to the central clearing of OTC contracts, however, poses some difficulties for the application of the 5%-10% limits in the UCITS directive: there is a limited number of CCPs that may be available to clear a specific kind of contract; the application of the maximum exposure limit of 20% vis-à-vis the same body would oblige the UCITS to diversify across several CMs, proving both difficult and costly to manage (i.e. in terms of collateral requirements – initial and variation margin – to be posted to more than one CM)

10. Notwithstanding the choice of segregation model, do you believe that the effective level of protections and degree to which the UCITS will be exposed to counterparty should be assessed on a case-by-case basis?

Yes, as there can be different versions of segregation models that may warrant different actions, specifically with regard to the use of omnibus segregation structures. Our suggestion would be for ESMA to establish a set of criteria for managers to assess the risks under different segregation models, allowing them to implement those models that, in line with their business strategy and market conditions, allow them to determine the margin at risk and then decide on limits accordingly in line with their end-clients’ needs.

Also, market authorities responsible for the authorisation and ongoing supervision of CCPs should provide asset management firms, as well as other market actors, with sufficient information around the risks they face through a CM when clearing with a specific CCP. A further step could even consist in determining exposure limits for all UCITS funds exposed to a given CCP on the basis of the chosen segregation model that is offered.

11. Do you agree that, under an omnibus client segregation, UCITS have a higher counterparty risk vis-à-vis the CM than under an individual client segregation? If not, please justify your position.

Compared individually against each other and when it is a full omnibus account (i.e. all the assets of all the clients of the CM are managed jointly), our answer is yes, as the UCITS will be exposed to the default of both the CM and the clients of the CM. However, there are numerous sub-types of omnibus accounts and risks may vary somewhat from sub-type to sub-type, where some may offer comparable protection to individual client segregation. Again, in line with our reply to Question 5 above, we would encourage ESMA not to look at segregation models in a vacuum, but also account for the aforementioned risk mitigating factors.

12. Do you agree that UCITS should be subject to counterparty risk limits to the CM under omnibus client segregation? If yes, do you agree that UCITS should apply those limits to the amount of collateral posted to the CM (i.e. initial margin, variation margins and excess collateral if applicable)? What should be the limits?

7 EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations

Yes, counterparty limits should apply, although these would depend on the kind of omnibus segregation model sub-type. ESMA should in this respect consider that a “one-size-fit-all” approach is not desirable. We believe that the limits should not be the same as the counterparty limits for UCITS, as these would not be practicable, especially in the light of the limited availability of CMs able to clear specific derivative contracts. Due to the EMIR requirements to have a second CM to ensure portability and the related costs to implement the EMIR model and contracts, we are of the opinion that only a second CM should be required. Consequently, those counterparty limits should be adapted to meet the requirement between 100 and 50% (the 100% could occur during a period of time required to negotiate a new CM relationship after the default of one of the initial ones).

13. Do you agree that UCITS should be subject to the same counterparty risk limits to CMs under omnibus client segregation for both OTC derivatives and ETDs? If not, please justify your position.

Where UCITS have opted for omnibus client segregation with their chosen CM and in line with our reply to Question 12 above, the relevant counterparty risk limits should apply to OTC trades. The same should apply in general to ETDs, with the caveat that – in line with the wording of the CESR advice (CESR 10/788)6 - such limits not be applied where cash collateral posted by the UCITS is protected by client money rules as per Article 13(8) of MiFID.

14. Do you agree that UCITS should apply counterparty risk limits to the CM under those other types of segregation arrangement? What should be the limits and the criteria for setting them?

Please refer to our answer to Question 12 above. In this regard, EFAMA encourages ESMA to consider the different types of contractual arrangements that CCPs and CM can offer to see which types of segregation models offer a good level of protection.

15. Do you agree that UCITS should be subject to the same counterparty risk limits applying to the CM under these other types of segregation arrangement for both OTC financial derivatives and ETDs? If not, please justify your position.

Apart from the client asset segregation models required under Article. 39 (2) and (3) of EMIR, the discussion paper usefully also considers alternative models (e.g. omnibus sub-type accounts where margin is collected from clients and further posted to a CCP on a gross basis). With regard to these models and to the extent that they rely on omnibus client segregation, the relevant counterparty risk limits (as outlined in our replies to Questions 12 – 14 above) should continue to apply, unless other mitigating measures (ensuring that client assets are adequately protected and restituted to the individual UCITS, including at the sub-fund level) are put in place. With regard to ETDs, please refer to the answer to questions 9 and 13 above.

6 See CESR Guidelines on Risk Measurement and Calculation of Global Exposure and Counterparty Risk for UCITS (CESR/10-788) of 28 July 2010, available at: http://www.esma.europa.eu/system/files/10_788.pdf 8 EFAMA Reply to ESMA’s Discussion Paper on the Calculation of counterparty risk by UCITS for OTC financial derivative transactions subject to clearing obligations

16. Do you agree that UCITS should treat OTC derivative transactions cleared by non-EU CCPs outside the scope of EMIR as bilateral OTC derivative transactions and apply the counterparty risk limits of Article 52 of the UCITS Directive to CMs? If not, please justify your position.

Given the early stage of ESMA’s recognition process of non-EU CCPs, where none have yet been recognised at the time of writing, an affirmative reply to this question may prejudge the outcome of such process. At the stage, we may opine that the Article 52 limits should apply only to trades cleared by non-ESMA recognized, non-EU CCPs; for trades cleared by an EU CCP, or by a non-EU CCP (albeit recognized by ESMA to be equivalent in the future), the limits should on the contrary not apply, although for exposures to non-EU CCPs legal risks may be different given the application of a non-EU resolution regime. This preliminary reply should be valid at least for the duration of the transition period sufficient for ESMA to assess and grant recognition to third-country, non-EU CCPs. Moreover, ESMA should address the issue of eventually calibrating the UCITS limits onto the U.S. “agent” clearing model used by U.S. CCPs where a CM would be acting as an agent for the UCITS to the CCP.

17. Do you agree that ICAs should be considered equivalent to direct clearing arrangements and that the same limits envisaged for the different segregation models in a direct clearing arrangement should apply to an ICA? If not, please justify your position.

EFAMA agrees with ESMA’s proposal to apply the same limits to ICA so as to not make indirect clearing more expensive for the smaller counterparties. Investors, however, through ICAs would in theory bear more risk. We also wish to note in this regard that for the time being the indirect clearing model is seldom used and particularly problematic in allowing for individual segregation.

18. Do you believe there might be circumstances under ICAs where UCITS have an exposure to the client of the CMs? If yes, what are those circumstances and do you think that UCITS should be subject to counterparty risk limits applying to the clients of the CMs? What should be the limits?

Yes, there may be circumstances were under ICAs UCITS have exposure to the client of a CM. In such instances, the counterparty risk limits should – in line with our responses above – depend on the offer of CMs able to clear certain contracts.

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22 October 2014 [14-4088]