Do you make use of futures and options exchanges? In fact, do you make use of any exchange that uses a central counterparty (CCP) for settlement?
If the answer to these questions is “yes”, then you had probably better read on.
Now, do you pay your initial margin to your clearing broker in cash? Or, do you have a deep knowledge of the European Market Infrastructure Regulation (EMIR) requirements for the operation and regulation of CCPs and the attendant Regulatory Technical Standards published by the European Securities and Markets Authority (more commonly known as the ESMA RTS)?
If the answer to either of these questions is “yes”, then you can probably stop reading now. There, that was easy, wasn’t it? If only everything to do with regulation and the EU was that simple. However…
The world of CCPs is changing. The final text of EMIR has been published and the regulation was adopted and entered into force on 16 August 2012. The final report of the ESMA RTS was published on 27 September 2012 and adopted by the European Parliament in February 2013. The regulations designed to de-risk large parts of the financial system by requiring derivative contracts to be cleared are now ready to roll all over the industry.
Those of us who are in Europe are probably as aware of Dodd-Frank, the US rules, as we are of EMIR – reflecting the size and importance of the US market to us as well as our trading history.
Why should these rules impact upon the corporate treasurer who occasionally uses exchange-traded derivatives purely for hedging purposes and has all of his arrangements handled for him by a friendly broker and his CCP clearing member? There is a simple explanation. The rules will inflict changes on CCPs. These will be passed up the line to the direct clearing members. The clearing members have the choice of passing the impact on to their customers or taking the hit to their bottom line. What is most likely?
This article is about chapters VIII, X and XI of ESMA RTS, which implement articles 44, 46 and 47 of EMIR. These articles cover liquidity, collateral and investment policy for CCPs. All of these items are inextricably linked as the regulators try to create rules that will de-risk CCPs as far as possible. After all, if the answer to market stresses and failures is to put as much volume as possible through CCPs, it is quite important that they continue in operation, meeting all of their liabilities. CCPs must be well managed and prudent in all areas of their operations.
Prior to EMIR, CCPs set their own collateral policy and could choose to take what they liked. As long as the CCP could satisfy itself as to the value of the collateral, there was no reason why it couldn’t take anything from cash to precious metals. What the ESMA RTS do is to tell CCPs what they can now consider as suitable collateral. There is no negotiation on this – the rules are quite clear (well, as clear as any regulations ever are). If the item isn’t in there, they can’t take it. They can be offered the finest quality diamonds with a haircut of 50%, but those will have no value under the new regulations.
Broadly speaking, there are five subgroups of eligible collateral:
On the face of it, that all looks quite simple. Of course the devil is in the detail – for example, cash is not quite that simple since not all cash is equal. And the CCP has to look beyond the rules and consider the impact of holding the collateral in its own name. Will it count towards its liquidity holdings or not?
Most of the margin that is posted to CCPs is in the form of cash – at least initially. It is simple to transfer and its value is readily calculated. You may even earn some interest on it from the CCP, although with rates what they are at the moment, it probably won’t be very much. The regulations, however, have added a twist or two to the taking of cash.
CCPs will be able to accept any currency as long as they can show that they have the knowledge, experience and systems to handle it. In short, only currencies in which a CCP settles contracts will probably be acceptable. It doesn’t matter how much renminbi you are able to deposit – if the clearing house doesn’t clear a renminbi product, it is unlikely to be able to take it as collateral.
And cash is cash. It does not include a charge over a money market fund (MMF) or similar arrangement.
The next big category for collateral is likely to be highly liquid debt securities. The regulations actually refer to ‘financial instruments’, which could encompass a wide range of instruments including equities. The qualifications to the category, however, restrict the numbers of items that can be used. The requirements include low credit and market risk as determined by an internal review. There must be an active secondary sale or repo market. Transfer of title must be possible without legal encumbrance. All of this effectively reduces the field of candidates to government or quasi-government debt. This should come as no surprise. Clearing houses LCH.Clearnet and ICE Clear already publish an eligible securities list, together with the appropriate haircuts. These lists are principally government securities with the addition of the likes of US mortgage provider Fannie Mae and German development bank Kreditanstalt Für Wiederaufbau. Some might argue about the credit quality of some of the governments on the list, but it suggests an intention to limit exposure to commercial entities.
‘Commercial bank guarantee’ seems to be a catch-all term to cover performance bonds and letters of credit. Since there is a general theme in the regulations and technical standards of restricting CCPs’ exposure to commercial bank risk (while still being comfortable with CCPs using commercial bank credit facilities), there are several conditions that need to be applied to a guarantee to make it eligible as collateral. It has to be ‘irrevocable’ and ‘unconditional’, and the issuer is to be allowed no legal defence to prevent payment. Furthermore, it has to be honoured on demand, and subject to no regulatory, legal or operational constraint.
Basically, there has to be no way that the CCP will not receive payment from the issuing bank.
If that wasn’t enough, the guarantee has to be fully backed by collateral to which the CCP has ‘prompt access’ and is ‘bankruptcy remote’. This is a pretty strict requirement, providing operational challenges to CCPs as well as possibly affecting the price of the guarantee itself. On the face of it, this isn’t just a catch-all description for performance bonds and letters of credit, but a new type of instrument.
In fact, the rules on bank guarantees are so far removed from current market practice that their implementation in energy markets has been identified as likely to cause severe disruption and so will be delayed for three years after the formal introduction of the RTS, coming into force on 15 March 2016.
As an aside, the bank guarantee rules were sufficiently strict to give the Economic Committee of the European Parliament pause for thought, and it actively considered rejecting the rules on the grounds that they made it ‘virtually impossible’ for them to be used.
Gold has made it onto the list with little complication. The only requirements are that it is “allocated pure gold bullion” (ie it is allocated to the CCP’s own account and the CCP is advised of the bar numbers) and that it is ‘of recognised good delivery’. For CCPs based in London that have access to the London bullion market, this should be no problem.
Presumably, when the rules refer to ‘allocated pure gold bullion’, it is acceptable for it to be transferred in an unallocated fashion by the clearing member and then allocated to the CCP’s account at the CCP’s gold custodian. After all, we don’t really want to increase the amount of gold being physically moved between depositories. But gold won’t be a cheap option after the CCP has billed you for custody and insurance.
The last category is a guarantee issued by a central bank. These don’t need to be backed by collateral themselves (unlike commercial bank guarantees), but they have to meet all the other strenuous requirements. This is a product that is certainly not available from the Bank of England, nor is it provided by any other central banks in jurisdictions that house the dominant CCPs.
It isn’t just the rules on collateral themselves that will have an impact. They will have to be read together with the rules on liquidity and investments. After years of being left to their own devices, CCPs now have to be able to demonstrate that they have adequate liquidity and that their investments are being held for all the right reasons (meeting their liabilities) and not the wrong reasons (making profits for the CCP). Daily reports are required to show that liabilities are matched with assets that are liquid.
Where assets don’t cover the liabilities in a time bucket, then the CCP needs to take steps to ensure that they do. And there are some assets, which despite looking or actually being liquid, do not count towards the calculation. A CCP’s investment portfolio average time-to-maturity can’t exceed two years. While it can legitimately hold a spread of government bonds, the maturity dates won’t be long, and large holdings at the more liquid tenors will break the average. This will impact the way CCPs look at collateral, especially in the event of a default.
Is there a market response to this? Not yet may be the answer. Those companies providing clearing services to their clients are slowly waking up to the impact of the rules.
Responses to the consultation period were illuminating in as much as what they say about the responders as the regulations. The representatives of the MMF industry can argue that MMFs are the answer to every liquidity need that a CCP may ever have. But reliance upon a single commercial institution to realise cash from liquidity was never going to be allowed.
So what will happen to those of you who use CCPs? As I said at the beginning, if you pay your margin in cash, then you have no worries. If you are using bonds or guarantees, then talk to your clearing member and your bankers. What are they doing for you? Are we about to enter into an era of new products or money-spinning opportunities for your bankers? ‘Collateral transformation’ is the new buzz phrase where good quality – but illiquid assets – can be miraculously transmuted into top-quality government bonds or similar – at a price.
In conclusion, the advice won’t come as any surprise. Be aware of the regulations. Be aware of the impact on your business. And talk to your clearing member and your banker. You might just be the first person to do so.
Graham Evans MCT is an independent treasury consultant. He has recently completed a contract designing collateral and treasury systems for LME Clear, the London Metal Exchange’s CCP, which is due to go live in 2014. You can connect with him on LinkedIn at: www.linkedin.com/profile/view?id=156784384