An opinion by the European Securities and Markets Authority could require European-based investment funds subject to the Undertakings for Collective Investment in Transferable Securities directive to apply restrictive exposure limits to both their clearing brokers and the relevant clearinghouses (CCPs) where they trade certain cleared derivatives. This would be the case where such derivatives are not processed through European Union-based CCPs or non-EU based CCPs that are recognized by the European Commission as having equivalent oversight.
Currently US-based CCPs are not considered by the EC to be subject to equivalent oversight as EU-based CCPs. (Click here for further background on the current dispute between the Commodity Futures Trading Commission and the EC related to the status of US-based clearinghouses in the article, “CFTC Chairman Argues for Equivalent Treatment for US CCPs by the European Commission; EC and CFTC Commit to Continue Talking—That’s All for Now” in the May 10, 2015 edition of Bridging the Week.)
The UCITS directive (originally adopted in 1985 and subsequently amended multiple times) generally establishes the requirements for collective investment vehicles authorized by one European jurisdiction to be offered freely throughout Europe.
Currently, under the UCITS directive, qualifying investment funds must limit their exposure to counterparties in connection with their over-the-counter financial derivatives transactions. This risk exposure to any one counterparty may not exceed 5 percent of the assets of a UCITS fund, or 10 percent when the counterparty is a so-called “credit institution” (e.g., a bank). No restrictions currently apply when financial derivatives are exchange-traded, however.
In its opinion, ESMA recommends that counterparty limits based solely on the distinction between OTC and exchange-traded financial derivatives transactions should be eliminated. Instead, ESMA proposes applying such limits based on the distinction between cleared and non-cleared financial derivatives transactions. Counterparties to non-cleared transactions should be subject to the same risk limits as today by UCITS funds, says ESMA.
However, claims ESMA, UCITS funds should not apply the same risk limits to all cleared transactions as they do not all involve the same level of counterparty risk. For example, opines ESMA, UCITS funds should be required to apply the same risk exposure limits to clearing members processing financial derivatives transactions settled through non-EU CCPs that are not recognized as subject to equivalent oversight as EU CCPs, as they would to counterparties in connection with bilateral OTC financial derivatives transactions today (the 5/10 percent standard). UCITs funds might also have to apply limits to the non-recognized CCPs themselves, ESMA says.
Transactions cleared through EU CCPs or EC-recognized, non-EU based CCPs would be considered to be of lower risk. However, ESMA recommends that even in connection with these transactions, UCITS funds should apply some limits to their clearing brokers where they determine to apply so-called “omnibus segregation” as opposed to “individual segregation.” ESMA says that no limits need apply when individual segregation is utilized.
Under the European Market Infrastructure Regulation, members of EU CCPs must offer their clients’ so-called omnibus or individual segregation. In connection with individual segregation, a clearing member posts with a clearinghouse the full amount of each of its clients’ collateral in connection with their transactions, while with omnibus segregation, the clearing member posts solely the net amount of collateral necessary to clear the transactions of its clients.
ESMA claims that clients have greater exposure to their clearing members when they opt for omnibus segregation. This is because, in case of a default of such a clearing member, the clearing member may not have sufficient assets to pay back 100 percent to all its customers as it may receive only a portion of its clients’ overall collateral back from a clearinghouse.
As a result, omnibus clearing is more risky for a client, and a UCITS fund should apply some risk limit to a clearing member when it opts for such lesser type of protection.
(Click here for additional information on ESMA’s opinion, including the significance of an opinion, in the article, “ESMA Calls for EMIR Modifications to UCITS Directive” in the May 29, 2015 edition of Corporate & Financial Weekly Digest by Katten Muchin Rosenman LLP.)
My View: I have previously implied my armchair quarterback’s frustration regarding the seemingly unnecessary divide between US and European regulators that threaten to cause European-based banks to have to take onerous hits against their capital to carry positions cleared by US clearinghouses. (Click here to see My View in the article, “CFTC Commissioner O’Malia Urges International Financial Regulators to Cooperate More to Avoid Fracturing Liquidity” in the July 20, 2014 edition of Bridging the Week.) This dispute appears to turn on whether one-day gross margin for customers (US requirement) is typically more or less than two-day net margin (European requirement), or whether one-day net margin for proprietary positions, including affiliated entities (US requirement) is typically more or less than two-day net margin for proprietary positions, excluding affiliated entities (European requirement). Now, this dispute also threatens to impair the ability of European-based funds that trade US-cleared derivatives, too. Enough is enough! Equivalency was never meant to require identical rules. The Commodity Futures Trading Commission and the European Commission should expedite the resolution of this seemingly esoteric political dispute that threatens the current, seamless access to international derivatives-trading venues by participants on both sides of the Atlantic Ocean, and undercuts the 2009 G-20 commitment to require the universal clearing of most OTC derivatives.