On 22 July 2014, the European Securities and Markets Authority (ESMA) issued a discussion paper (DP) on counterparty risk calculation methods for undertakings for collective investment in transferable securities (UCITS) subject to central clearing.

The DP requests views on how counterparty risk can be calculated by UCITS which enter into over-the-counter (OTC) derivative transactions which need to be centrally cleared under the European Markets Infrastructure Regulation (EMIR). Under the UCITS directive, UCITS can invest in both exchange traded derivatives (ETDs) and OTC derivatives, however only OTC derivatives are subject to counterparty risk exposure limits.

The DP focuses on the impact of a default of a clearing member (CM) or of other clients of that CM on UCITS that enter into centrally cleared OTC derivative transactions. It takes into account the fact that European clearing houses (CCPs) and non-EU CCPs recognised by ESMA are already subject to stringent collateral requirements and should generally be considered as entailing low counterparty risk.

Individual client segregation with EU CCP or non-EU CCP recognised by ESMA

In the case of a default of a CM under the individual client segregation model, the CCP must attempt to transfer the assets and positions of the UCITS to another CM (known as porting) or to close the positions of the UCITS.

If the CCP closes the positions, the UCITS will receive the liquidated value of its positions and any residual collateral to cover such positions directly from the CCP. The UCITS will therefore not run the risk of being impacted by the default of the CM. Furthermore, the assets and positions of the UCITS are legally and operationally separated from the assets and positions of other clients of the CM.

ESMA therefore takes the view that under this model, UCITS have no counterparty risk vis-à-vis the CM or other clients of the CM. The risk that the CM defaults before it posts the assets to the CCP is not considered as significant by ESMA.

Omnibus client segregation with EU CCP or non-EU CCP recognised by ESMA

Under an omnibus client segregation model, the obligation for the CM and the CCP is only to distinguish the assets and positions of the CM from the assets and positions held for the account of the clients of the CM. This means that the CM is allowed to post to the CCP only the net amount of collateral required by the CCP in respect of the OTC transactions of its clients. There is no individual segregation of collateral at CCP level and no requirement to collect margin from clients on a gross basis.

In the case of a default of a CM under an omnibus client segregation model, in the majority of cases the CCP will deliver back to the CM/the liquidator of the CM the residual collateral (if any) following the liquidation of the CM’s clients’ positions. This means that the UCITS may not get its assets back or there may be a substantial delay in the return of the assets because this depends on the outcome of the liquidation procedure of the CM. It also means that, until it has entered into replacement OTC derivatives, it will no longer have exposure to the underlying instruments whether the transaction was for investment or hedging.

Therefore, ESMA has concluded that omnibus client segregation provides UCITS with less protection than individual client segregation when the CM defaults. In particular, UCITS will be exposed to both the default of the CM and of other clients of the CM. ESMA therefore considers it logical for UCITS to apply counterparty risk limits to CMs in the case of omnibus client segregation. Given that under an omnibus client segregation structure UCITS may be affected by the default of the CM (and of its other clients) irrespective of whether the contracts cleared by the CCP are ETDs or OTC derivatives, ESMA considers that it is not appropriate to apply limits only to OTC derivatives.

Other types of segregation arrangement with EU CCP or non-EU CCP recognised by ESMA

CCPs may offer different types of client segregation arrangements and those arrangements may differ from one CCP to another. One of these possible structures is an omnibus account where the margin from clients is collected and posted to the CCP on a gross basis. Under this type of segregation arrangement, the CCP could ensure the portability of the clients’ positions to another CM, although it may be more complex than under individual client segregation.

In this structure, the value of the liquidated positions and the residual collateral are returned to the CM (or the liquidator of the CM) for the account of its clients. However, the excess margin that the CM might collect from clients might not be passed on to the CCP, as prescribed under individual client segregation.

Also, in the case of a default of the CM, the CCP might not be in a position to allocate the excess collateral between the clients of the CM.

Finally, until the UCITS has entered into replacement OTC derivatives, it will no longer have exposure to the underlying instruments, whether the transaction was for investment or hedging.

Therefore, ESMA considers that it is correct to apply some counterparty risk limits to these other types of segregation arrangement. For the reasons already mentioned above, ESMA does not consider that ETDs and OTC derivatives should be treated differently.

Segregation arrangements with non-EU CCP outside the scope of EMIR

UCITS may enter into OTC derivative transactions (not subject to the EMIR clearing obligation) cleared through a non-EU CM by a non-recognised third country CCP. Since those third country CCPs are subject to standards which may not be equivalent to those applicable to EU CCPs, ESMA considers that those transactions do not provide a level of protection equivalent to OTC derivative transactions centrally cleared under EMIR. Therefore, UCITS should treat those transactions as bilateral OTC derivative transactions and apply the relevant counterparty risk limits.

Indirect clearing arrangements

Pursuant to EMIR, a counterparty will become a CM, a client of a CM, or will establish indirect clearing arrangements (ICA) with a CM (i.e. through a client of a CM).

If a UCITS enters into an ICA with individual client segregation, ESMA believes that the UCITS has a very low counterparty risk vis-à-vis the client of the CM providing the ICA. However, if the UCITS does not benefit from individual client segregation, it is exposed to higher counterparty risk and the UCITS should therefore apply counterparty risk limits to the client of the CM providing ICAs.

Next steps

All contributions should be submitted online by 22 October 2014.