Thursday, April 12, 2012

Hedge Fund Industry Views Risk Mitigation and Regulatory Arbitrage under EU EMIR Derivatives Regulation

As EU authorities ready technical standards under the European Market Infrastructure Regulation (EMIR) for OTC derivatives, the hedge fund industry has asked for certain assurances and clarifications around risk mitigation. In a letter to the Joint Committee of the European Supervisory Authorities, the Managed Funds Association noted that a critical piece of the risk mitigation framework is an appropriate segregation regime for posted initial margin. Specifically, the regime must ensure that, in the event of the receiving party’s default or insolvency, the posting party’s initial margin is segregated in a manner that is bankruptcy-remote under the local insolvency laws of the relevant Member State and allows for the efficient return of the posting party’s collateral.

The MFA believes that the posting of initial margin by all parties may be too costly to implement without commensurate benefit. Instead, in conjunction with such segregation, the MFA endorsed the option of the collection of initial margin by prudentially regulated financial counterparties only, coupled with an exposure threshold. This option would provide sufficient protections to all parties, would complement current practice in the derivatives markets and would represent a more suitable basis for the standards.

Where the standards do not provide appropriate segregation, the MFA said that the posting of margin by all parties is necessary because it would provide an acceptable means for each party to manage its counterparty credit risk. The MFA acknowledges that such an option may significantly increase costs to market participants and reduce liquidity in the market, particularly where the standards do not permit legally enforceable netting arrangements. Thus, the MFA urges the authorities to draft standards allowing such legally enforceable netting if they require all parties to post initial margin.

In calculating initial margin, the MFA said that margin methodologies must be transparent and replicable in a manner that allows both parties to determine independently the applicable margin. Transparency is fundamental to conducting effective capital planning and promotes margin practices that are fair and understood by all market participants.

With regard to regulatory arbitrage, the MFA generally noted the importance of consistent global regulation and encouraged regulators to continue harmonizing and aligning margin and segregation requirements across jurisdictions because such alignment is crucial to avoid regulatory arbitrage. Inconsistency of global derivatives regulation would lead to discrepancies as to the obligations of, and protections available to, market participants around the world, emphasized the MFA, and make it difficult and costly for market participants to comply with differing regulatory frameworks.

That said, the MFA pointed out that there are significant differences between the EU proposals and US proposals on the same topics. US financial regulators propose to require only swap dealers and major swap participants to collect initial margin from their counterparties for non-cleared swaps. Some entities classified in the US as major swap participants would, in the EU, fit within the non financial counterparty classification.

Under EMIR, the non financial counterparty category is based solely on the type of market participant, whereas in the US the major swap participant category applies to all types of market participants based on whether they maintain a substantial position in swaps, create substantial counterparty exposure that could seriously and adversely affect US financial stability, or are highly leveraged relative to the amount of capital that they hold.

US regulators propose different approaches for the initial margin calculation requirements. The US proposals draw eligible initial margin collateral from a limited set of assets for which there are deep and liquid markets, whereas the current EU eligibility criteria could potentially be much broader.

US regulators also propose different requirements for the exchange of variation margin. The MFA supports the EU proposed approach to the bilateral exchange of margin. The US proposals require covered swap entities to collect, but not post, margin when they enter into transactions with financial entity counterparties. The MFA has strongly urged the CFTC and SEC to require covered swap entities to post and collect margin with all non-financial entities because such bilateral exchange of margin is crucial to the proper functioning of the derivatives markets and the reduction of counterparty and systemic risks in that market.

The MFA urged the EU authorities to require the daily exchange of collateral, adding that the bilateral exchange of variation margin is crucial to the proper functioning of the derivative markets. In particular, the daily, bilateral exchange of variation margin is current best practice for collateral management and reduces counterparty and systemic risk by preventing either party from accumulating substantial unsecured exposures. It also increases market transparency and facilitates central clearing by creating symmetry between the margin posting requirements for cleared and non-cleared derivatives. Further, the mandated daily exchange of variation margin is consistent with the goals of EMIR, which sets out that where a central counterparty does not consider an OTC derivative transaction to be suitable for clearing, the transaction creates operational and counterparty credit risk, and thus, regulations should mitigate those risks, including requiring the exchange of collateral.

Consistent with its view that parties should have flexibility to negotiate the terms of initial margin requirements, the MFA urged the EU authorities to adopt standards allowing the parties to a bilateral collateral arrangement to negotiate the reuse of collateral. In the OTC derivatives market, tri-party arrangements currently prohibit the receiving party from re-using initial margin posted by its counterparty, since the third party custodian holds the collateral in an account under the name of the posting counterparty. Therefore, any prohibition on re-use would have minimal impact on such arrangements. In contrast, under bilateral arrangements, the parties to the agreement determine the re-use of collateral. Thus, an inflexible prohibition in this context would restrict the choices of the counterparties and potentially increase costs.

In the view of the MFA, parties to the transaction should agree as to what constitutes eligible collateral. Thus, the hedge fund association urged the EU authorities to permit parties to exchange a wide range of assets. The MFA is concerned that restricting eligible collateral to a list will result in an additional premium on such collateral, and that standards restricting the range of eligible collateral will adversely impact liquidity because market participants will be exchanging a finite set of instruments. The MFA suggested that any criteria for determining what constitutes eligible collateral should include that the collateral have a determinable market value; be capable of accurate revaluation; be susceptible to frequent valuation; and be readily transferable so that the relevant party can liquidate it promptly. These criteria will ensure appropriate protection in a default scenario without being unduly restrictive.

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