What now for EMIR?
The European Market Infrastructure Regulation (EMIR) requires financial institutions such as fund managers to centrally clear their straightforward, vanilla over-the-counter (OTC) derivatives. Regulators have put enormous faith into central counterparty clearing houses (CCPs) to scale down the risk in the OTC market, turning these utilities into systemically important financial institutions (SIFIs). CCPs are certainly not invincible (there have been failures in Malaysia and Paris and a near-failure in Hong Kong), but they are a major improvement on the pre-crisis OTC environment. However, CCPs’ creditworthiness is dependent on the conservative nature of their margining policies and the quality of the collateral they take to cover anticipated market risk.
EMIR compliance obligations are being phased in. Clearing members – also known as category one clearers - (such as banks) have been centrally clearing their OTC contracts since June 2016. Category two clearers comprise of financial institutions such as alternative investment funds (AIFs) above a clearing threshold of EUR 8 billion. These organisations will start clearing in December 2016. Category three clearers will incorporate financial institutions and AIFs below the EUR 8 billion threshold. They will begin clearing in June 2017 although this could be delayed as the European Securities and Markets Authority (ESMA) is debating whether to extend the deadline for low volume OTC users. Nonetheless, fund managers need to be thinking about how to ready themselves.
The first priority is for impacted fund managers to appoint a clearing member. Very few managers have become direct members of CCPs due to the cost constraints and potential counterparty risks. Clearing banks act on behalf of buy-side clients and post the relevant margin to CCPs. Appointing a clearing member – certainly under Dodd-Frank – was originally quite straightforward. Banks originally jumped at the opportunity of clearing because they thought they would be allowed to re-hypothecate or re-use client collateral. Regulators quickly clamped down on this, rendering clearing less lucrative than many banks had hoped for.
The main issue for clearing banks now is a consequence of Basel III. Basel III requires banks to hold more capital. It also requires banks to hold capital for all on-balance sheet derivatives collateral. This includes client collateral posted to CCPs. In other words, clearing is now a cost rather than a commercial opportunity for banks. This has prompted a number of banks to exit the clearing business altogether and others are likely to follow. This presents a huge issue for the buy-side. If banks are unwilling or unable to clear their OTCs, fund managers may have to stop trading OTCs which could result in a decline in hedging. If this were to occur, firms and markets could face significant risks. The Bank of England is recommending a rethink on these capital requirements, although in the interim buy side firms are likely to see their clearing fees increase as the market consolidates and major banks/brokers decline to clear except on behalf of their largest clients.
The second challenge for fund managers is identifying the correct collateral to post as initial margin and variation margin at CCPs. CCPs cannot accept low quality collateral due to their systemic nature. Many managers – particularly equity fund managers – will have assets that are considered low quality by CCPs due to their marketability and volatility. Attempts by some CCPs to lower their margin requirements or adjust their collateral policies have been slapped down by regulators and some clearing members who accused them of trying to “race to the bottom” in an effort to gain market share. Margin comes in two forms. Initial margin is typically high-grade government bonds or cash. Variation margin – something which can be called intra-daily in turbulent markets – is usually cash. Some CCPs do permit quality equities to be posted as initial margin but subject them to severe haircuts.
Given investors’ over-subscription to bonds and the immobilisation of high-quality liquid assets (HQLAs) by insurers and banks due to Solvency II and Basel III respectively, fund managers need to find quality collateral from somewhere or someone. Industry experts have predicted that a collateral squeeze – whereby available eligible collateral simply gets stuck in CCPs – could occur, although market analysis does suggest there are sufficient high-grade assets for organisations to source. Nonetheless, a shortage could occur in a market stress event, and this could exacerbate instability.
Collateral transformation upgrades – a process whereby a bank will swap illiquid or risky assets into safer instruments which fund managers can then post as margin – is one option. The repo market has shrunk as Basel III subjects these activities to heightened capital requirements. There is a possibility that cash-heavy managers such as private equity or firms which are long high-grade government bonds could lend out these assets to collateral hungry firms on a collateralised basis in exchange for a fee. Some firms are looking at this, although it could increase counterparty risk, and many potential lenders do not have suitable treasury operations to make it workable. At a basic level, fund managers need to manage collateral efficiently, and to build systems in place and work closely with service providers to ensure they do not miss margin calls.
The move towards mandatory clearing is inevitable and it is going cause challenges for fund managers. Firms need to ensure they are ready for these requirements by initiating early discussions with their service providers.