Lecture 7 OTC Derivatives Markets PDF

Lecture 7 OTC derivatives markets and post- trade infrastructure regulation Diego Valiante, Ph.D. Opinions ex...

Lecture 7 OTC derivatives markets and post- trade infrastructure regulation Diego Valiante, Ph.D. Opinions expressed are strictly personal and cannot be LEIF Master Programme attributed in any way to the European Commission.  Student survey first! © Valiante Diego – 2  Agenda The market for OTC derivatives – Origins and current trends – The ISDA Master Agreement – The legal framework for collateral – The key role of netting Close-out netting – Default and termination events under the ISDA MA Clearing services – Central clearing and the central clearing obligation Links with the trading obligation – Prudential requirements and risk management of a CCP – Organisational and other requirements – CCP Recovery and resolution Risk mitigation techniques for non-centrally cleared trades OTC derivatives Reporting Settlement and the Central Securities Depository Regulation (CSDR) Securities Financing Transaction Regulation (SFTR) © Valiante Diego – 3  The market for Over-The-Counter (OTC) derivatives © Valiante Diego – 4  Basics Derivatives – Def.: “financial instruments whose value (price of the contract) is derived from the value of an underlying asset (e.g. equity, bond or commodity) or market variable (e.g. interest rate, credit risk, exchange rate or stock index)” (EU COM, ‘09). – Futures (or forwards), Options, Swaps and Exotic Instruments by asset classes (currency, equity, rates, credit and commodity). – Over-the-counter (OTC) or on-exchange. – They can be very long-term contracts (e.g. 30 years). Used for different strategies – ‘Pure’ hedging (e.g., Airline company; counterparty risk) – Funding (e.g., capital rules [CDS]) – Arbitrage (e.g., price changes) – Speculation (latin: speculare; ‘informed trading’) © Valiante Diego – 5  Context High level of concentration – Dealer market – 85% in 10 financial institutions (in 2010) Derivatives markets are mostly over the counter (OTC), with the remaining part being exchange-traded [ETD] (such as commodity futures or interest rate markets) Non-financial entities are a small part (roughly 10%) of the market, while the rest is traded among financial institutions. © Valiante Diego – 6  Reasons of growth: Legal (Stout, 2009) – With the repeal of the ‘rule against difference’, which stated that the use of derivatives is legal only if parties hold the underlying, In the UK, in 1986, with the Financial Services Act. In the US, with the Commodity Futures Modernization Act of 2000. Economic – Derivatives are market Innovation that helped to free resources on balance sheet with better hedging and through multilateral netting that reduced operational and counterparty risks – The growth of public and private debt (counterparty exposures) promoted the use of derivatives, such interest rate swap, to better manage the interest rate risks of this rising debt pile. © Valiante Diego – 7  Outstanding OTC derivatives © Valiante Diego – 8  Uncollateralised exposure © Valiante Diego – 9  Outstanding OTC derivatives © Valiante Diego – 10  Key risks of an OTC derivative transaction Idiosyncratic risks External risks 1. Collateralisation and transparency of transactions and market infrastructures 1. (Potential) size, embedded leverage and 2. Market liquidity complexity of exposures 3. Legal risks (e.g. definition of credit event) 2. Counterparty credit risk 4. Network externalities and cascade effects 3. Market risks 5. Number of dealers and/or CCPs 4. Long-term funding 6. Clearing and settlement risks (confirmation backlogs, etc.) 7. Custodial risks (e.g. Lehman Brothers) © Valiante Diego – 11  The ‘systemic’ negative feedback loop risk © Valiante Diego – 12  The legal framework for OTC derivatives: The ISDA Master Agreement and beyond © Valiante Diego – 13  The ISDA Master Agreement package 1. The ISDA Master Agreement (MA) – A pre-printed document with applicable clauses (incl. credit event, early termination, etc) in standard format See for a sample https://www.sec.gov/Archives/edgar/data/1107694/000119312508091225/dex1032.htm – Moreover, at the point in time when a CDS contract is entered into, the two parties thereto agree that the contract will be governed by the Credit Derivatives Definitions and that the determinations of the relevant ISDA Determinations Committee will be binding on the contract. See more on ISDA as ‘gatekeeper’. 2. Schedule (to the MA) – Amends the terms of the MA as required by the parties (customisation) 3. Credit Support Annex (CSA) – Provides collateral or other security for the obligations under the derivative transaction 4. Confirmation – Contains the economic terms of an individual derivative trade 5. Voluntary protocols and adherence letters – The protocol is a multilateral contractual amendment mechanism, which provides standard amendments to the MA. It comes with an adherence letter to the protocol, which includes acceptance a dispute resolution via decision by a specific ISDA committee. © Valiante Diego – 14  Credit Support Annex (CSA) It contains the documentation that governs the posting of collateral in OTC derivatives transactions. – Collateralisation is the main risk mitigation technique for derivatives. – ’Financial collateral’ aims at providing protection to the collateral taker against credit risk of the collateral giver. – The CSA is not mandatory and in the past collateral arrangements were individually subject to negotiations among parties. – The CSA was created to simplify such negotiations with standardised documents, first drafted in 1994 (NY law) and 1995 (English law). It includes important documentations, such as information on whether collateral is exchanged as a ‘pledge’ or as a ‘security interest’. – Pledging a security as collateral requires a ‘title transfer’, with the collateral giver being the ’beneficial owner’ (who continue to receive the benefits of ownership; e.g. dividends) and the collateral taker becoming the ‘legal owner’ (who can dispose of the collateral; automatic right of use). Example: repo transactions. – Posting collateral as a ‘security interest’ does not imply a transfer of legal ownership on the security and the collateral cannot be disposed. It can be rehypothecated if there is consent (discretionary right of use). The right of use (rehypothecation) under a ‘security interest’ was introduced in 2003 by the Financial Collateral Directive in Europe. The scope of the right of use is defined by the collateral arrangements. (art. 2(1)(m), FCD) © Valiante Diego – 15  The legal framework for collateral & margins Financial Collateral Directive (FCD, Directive 2002/47/EC) provides the legal framework for margining and protection of collateral more broadly. – Applicable to cash, financial instruments (different from MiFID definition, e.g. shares, bonds, UCITSs and money market instruments) or credit claims. – Applicable to all non-natural persons ‘Provision of financial collateral’ means ‘financial collateral being delivered, transferred, held, registered or otherwise designated so as to be in the possession or under the control of the collateral taker or of a person acting on the collateral taker's behalf’ (art. 2(2), FCD) Two types of ‘collateral arrangements’ (Article 2(1)(b) and (c), FCD): 1. "title transfer financial collateral arrangement” (TTFCA) means an arrangement, including repurchase agreements, under which a collateral provider transfers full ownership of financial collateral to a collateral taker for the purpose of securing or otherwise covering the performance of relevant financial obligations; 2. "security financial collateral arrangement” (SFCA) means an arrangement under which a collateral provider provides financial collateral by way of security in favour of, or to, a collateral taker, and where the full ownership of the financial collateral remains with the collateral provider when the security right is established; © Valiante Diego – 16  The legal framework for collateral & margins (2) The FCD improves the financial collateral enforcement rules. – For instance, if the borrower (collateral giver) defaults on its obligation to the lender, the lender (collateral taker) can immediately realise the collateral (e.g. by sale or appropriation), in or outside insolvency proceedings. (art. 4, FCD) – EU countries are blocked from applying their national insolvency rules to financial collateral arrangements in certain cases. (art. 8 FCD) Such arrangements may not be declared invalid or void in order, for example, to take account of changes in market value. The FCD facilitates the cross-border use of financial collateral by: – abolishing different formal requirements across EU countries such as the need to register the collateral (art. 3, FCD) – enhancing legal certainty as to which law applies to book-entry securities collateral in cross-border situations (art. 9, FCD) © Valiante Diego – 17  The key role of ‘netting’ © Valiante Diego – 18  ISDA Master Agreement – Payment Netting …“means the calculation of a single sum representing the potential result of the actual or notional discharge of two or more claims for payment that two persons have against each other.” (Crawford, 1993, p.163) Netting can take two forms in the ISDA Master Agreement. 1. Payment netting is just an exchange of payment (no contract termination; e.g. bilaterally-cleared OTC derivatives), which takes place during the normal business of a solvent firm and involves offsetting cashflow obligations between two parties on a given day and in a given currency into a single net payable or receivable. The application of payment netting can be done to individual transactions (same transaction, same currency, same value date), also called ‘single transaction netting’. Parties may elect for it to apply also across a specific group of transactions or transaction types, or across all transactions (cross-product netting; e.g. a forward FX transaction and a currency swap between the same counterparts). It can also involve multiple parts (multilateral netting). Source: ISDA © Valiante Diego – 19  ISDA Master Agreement – Close-out Netting 2. Close-out netting, which applies to the netting of transactions when the ISDA Master Agreement is terminated or ‘closed out’ – As part of the close-out process, all of the outstanding payment and delivery obligations of the parties with respect to terminated transactions are replaced with a single early termination amount due from one party to the other. – Close out netting has three components (Haentjens 2020): 1. The agreement is ‘closed-out’, ie terminated either automatically (occurrence of predetermined circumstance) or upon notice. Outstanding obligations are accelerated to become immediately payable. 2. All payable obligations are given a value and become monetary claims (e.g. transferred security is marked to market) 3. All monetary claims are set off or ‘netted’ against one another. Only the net balance need to be paid by the party owing a higher amount to the other. © Valiante Diego – 20  ISDA Master Agreement – Close-out Netting Key tool for central clearing (together with novation, i.e. a contractual provision that triggers the closing-out netting; see next slides) The close-out netting provisions of the ISDA Master Agreement may not always be enforceable due to the operation of insolvency law in the jurisdiction in which the insolvent party is based. EU countries must recognise close-out netting arrangements (even beyond financial collateral arrangements), even if the collateral taker or provider is subject to insolvency proceedings or reorganisation. (art. 7 FCD) → ‘safe harbour clause’ Under the ISDA Master Agreement, it may arise upon the occurrence of an event of default or termination event. © Valiante Diego – 21  Termination and default events © Valiante Diego – 22  ISDA Master Agreement – Termination Event Termination events are those events where neither party is strictly at fault (so they are called ‘affected parties’) Parties can designate additional termination events Source: ISDA © Valiante Diego – 23  ISDA Master Agreement – Default Events (one party at fault) Source: ISDA 3 cases of changes to credit event definition following times of stress – 1999 – ISDA introduced standard credit/default events (i.e., bankruptcy, failure to pay and restructuring) and standardized terms of CDS contracts in ISDA first credit derivative definition 2001 – 2003 – ISDA clarifies further what a credit/default event should be (removing restructuring as default event) – After the GFC and Euro sovereign debt crisis, in 2014, ISDA issued revised documentation (especially for CDS contracts) to include ‘Governmental Interventions’, e.g. bail-in clauses as ‘credit event’ and to add the possibility to replace bailed-in bond with a package of assets (mainly cash, equity or debt instruments) so that protection buyers are not deprived of the economic benefit of the CDS contract. Since 2009, the ISDA credit determinations committee (10 dealers and 5 buy-side) decides if a credit event occurred. © Valiante Diego – 24  ISDA Master Agreement – Default When default occurs, this does not necessarily mean any transactions will actually be terminated as a result, but it gives rise to a ‘right to terminate’ (close out), once the non-defaulting party notifies the defaulting one. – The non defaulting party may decide not to exercise it (e.g. if it is out of money and would need to make a big cash payment) or the credit event may be remedied. The actual termination takes place under a close-out netting action. Source: ISDA © Valiante Diego – 25  Clearing services © Valiante Diego – 26  Derivatives value chain © Valiante Diego – 27  Clearing service Def: “... the link between trading and settlement in which the obligations of each party to a transaction are finalised, that is, the process of transmitting, reconciling and confirming payment orders (or security transfer instructions) prior to settlement, possibly including the netting of instructions and the establishment of final positions for settlement” (NERA, 2007, p. 9). – ‘After confirmation before settlement’ Bilateral or centralised (CCPs) Economic function – Reduces operational costs and increases efficiency Execution/performance costs Enforcement costs – Systemic risk absorption by Mutualising default risks (aligned with the cycle) Compressing trades and exposures © Valiante Diego – 28  Central clearing Central Counterparty Clearing (CCP) – Def: “interposes itself between counterparties to a trade, becoming the buyer to every seller and the seller to every buyer. [...] the credit risk of the CCP is substituted with the credit risk of the other participants” (CPSS-IOSCO, 2004, p. 6; ESCB-CESR, 2009, p. 33: art. 2(1) EMIR). – Key components: 1. Novation (key for multilateral netting). 2. (multilateral) Netting (net amount; legal recognition); 3. Risk management tools (e.g. initial and variation margins, other clearing membership requirements) Novation Margining Netting Finality © Valiante Diego – 29  1. Novation 1. It is a process terminating a bilateral transaction and replacing it with two matching transactions with a third party (two CM-client transactions in this case). – No direct right vs CCP 2. Then a corresponding CCP-CM transaction is completed (matched book) Source: Slaughter & May. © Valiante Diego – 30  Indirect clearing arrangements ‘Indirect’ clearing membership (art. 4.3, EMIR; 2-5, Del. Reg. 149/2013), i.e. when another financial institution clear a trade on the CCP through a clearing member. – This exists if the financial institution is not able to meet the strict requirements for clearing members (e.g. to be resilient in case of a default) – Keeping separate records for the direct clients and no obstacle from the CCP. © Valiante Diego – 31  British Eagle v Air France 76 airlines entered into a mutual clearing arrangement, where they settled net debts amongst each other IATA calculated the monthly net sum due to or from each member No central counterparty clearing and no novation of exposures (and novation was anyway not shielded from insolvency proceedings) When British Eagle failed was an overall net debtor of the system, but a creditor of Air France Liquidators took Air France to court, as clearing rules did not apply after insolvency under the fact that it would prevent all creditors from benefit from it (‘pari passu’), also called anti- deprivation principle. – Air France had to pay and then the ‘clearing system’ run by IATA tried to recover it by entering as creditor of the liquidated company. © Valiante Diego – 32  2. (Multilateral) Netting by novation Close-out netting via novation is key for CCPs; Close-out netting is a procedure that terminates the derivative transaction, with a pre-defined payment (non-executory contracts) or marked-to-market netting of reciprocal payments (executory contracts), or when a credit event occurs. It can be bilateral (CH) or multilateral (CCP) 20 25 5 10 -10 20 10 -78% © Valiante Diego – 33 20  ‘Safe harbour’ protection (novation and netting) In the Settlement Finality Directive (SFD, Dir. 98/26/EC), novation and netting are granted a specific ‘safe harbor’ clause to avoid market disruption and provide as much ‘legal certainty’ as possible for ‘payment and securities settlement systems of a domestic as well as of a cross-border nature’ (e.g. CCPs). – “Transfer orders (executed instructions on ‘book entry’ systems; art. 2(1)(i)) and netting shall be legally enforceable and binding on third parties even in the event of insolvency proceedings against a participant, provided that transfer orders were entered into the system [incl. CCP] before the moment of opening of such insolvency proceedings as defined in Article 6(1). This shall apply even in the event of insolvency proceedings against a participant (in the system concerned or in an interoperable system) or against the system operator of an interoperable system which is not a participant.” (Article 3) This ‘safe harbour’ clause guarantees that financial product transfer and payment orders (netting) can be finalised, mainly by mitigating problems arising from a participant’s insolvency. These participants may be: – financial institutions, e.g. banks; – systems operators, such as central securities depositories. © Valiante Diego – 34  Close-out netting without ‘safe harbour’ clause If close out netting is not recognised… Source: ISDA © Valiante Diego – 35  3. Risk management tools CCP Bilateral Financial requirements of clearing Margin requirements members Other requirements (e.g. Initial and variation margins independent amounts, asset Collateral segregation segregation and capital charges) Loss mutualisation (e.g. CCP’s default fund) Other safeguards (such as CCP’s capital) © Valiante Diego – 36  Benefits of central clearing 1. Systemic risk mitigation mainly through: 1. trade compression via multilateral netting (netted value reduces by 95-99% the notional value) 2. Counterparty risk management and reduced spill-over effects of default via: 1. Margins 2. Collateral segregation 3. Loss mutualisation 2. Promotes liquidity resilience by promoting higher transaction volumes. 3. Greater transparency as the CCP has full view over the net positions (it does not imply disclosure to the public, though) © Valiante Diego – 37  Risks of central clearing 1. High switching costs for members (sunk costs due to no fungibility of collateral pools and interoperability among CCPs) 2. Cross-border legal risks (e.g. netting with novation or access to central bank liquidity) 3. Concentration and infrastructural risks (e.g. CCP outage?) 4. Liquidity costs due to the highly liquid collateral required to clear. 5. Interoperability risk due to a potential race to the bottom among CCPs in risk management policies to attract volumes. 6. Adverse selection risks (if eligibility and initial financial requirements on clearing members are misevaluated) 7. Moral Hazard risk if the company running the infrastructure has not enough ‘skin in the game’. 8. Governance and access risk of a complex infrastructure. 9. ‘Offloading most liquid exposures’ (more suitable for central clearing) from banks’ balance sheets to CCPs may increase tail risk left on banks’ balance sheets. © Valiante Diego – 38  Key legislative acts on clearing of derivatives (for info) European Market Infrastructure Regulation, EMIR (EU) No 648/2012 on OTC derivatives – Regulation (EU) No 575/2013 (CRD IV; prudential requirements for exposures to CCPs) – Directive (EU) No 2014/59/EU (BRRD; NRAs recognition) – Regulation (EU) No 600/2014 (MiFIR; non-discriminatory treatment & TR reporting) – Directive (EU) No 2015/849 (AMLD safeguards for TC CCPs) – Regulation (EU) No 2015/2365 (SFT; equivalence OTC derivative definition) EMIR REFIT – Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories EMIR 2.2 EC Proposal (June 2017) – Proposal for a Regulation amending ESMA Regulation (EU) No 1095/2010 and EMIR Regulation (EU) No 648/2012, as regards the procedures and authorities involved for the authorisation of CCPs and requirements for the recognition of third-country CCP Forthcoming EMIR 3.0 (strengthening risk management tools for CCPs and attempts to reduce cyclical effects of margins) Regulation (EU) 2021/23 of the European Parliament and of the Council of 16 December 2020 on a framework for the recovery and resolution of central counterparties © Valiante Diego – 39  The central clearing obligation © Valiante Diego – 40  G20 Commitments G-20 Commitments (Washington, London and Pittsburgh): – Strengthening transparency, responsibility and capital requirements; and – Better prevention and management of future crises G-20 Pittsburgh 2009: – “All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.” © Valiante Diego – 41  Objectives of regulatory intervention Scope: greater transparency, standardisation and reduction of counterparty risk 1. More safeguards... –...vs counterparty risk 1. Central clearing obligation 2. Risk mitigation techniques for those that are not centrally cleared –...vs systemic risk 3. Trade reporting obligation 2. More standardisation and accessibility – Risk management/mitigation procedures (EMIR) – Trading (MiFID/MiFIR) – Market infrastructure rules (MiFID/MiFIR/EMIR) © Valiante Diego – 42  Scope of clearing obligation Applies to all OTC derivatives contracts, i.e. a contract the execution of which does not take place on a regulated market as within the meaning of art. 4(1)(14) of MiFID (Dir. 2004/39) or on a third-country market considered equivalent (by the ESMA) to a regulated market in accordance with art. 19.6 of Directive 2004/39, as below: – Between FCs (investment firms, credit institutions, insurance, UCITS, pension funds, AIFMs) – Between NFCs and FC/NFC (if above the threshold of art. 10) – With an entity in a third-country (if that entity would be captured in the EU) It applies also between two entities in one or more third-countries if ‘substantial and foreseeable effect within the EU’ Contracts with ‘substantial and foreseeable effect within the EU’ (2 alternative conditions) → for info 1. One of the two non-EU counterparties is guaranteed by an EU FC for a total notional of >€8bn 2. At least equal to 5% of the sum of current exposures in OTC derivatives of EU FC 3. Non-EU counterparties execute transactions through EU branches AND would qualify as FC in the EU © Valiante Diego – 43 Central clearing  Clearing obligation (example) © Valiante Diego – 45  Clearing thresholds for Non-Financial Corporations (NFCs) The clearing obligation applies to all OTC derivative contracts once one of the thresholds below is reached (for NFCs; art. 10, EMIR, art. 11 Del. Reg. 149/2013) – Based on notional value – Set by asset class Credit (€1bn) Equity (€1bn) Currency (€3bn) Interest rate (€3bn) Commodities (€3bn) Other (€3bn) When calculating positions, a NFC must include all contracts entered into by all non-financial entities within its group If rolling average position over 30 days exceeds threshold, notification to ESMA (from March 2013) © Valiante Diego – 46  Exemptions (for info) Transactions ‘objectively reducing risk’ (for NFCs; art 10, EMIR and art. 10 Del. Reg. 149/2013) – Do not contribute to the threshold but are in if threshold kicks in… – Direct or indirect (from fluctuation of IR, inflation, FX) exposure to price risk (underlying) – IFRS 39 (art. 3 Reg. 1606/2002) Intragroup transactions (for NFCs) – If in the ‘same consolidation’ (IFRS) Double counting if not for hedging… – Info to be notified to ESMA (art. 11.14 EMIR, art. 18 Del. Reg. 149/2013) – Public disclosure of key info (art. 20 Del. Reg. 149/2013 ) Legal counterparties and relationship between the counterparties Full exemption or a partial exemption Notional aggregate amount of the OTC derivative Pension funds (temporarily) – Until non-cash collateral for variation margin is available FX options, forwards (CFDs) and swaps may be exempted (recital 19, EMIR; as in the US) – Commission says “no”, as they fall under MiFID definition of financial instrument – For spot exemption may indeed makes sense © Valiante Diego – 47  Procedure for OTC derivatives (art. 5 EMIR) – (for info) 1. Bottom-up’ procedure (CCP could apply to NCA) – After NCA approval, notification to ESMA (register for eligible products and CCPs; art. 5.1, EMIR) Provision of a set of data (art. 6, Del. Reg. 149/2013) – Data on volumes, liquidity, pricing information (from CCP) » Specific data (art. 6, Del. Reg. 149/2013; number of transactions, volumes, OI, etc) ESMA issues within 6 months RTS to formalise mandatory obligation... –...which applies also for outstanding trades executed before approval but after bottom-up process begins (‘frontloading’) 2. ESMA can identify products that can be potentially cleared (‘top down’; (art. 5.4, EMIR; art. 7, Del. Reg. 149/2013) – Standardisation (legal [master agreements] and operational [automated post-trade/life-cycle process]) – Volumes and liquidity testing (if default of counterparty [proportionate margining]) – Accepted pricing information available (on reasonable commercial basis) Once fallen under the obligation → 4 months for clearing There should be a public register for eligible products (art.6, EMIR) © Valiante Diego – 48  Derivatives listed on RMs, MTFs and OTFs (art. 29 MiFIR) Listed derivates have an automatic clearing obligation – “The operator of a regulated market shall ensure that all transactions in derivatives that are concluded on that regulated market are cleared by a CCP.” (art. 29 MiFIR) © Valiante Diego – 49  Prudential requirements and risk management of a CCP © Valiante Diego – 50  Capital and liquidity Capital (Risk Weighted Assets; RWA) – Conditions for authorisation ‘Adequately capitalised’ → at least €7.5 mn ‘Proportional’ to the risks Covering gross operational expenses for winding down – Capital requirements subject to EBA RTSs Central bank support – Access to liquidity facilities after evaluation of ESCB – Preserve ECB’s ‘independence’ (no legal duty to support CCP) © Valiante Diego – 51  Margins (art. 41, EMIR) “They shall also be sufficient to cover losses that result from at least 99 % of the exposures movements over an appropriate time horizon and they shall ensure that a CCP fully collateralises its exposures with all its clearing members, and, where relevant, with CCPs with which it has interoperability arrangements, at least on a daily basis.” – Time horizons for historical volatility (lookback period) Last 6 months 6 months of most stressed conditions in last 30y It can modified by CCPs (if stress tests) Intra-day margin calls when thresholds are breached Conservative calculation – Too high may limit resources for a multiple default event (because it makes more costly to contribute to the default fund) – Risks to hamper liquidity CCPs to regularly monitor and, if necessary, revise the level of margins to reflect current market conditions, taking into account any procyclical effects of such revisions. © Valiante Diego – 52  Collateral requirements (art. 46, EMIR) ‘Highly liquid’ (both for initial and variation margin) 1. Cash – Currency ‘able to manage’ – Currency in which the CCP ‘clears’ 2. Financial instruments (e.g. covered bonds, HQ corporate bonds, government bonds) – Issuer with low credit risk (to demonstrate; ratings?) Internal or external stable assessment (e.g. home country) – No regulatory or legal impediments for liquidation – Active (liquid?) outright or repo market – Reliable price data available – Not issued by the clearing member’s group itself, the CCP’s group itself, firm providing essential services to the CCP, firm owning and managing real estate 3. Commercial bank guarantee – Covering a segregated account of a firm the CCP knows – Irrevocable and can be honoured on demand – No wrong-way risk 4. Gold (held in specific locations) 5. Central bank guarantees (currency to which the CCP is exposed) © Valiante Diego – 53  Other collateral requirements 1. Segregation – Above clearing threshold 1. Client’s assets recorded in separate accounts 2. No netting of positions across accounts 3. Assets covering the position are not exposed to losses for positions recorded in another account – Default funds are treated differently. 2. Portability – (Direct and indirect) clients’ assets and positions – Increased by greater use of margins 3. Haircuts (subject to general requirements; art. 3 COL, ESMA) 4. Concentration limits on collateral (art. 4 COL, ESMA) – No > 10% of CCP collateral (total value of exposures, including reverse repo, deposits, credit lines, etc) from same issuer or guaranteed by the same institution or group – Other conservative requirements (amount by the clearing member, etc) – If > 50% commercial guarantees, the limit can go up to 25% © Valiante Diego – 54  Default safeguards Default fund (art. 42, EMIR) – For losses exceeding the margins – Amount able to withstand default of top two clearing members and adverse market conditions (over 30y) Default waterfall (art. 45, EMIR) 1. Margins 2. Default fund Defaulting members 3. CCP resources (capital + additional resources [at least 50% of capital]) 4. Default fund Non-defaulting members No-use of margins posted by non-defaulting members © Valiante Diego – 55  Organisational requirements (for info) © Valiante Diego – 56  Other requirements (for info) Organisational requirements – Open access – Interoperability – Authorisation and supervision – Recordkeeping – Other (remuneration policies, governance arrangements, stress testing, etc) © Valiante Diego – 57  Open access (for info) ‘Non-discriminatory and transparent access’ (art. 8 EMIR) – ‘Reverse access’ (CCP and trading venue) – Except if entails ‘liquidity fragmentation’ (within a single venue) and requires interoperability (Rec. 34, EMIR) No ‘liquidity fragmentation’ (art. 9, Del. Reg. 149/2013) if – At least 1 CCP in common – There are clearing arrangements established by the CCP Ban on interoperability can be waived if agreement from both parties (and authority)! Denial of access by a CCP based on: 1. The anticipated volume of transactions Exceeding scalable design or planned capacity 2. Operational risk and complexity Incompatibility of CCP’s IT systems r lack of human resources 3. Significant undue risk Product never cleared before, threat to economic viability, legal risks (e.g. unable to enforce close-out netting) or incompatible rules between CCP and trading venue © Valiante Diego – 58  Interoperability (art. 51-54, EMIR) (for info) ‘Cross-system execution [and margining] of transactions’ – Cross-margining arrangements can be designed to allow a trader to trade on more than one exchange and to collateralise its positions using assets held in one or more collateral pools. However, because of legal impediments, there are only a few examples of such arrangements internationally Limited to cash securities (not allowed for derivatives!) CCP should have at least 3 years of operation Adequate policies to identify and manage risks Approval by national authority (notification to ESMA) – If disagreement, ‘it should reconsider’ (art. 50.3, EMIR) For derivatives not yet © Valiante Diego – 59  Other organisational requirements (for info) Colleges (art. 18, EMIR) – To supervise compliance with EMIR – Defined by competent authority ‘Relevant currency’ (to involve the central bank) – Share of each currency at the end-of-day CCP open positions – ‘Most relevant’ → 3 with highest share (yearly) Recordkeeping – Common formats and accessible (Annex I, table 1, ITS) – At least 10 years (minimum info) Transactions Positions Business records Business continuity and disaster recovery plan – Max downtime and backup facilities © Valiante Diego – 60  Other organisational requirements (for info) Authorisation and recognition of a CCP (art. 14 and 25, EMIR) – National rules are currently applied – ESCB involvement too – List of ‘authorised’ activities – Compliant with Settlement Finality Directive – Response within 180 working days – Third country Detailed info about business and compliance with home country rules Equivalence and supervisory arrangements agreement (rec. 13) TC CCPs will be subject to third-country rules only Settlement in central bank money (if possible) © Valiante Diego – 61  Other organisational requirements (for info) Other organisational requirements (art. 26, EMIR) – Governance arrangements (art. 2 ORG, ESMA) Board should assume final responsibility – On key areas (risk management, compliance etc; art. 4 ORG, ESMA) – Risk management function (art. 2.5 ORG, ESMA) – Compliance policy and procedures – Remuneration policies (art. 5 ORG, ESMA) – Reporting lines (art. 4 ORG, ESMA) – Audits (art. 8 ORG, ESMA) – Information technology systems (art. 6 ORG, ESMA) Disclosure about holdings (as for IFs) and other requirements – To verify changes in the ‘subsidiary’ status © Valiante Diego – 62  Other organisational requirements (for info) Stress testing → periodic confidential reporting – Models to evaluate risks (for total and liquid financial resources) – At least annually – Testing financial resources coverage at least daily Back testing – Models for initial margins Sensitivity testing – Historical data about stressed conditions and hypothetical stressed conditions Some key aspects of default procedures must be disclosed – E.g. circumstances when action should be taken © Valiante Diego – 63  Other organisational requirements (for info) Conduct of business rules – Conflicts of interest Also concerning the CCP governance Liquidity risk controls (art. 44, EMIR) – MMF and time deposits, not liquid – No minimum cash requirement CCPs investment policy (art. 47, EMIR; art. 1-6 INV, ESMA) – ‘Cash or highly liquid instruments’ (cumulative conditions) Governments, central banks, multilateral development banks Low market risk, volatility risk, inflation risk Freely transferable and specific currency (as for collateral) Active outright and repo market Reliable information on price available (?) and no wrong-way risk – Also liquid if used to hedge defaulted clearing member © Valiante Diego – 64  Risk mitigation techniques for non- centrally cleared derivatives trades (for info) © Valiante Diego – 65  Risk mitigation techniques (ch. 8 EMIR) (for info) 1. Margins 2. Timely confirmation 3. Daily valuation 4. Portfolio reconciliation 5. Portfolio compression 6. Dispute resolution © Valiante Diego – 66  Margins (for info) Initial and variation margins (BCBS/IOSCO paper; Commission Delegated Regulation (EU) 2016/2251) – Apply to FC and NFC+ firms not subject to mandatory clearing – Two-way initial and variation margin may impact liquidity – Liquid collateral Cash, HQ govs, corp and cov bonds, equities (blue chips), gold – Initial margin to be segregated A battle for global standards → Risk of regulatory arbitrage! Exemptions: – Outstanding contracts before December 2015 – €50mn threshold (no initial margin) – Minimum level of €8bn non-centrally cleared notional for initial margin – Physically settled FX forwards and swaps Cross-currency, FX element exempted – Sovereigns, central banks, development banks © Valiante Diego – 67  Timely confirmation and daily valuation (for info) 1. Timely confirmation (art. 12, Del. Reg. 149/2013; phasing out) – By electronic means where available – For FC and NFC+ → T+1 – For NFC- → T+2 – By the end of the day!→ for others 2. Daily valuation (for FC and NFC+, art 11.2, EMIR) – Marking-to-market (M-T-M) value of outstanding contracts, except if (art. 16, Del. Reg. 149/2013): Market is inactive (quoted price not readily available or not representing arm’s length transactions) Reasonable fair value estimates are too different and not probabilities can be reasonably assessed – If no M-T-M, marking-to-model, following these criteria (art. 17, Del. Reg. 149/2013): Use as much MTM info as possible Accepted economic methodologies Observable market transactions Documented by the Board (at least annually) © Valiante Diego – 68  Portfolio reconciliation (for info) (art. 11.1(b), EMIR; art. 14, Del. Reg. 149/2013) 3. Portfolio reconciliation. Spot trade mismatches (e.g. valuation) in the eye of the counterparty and solve them, preventing disputes – FC and NFC+ If >500 outstanding contracts → daily If 51-499 → once per week If 100 Once per year 5 days © Valiante Diego – 70  Reporting (for info) © Valiante Diego – 71  Reporting obligation (art. 9 EMIR) (for info) Disclosure to trade repositories (or ESMA, if not available) – Level of data to be reported (art. 1, Del. Reg. 148/2013) Parties to the contract (or the beneficiary) Type of contract Maturity Notional value Price Settlement date – To mention if from both counterparties (i.e., data reported as had been done separately) – Not done by the CCP (if traded and cleared there, CCP mentioned as ‘counterparty’; art. 2.2, Del. Reg. 148/2013)… …but can be delegated! NFC- shall not report: – Collateral, mark to market, or mark to model valuations of the contracts © Valiante Diego – 72  Trade repositories (Title VI EMIR) (for info) Legal entity in the EU Passport (and direct ESMA supervision) – ESMA response within 20 working days Data compatibility with MiFID to become ARM Criteria in ESMA RTSs – Identification (e.g. types of derivatives to be reported) – Ownership disclosure and chart (e.g. holdings disclosure above 5%) – Policies and procedures (e.g. how compliance will be ensured) – Organisational chart – Corporate governance (e.g. internal policies) – Internal controls and regulatory compliance (e.g. next 3y work plan) – Senior management and Board (e.g. experience and reputation) – Personnel and remuneration (e.g. compensation policies) – Financial reports and business plans – Management of conflicts of interest © Valiante Diego – 73  Reporting obligation (art. 9 EMIR) (for info) TRs will report as under art. 26, MiFIR 1. Transaction reporting All data cleared and reported by TRs Access to all transaction data to ESMA (energy to ACER, etc; but also takeover authorities, ESRB, ESCB) Third country authorities? – International agreement, ex art. 75, EMIR 2. Trade reporting? → aggregated positions (art. 2 Del Reg, ESMA) Aggregate positions, breakdown by type of derivative, online, and at least weekly update Standards for aggregation of positions (ESMA guidelines) © Valiante Diego – 74  Data formats (for info) Standardised code to spot underlying (rec. 3, Impl. Reg. 1247/2012) Unique Product Identifier (UPI) to identify OTC derivatives – Uniqueness, neutrality, reliability, open source, scalability, accessibility, at reasonable cost, with governance arrangements. – If no UPI, identification by asset class and type (e.g. FX option) Report should include a Legal Entity Identifier (LEI) to identify (art. 3, Impl. Reg. 1247/2012) – General legal entity, broking entity, reporting entity, legal person, CCP If compatible with MiFIR, TR will report! © Valiante Diego – 75  CCP recovery and resolution © Valiante Diego – 76  Background Value of the CCP is the value of its network of CMs CCPs are not bank-like business but they are subject to ‘run’ – Pre-funding/commitment is key Legal risks grow as the CCP gets closer to the point of failure, despite ‘safe harbours’ (e.g. valuation) – Higher risk to deviate from CCP Rulebook © Valiante Diego – 77  A CCP crisis is a liquidity story (cyclical behaviour)! Liquidity problems can occur in central clearing, even if all counterparties have the financial resources to meet their obligations, if they are unable to convert those resources into cash quickly enough. (J. Powell, FED Chairman) 78  Recovery and resolution Ensuring continuity of critical functions needs some level of pre- funded tools, otherwise recovery usually exhausts all pre-funded measures. CPP should be ‘failing or likely to fail’ to trigger its resolution, i.e.: 1. The CCP infringes or is likely to infringe in the near future the EMIR prudential requirements for maintaining its authorization; 2. The recovery measures (EMIR waterfall) are insufficient to restore its viability; 3. The CCP is unable, or is likely unable in the near future, to maintain critical clearing services (i.e. excluding pure commercial reasons); 4. The CCP is or will in the near future be unable to meet its obligations and other financial commitments. When no private sector alternative or supervisory measure can avert failure in a reasonable timeframe; and, When its failure would jeopardise the public interest (e.g. normal insolvency proceedings would be detrimental to for financial stability). © Valiante Diego – 79  Initial Margin (IM) This might be se cases IM should CCP loss-allocation waterfall Defaulting CM’s default fund contribution Usually cash – d defaulting CMs Tranche of CCP’s capital Tranche of CCP Recovery planning in CCP Rulebook and Default fund contributions of surviving Default fund con CMs approved EMIR College Resolution tools are: Assessments/ unfunded default fund Most CCPs can Variation Margin Gains contributions (an “assessmen contribution Haircut (VMGH) Cash calls (assessment Can mitigate mo rights) Additional CCP capital tranche with either insuf Auctions assumes it will b Tear-ups VMGH CCP Recovery R beyond those re management pr portfolio or repla Service closure * As an aside, whether securities collateral is likely Source: ISDA. remote” from the CCP remains uncertain and will d assessments; cash collateral is expected not to be “  Variation margin gains haircutting (VMGH) It enables the CCP to reduce (“haircut”) pro rata across clearing members the variation margin payments that it is due to be returned to those members whose positions have increased in value since the default. Members whose positions have decreased in value must continue to pay the variation margin in full. It does not create an unlimited contingent exposure from a clearing member to the CCP. A clearing member can lose no more than the amount by which its position has gained in value since the default. © Valiante Diego – 81  Service closure (LCH.Clearnet) This process is also referred to as “tear-up.” Service closure involves the closeout of all outstanding contracts at a price established under the LCH’s rules. Non-defaulting clearing members that are in the money will also receive variation margin profits and coupon payments on a pro rata basis. Initial margin will be returned to all non-defaulting clearing members. For most asset classes cleared by LCH, service closure will completely allocate any residual losses incurred due to the default and the tear-up of contracts to the non-defaulting clearing members. © Valiante Diego – 82  Other post-trade regulations © Valiante Diego – 83  Securities value chain © Valiante Diego – 84  What is settlement? ‘Settlement’ is “The completion of a transaction or of processing with the aim of discharging participants’ obligations through the transfer of funds and/or securities. A settlement may be final or provisional.” (ECB Glossary) Three settlement types (BIS-CPMI principles #12): – A Delivery vs Payment (DvP) is a mechanism that links a securities transfer and a funds transfer in such a way as to ensure that delivery occurs if and only if the corresponding payment occurs. – A Payment vs Payment (PvP) a PvP settlement mechanism is a mechanism which ensures that the final transfer of a payment in one currency occurs if and only if the final transfer of a payment in another currency or currencies takes place. – A Delivery vs Delivery (DvD) settlement mechanism is a securities settlement mechanism which links two or more securities transfers in such a way as to ensure that delivery of one security occurs if and only if the corresponding delivery of the other security or securities occurs. © Valiante Diego – 85  What is settlement finality? CPMI-IOSCO principle #8: – “A Financial Market Infrastructure (FMI) should provide clear and certain final settlement, at a minimum by the end of the value date. Where necessary or preferable, an FMI should provide final settlement intraday or in real time.” ‘Settlement finality’ is a legal definition to establish with a high degree of certainty when the settlement is ‘final’ (reducing transaction costs). – When the transfer of an asset or financial instrument to a counterpart, or the obligation by the FMI or its participants in accordance with the terms of the underlying contract are discharged irrevocably and unconditionally. © Valiante Diego – 86  Post-trading architecture Source: ECB (2007) Central bank money vs commercial bank money © Valiante Diego – 87  The Central Securities Depositories Regulation (CSDR) © Valiante Diego – 88  Central Securities Depositories Regulation (EU n. 236/2012) Central Securities Depositories (CSDs): – allow the registration and safekeeping of securities – allow the settlement of securities in exchange for cash – track how many securities have been issued and by whom – track each change in the ownership of these securities The main objective of the regulation is to increase the safety and efficiency of securities settlement and settlement infrastructures in the EU. © Valiante Diego – 89  Key measures of the Central Securities Depositors Regulation (EU n. 236/2012) 1. Shorter settlement periods (depends on securities, trading venue, market) → no longer than T+2 (soon T+1) – Transferable securities, money-market instruments, units in collective investment undertakings and emission allowances which are admitted to trading or traded on a trading venue or cleared by a CCP – Same day confirmation obligation 2. Cash penalties (paid to receiver) and other deterrents for participants that cause settlement fails 3. Strict organisational, conduct of business and prudential requirements for CSDs 4. Passport system allowing authorised CSDs to provide their services across the EU 5. Increased prudential and supervisory requirements for CSDs and other institutions providing banking services that support securities settlement © Valiante Diego – 90  The ‘buy-in’ remedy Buy-ins are not a ‘penalty mechanism’, they are a contractual remedy to provide for physical settlement of a trade – Where a failing participant does not deliver the financial instruments to the receiving participant within 4 business days (15 for SMEs Growth markets listed instruments), called ‘extension period’, a buy-in process shall be initiated whereby those instruments shall be available for settlement and delivered to the receiving participant within an appropriate time-frame. (art. 7.3 CSDR) If the buy-in fails or is not possible, the receiving participant can choose to be paid cash compensation or to defer the execution of the buy-in to an appropriate later date (‘deferral period’). The failing participant shall reimburse the entity that executes the buy-in for all amounts paid, including any execution fees resulting from the buy-in. No sell-out mechanism if the settlement fails through buyer’s fault © Valiante Diego – 91  The Securities Financing Transaction Regulation (SFTR) © Valiante Diego – 92  Securities Financing Transactions (SFTs) Securities financing transactions (SFTs) allow investors and firms to use assets, such as the shares or bonds they own, to secure funding for their activities. A securities financing transaction can be 1. A repurchase agreement transaction or repo (selling a security and agreeing to repurchase it in the future for the original sum of money plus a return for the use of that money) Ownership transfer Only temporary use of the assets for the buyer and of the cash for the seller Obligation to return a fungible or same instrument at an agreed date Difference between price of purchase/sale is the return (as an annual percentage is called ‘repo rate’) © Valiante Diego – 93  Other securities Financing Transactions (SFTs) 2. Lending a security for a fee in return for a guarantee in the form of financial instruments or cash given by the borrower 3. A buy-sell back transaction or sell-buy back transaction 4. A margin lending transaction © Valiante Diego – 94  Securities Financing Transactions (SFTs) Regulation All SFTs, except those concluded with central banks, to be reported to central databases known as trade repositories Information on the use of SFTs and Total Return Swap by investment funds (UCITS and AIFs) to be disclosed to investors in the regular reports and pre-investment documents issued by the funds – ‘total return swap’ means a derivative contract in which one counterparty transfers the total economic performance, including income from interest and fees, gains and losses from price movements, and credit losses, of a reference obligation to another counterparty. Minimum transparency conditions to be met when collateral is reused, such as disclosure of the risks and the obligation to acquire prior consent © Valiante Diego – 95  Synthetic ETF I NDEX UCITS manager RE TURN SWAP ETF Funded or unfunded Cash Collateral (creation units) Authorised Counterparty CASH participant ETF Cash Cash Securities (shares) Exchange Secondary market Markets ETF (shares) Cash Investor © Valiante Diego – 96  Recommended readings Valiante, D. (2010). Shaping Reforms and Business Models for the OTC Derivatives Market: Quo vadis?. ECMI Report, https://www.ceps.eu/ceps-publications/shaping-reforms-and- business-models-otc-derivatives-market-quo-vadis/ (p 1-28). OTC derivatives—A primer on market infrastructure and regulatory policy https://www.chicagofed.org/~/media/publications/economic- perspectives/2014/3q2014-part2-ruffini-steigerwald-pdf.pdf Menkveld, Albert J. and Vuillemey, Guillaume, The Economics of Central Clearing (November 24, 2020). Annual Review of Financial Economics Available at SSRN: https://ssrn.com/abstract=3736580 Braithwaite, J. and Murphy, D. (2016), Got to Be Certain: the Legal Framework for CCP Default Management Processes, Bank of England, Financial Stability Paper, No. 37. Additional readings – P Saguato Hidden costs of clearinghouses https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3269060 – UNIDROIT, Principles of close-out netting https://www.unidroit.org/wp- content/uploads/2021/06/netting-English.pdf (p. 1-18) © Valiante Diego – 97  Diego Valiante LEIF Master Programme [email protected] www.unibo.it