EFAMA reply to European Commission public consultation on Derivatives and Market Infrastructures

Transcription

1 EFAMA reply to European Commission public consultation on Derivatives and Market Infrastructures EFAMA is the representative association for the European investment management industry. Through its 26 member associations and 42 corporate members, EFAMA represents about EUR 13 trillion in assets under management, of which EUR 7 trillion managed by 53,000 investment funds at end KEY POINTS Buy side support for central clearing The buy side supports the move from bi lateral to central clearing. However, central clearing could produce perverse results should the impact on the client side of the market not be fully considered. The cost of central clearing should be proportionate to the risks, but unless the margining and collateral arrangements established within the CCPs are correctly calibrated to take account of all the risks in the system, the cost of central clearing will be borne disproportionately by the very people the legislation seeks to protect the man in the street, through pensions, insurance endowment policies and savings in UCITS funds. The long term savers could end up cross subsidising the CCPs, clearing members and leveraged market users. Using available industry data, our members have calculated that the potential cost of the cross subsidy is a massive 2% performance drag year on year for pension funds (see Annex I), and an estimated additional 0.5% for insurance funds. The drag for funds is lower, but may still be significant. Segregation for all client money and assets We agree with the Commission s proposals as regards the segregation of client money and assets, in particular that all client money and assets should be segregated. This is an important reform in EU markets and sets an appropriate standard for the treatment of client property. Fair initial margin charge Initial margin charges proposed to date by CCPs do not take into account default/counterparty risk factors, but rather focus on product and market risk. Whilst this is akin to on exchange derivatives, the initial margin charges in relation to fungible exchange contracts is fractional compared to that proposed for bi lateral contracts. Therefore, instead of assessing the likely default risk of asset rich clients such as pension funds (virtually zero), the CCPs calculate a default rate applicable to the product and to the clearing member. Solutions should be written into the legislation to ensure 18 Square de Meeûs B-1050 Bruxelles Fax info@efama.org

2 2 that a wholesale transfer of value does not occur. The alternative would be a whole or partial cessation in using derivatives to manage risk within the long term savings industry, which would increase risk. EFAMA does not believe that the intention is to introduce arrangements which lack proportionality in this way. We therefore propose a number of ways in which initial margin might be more fairly charged: Require CCPs to break down the initial margin charge into its components and price these accordingly. These are: an element attributable to intraday market risk; an element attributable to product risk; and an element attributable to clearing member default, which must also reflect the requirements set out in the Commission working document, section II 8 C (a). Ensure a balance between the CCP default fund and initial margin that can, inter alia, reflect the likely default of the clearing member (as regards the default fund) and the likely default of the end investor (as regards initial margin). CCPs should be required to adjust the contribution of its clearing members to the default fund up to reflect reductions to initial margin charges agreed by the clearing member with its clients, reflecting the default risk element referred to in the previous bullet point. Require clearing members to pass on initial margin charges only to the extent that each element of the charge is justifiable for each client. Encourage CCPs to consider introducing gross margining across the system. This would require fractional levels of initial margin to be charged (compared to existing proposed initial margin charges), but applied in relation to all contracts traded and held for its duration. High frequency strategies could require initial margin to be collected ahead of trading. This approach would remove the netting benefit taken by the clearing members although of course not deny it to the CCP and replace it with a fairer charge across all market users. This would prevent the bulk of the initial margin charge being carried by the long term directional investors such as pension funds. Expand approach to collateral The proposed rules on acceptable collateral work for the clearing house but not for clients and not in support of a more stable financial system. There are three basic problems: The requirement for highly liquid collateral means that much of the long term savings clients will be forced to convert collateral through a CCP clearing member in order to achieve a form of collateral acceptable to the CCP. This negates any freedom for clients to post collateral direct to the CCP, bypassing the clearing member, and thus introduces an additional level of counterparty risk for the long term savings industry that does not exist now.

3 3 The requirement to convert collateral will also reduce returns for the long term savings industry, as lower yielding liquid assets required for collateral purposes are substituted for higher yielding assets held for investment purposes. The requirement to collateralise daily, possibly intraday, introduces significant operational risk as collateral is moved around the system and made subject to the vagaries of different IT and record keeping systems. We note that the Lehman administration has been very seriously hampered owing to poor record keeping. To ameliorate this problem for the client side of the market, our members propose that the Commission should: Consider permitting investment managers and their clients or funds to retain collateral at their existing custodian, segregated from the investor s other assets and held in a ringfenced account or in trust for the CCP. If arrangements of this kind could be introduced it would carry a significant benefit in terms of limiting the amount of collateral moving round the system on a daily basis, with the attendant operational risks. We understand this approach is utilized in the US for 1940 Act regulated funds and formalised within a control agreement agreed by the custodian, fund and counterparty. In conjunction with the particular arrangement described above, permit the CCP to accept a wider range of assets held, with appropriate haircuts for different asset types. This would relieve the long term savings industry from the need to pay clearing members to convert their existing collateral into more liquid collateral; it would also permit the collateral to be managed with regard to its investment purpose, whilst held with regard to the collateral requirement. As well or instead, encourage CCPs to set up custodial arrangements within the main custodian banks utilised by investors, such that in respect of these institutions collateral would not have to move through the clearing member or across a number of custodians to reach the CCP s segregated account. Again, it would be necessary to permit the CCP to accept a wider range of assets held, with appropriate haircuts. Avoiding portfolio fragmentation Investment managers will need transitional arrangements to ensure that underlying clients do not suffer portfolio fragmentation over the transfer to central clearing. Portfolio fragmentation would significantly increase the risks for clients of the market. Investment managers will also need additional time, beyond what is allowed to the clearing members and CCPs, to make operational changes and to do their due diligence on the choices offered by CCPs and clearing members. Investment managers are not able to start adapting their processes until the CCPs and clearing members have completed theirs, which effectively means that they would have a much shorter period of time to bring about the necessary changes. Fund depositaries/custodians will also need time to make operational changes to adapt to central clearing.

4 4 We therefore seek a transitional period of 12 months for all investment managers (whether managing funds or discretionary portfolios) beyond the period after which central clearing of eligible derivatives becomes mandatory. Inclusion of Forward Foreign Exchange in central clearing obligation The consultation does not discuss in any detail which instruments would be in scope for the central clearing obligation. Many of the instruments are self evidently in scope, but it is not clear to what extent FX forwards would be expected to go into central clearing. Central clearing of FX forwards would create a number of issues for asset managers and their clients. We have categorized types of FX forwards and their usage as follows: Very short dated FX forwards Short dated FX forwards driven by the receipt or payment of non base currency proceeds. Many equity and bond markets operate on a T+3 to T+5 settlement basis. FX trades executed to match these transactions would technically be considered forward trades (spot trades are normally T+2). Nevertheless, to all intents and purposes their characteristics and objectives are entirely consistent with spot trades. Hedges for underlying equity and fixed income holdings FX forwards are commonly used by both institutional clients, such as pension funds and insurance companies investing in separate accounts and by retail and high net worth clients investing in hedged share classes of pooled funds. They are a significant component of both active and passive funds and are used as hedges for underlying bond, commodity or equity portfolios (or related feeder funds/hedged share classes) where the investment manager manages the underlying assets. These contracts usually have between one and three months original maturity, and can extend to twelve months maturity. For example, such buy side clients are seeking the diversification of returns generated by exposure to European equities without the related currency risk. Given the expected returns in typical equity or fixed income mandates, the volatility created by un hedged currency exposure could outweigh the benefits of international asset diversification. Overlay strategies Collateralisation of overlay strategies where core assets are externally managed would challenge the viability of this strategy. Were collateralisation of FX forwards to become mandatory, overlay strategies would require an up front capital commitment and the daily availability of cash to cover mark to market movements. Where the availability of these assets is limited, investors face the choice of either making such collateral available to the fund manager by reducing their investments elsewhere or incorporating currency risk into their investment decisions. If the latter, hedging strategies designed to minimise risk are sacrificed in order to maintain full market

5 5 exposure and competitive returns. Past experience strongly suggests that this would decrease the use of such overlay products, resulting in increased volatility of returns and weaker risk control for the underlying investors. We recommend the following: For very short dated maturities, where the most important source of risk is settlement exposure, central clearing should only be used for FX forwards with an original tenor of at least one week. For hedging of underlying portfolios and related hedged share classes, central clearing for contracts of less than 13 months original tenor should be optional rather than mandatory. Forward contracts related to hedging could be clearly identified as those that offset, in whole or in part, a currency exposure in the underlying portfolio or share class or that serve to terminate such an offsetting contract. For longer dated FX forwards, central clearing should only become mandatory when the CCPs can manage a broad range of collateral types for both initial and variation margin. This should be read in conjunction with our comments about a mechanism to extend the range of eligible collateral for contracts with the underlying clients of portfolio managers 1. FX contracts carry more market risk than counterparty risk, particularly if the trades are cleared via CLS (or similar payment vs payment settlement system). This also distinguishes them from other classes of OTC derivative contract. Definitions for market participants The financial counterparty definition is too broad, in that it fails to distinguish between (1) dealers/market makers providing services in the market (2) investment managers and other market users of these services who are clients of the market and (3) regulated underlying clients such as pension funds and UCITS funds who are the principals to the transactions but deal mostly through their appointed agents. The inability to distinguish between the different types of regulated firms means that the regulations cannot contemplate easily different approaches for different groups, for example in relation to collateral quality and collateral handling. We suggest that there should also be a cross reference to the MiFID definitions for market maker, portfolio manager, dealing on own account and client. UCITS SPECIFIC ISSUES With the introduction of central clearing it is opportune to review provisions on counterparty risk exposure and concentration limits that are to be found in UCITS. Presently they are not easy to apply to centrally cleared OTC instruments. With the onset of mandatory central clearing across a wide range of derivative instruments, EFAMA members seek clarity and consistency across the 1 Portfolio managers refers to the MiFID definition for those undertaking portfolio management: Portfolio management means managing portfolios in accordance with mandates given by clients on a discretionary client-by-client basis where such portfolios include one or more financial instruments

6 6 single market as to the measurement of counterparty risk exposure and concentration limits for cleared OTC instruments. Issues arise because even where a contract is centrally cleared: a) the exposure of the UCITS fund is likely to be legally to the clearing member (but may be to the CCP); b) collateral is placed by the fund with the CCP or a clearing member; c) collateral is not received from the CCP, so there are no collateral offsets in the calculations; d) a fund is likely to have fewer relationships with clearing members in the future than it does with banks for OTC business presently, so increasing notional concentration; and e) CCPs need not be credit institutions. UCITS risk and concentration The current provisions can be found in Article 52 of UCITS. Additionally, Commission Recommendation 2004/383/EC of 27 April 2004 includes the statement: 5.1. Criteria for the limitation of counterparty risk exposure to OTC derivatives Member States are recommended to ensure that all the derivatives transactions which are deemed to be free of counterparty risk are performed on an exchange where the clearinghouse meets the following conditions: it is backed by an appropriate performance guarantee, and is characterised by a daily mark to market valuation of the derivative positions and an at least daily margining. Current provisions only apply to exchange traded derivatives, but EFAMA believes that language should be introduced in the UCITS Directive to ensure that the exposure to a clearinghouse for bilaterally traded derivatives should also be considered equal to zero. CESR has already dealt with the subject in its Consultation paper on CESR s Guidelines on Risk Measurement and the Calculation of Global Exposure and Counterparty Risk for UCITS (Ref.: CESR/10 108). UCITS and CDS in central clearing There was a considerable amount of work undertaken when the Eligible Assets Directive (EAD) was published to ensure that the position of UCITS in regard to credit default swaps (CDS) was made clear. Article 8 (2) of the EAD reads as follows: Financial derivative instruments as referred to in Article 19 (g) of Directive 85/611/EEC shall include instruments which fulfil the following criteria: (a) they allow the transfer of the credit risk of an asset as referred to in point (a) of paragraph 1 of this Article independently from the other risks associated with that asset; (b) they do not result in the delivery or in the transfer, including in the form of cash, of assets other than those referred to in Article 19 (1) and (2) of Directive 85/611/EEC.

7 7 UCITS are not permitted to invest in non eligible assets. This restriction can extend to investments where settlement is determined by reference to an ineligible asset (or pool of assets including an ineligible asset). As funds migrate to clearing CDS through CCPs, this opens a potential difficulty should the CCP include an ineligible asset in any part of their clearing process. Typically, under bilateral arrangements, managers will attempt to deal with restrictions arising from the EAD by agreement with their bank counterparties. From our perspective it appears clear that one of the purposes of introducing central clearing is to improve settlement liquidity and risk management (via standardisation of contractual terms and centralisation of clearing and settlement processing). UCITS funds wish to participate in central clearing for CDS. Central clearing should in principle be available for UCITS funds in relation to all instruments (in eligible assets) that can be centrally cleared, regardless of the eventuality of a CCP using ineligible assets in any part of their clearing process. UCITS and valuations There is also an issue on valuation timing. Funds are required to value at fixed points of their choosing each day. Some funds have identified that the valuations that will be issued by the CCPs may have diminished usefulness because the time lapse will be too great between the CCP s valuation and the valuation point for the fund. For instance, this could happen when a fund values at 10am and the CCP values at 11am, meaning that the fund would be using information that is 23 hours old. Clearly, one of the benefits of central clearing is that it will assist the funds towards more accurate valuations than those issued by single counterparties (although these may still be used). In order to utilise the valuations used by the CCPs, there has to be transparency of outcome (ie the valuations should be made public to market participants) and there should be transparency as to the methodologies adopted in preparing the valuations. This should be made a requirement in the legislation. I. CLEARING AND RISK MITIGATION OF OTC DERIVATIVES What are stakeholders views on the clearing obligation, the process to determine the eligibility of OTC derivate contracts for mandatory clearing, and its application? Do stakeholders agree that access from trading venues to CCPs clearing eligible contracts should be guaranteed? Investment managers support the proposals outlined to introduce a clearing obligation and set the framework for a robust process to determine the eligibility of OTC derivative contracts to which mandatory clearing will apply. We agree as well that access to CCP services in respect of clearing eligible contracts should be guaranteed for trading venues, in the sense that this requires CCPs to grant non discriminatory access. We would expect the usual counterparty risk and other requirements to apply to each

8 8 venue seeking access to a CCP. In the case of third country venues (and in respect of interoperability) such access should require an equivalence test requiring the trading venue to meet the same standards as those imposed on EU venues by a CCP. Whilst a combination of both bottom up and top down approaches to central clearing seems to provide the best opportunity to ensure a wide range of assets become clearing eligible, it is important that the top down element of the approach does not give rise to inappropriate assets being cleared, for instance those which are very difficult to value. This would not reduce systemic risk. Do stakeholders share the general approach set out above on the application of the clearing obligation to non financial counterparties that meet certain thresholds? A majority of EFAMA members agree with the approach in principle, but believe that in the detail there are some problematic gaps which will need looking at further. The basis of the Commission s proposal is to apply the clearing obligation to financial counterparties as defined. In order to introduce a threshold condition for non financial counterparties a further definition has been developed, but this applies only to EU legal entities (presumably because the Commission cannot make laws for non EU legal entities). This is intended to pull corporates that have put on trades above certain threshold levels within the requirements that would obligate central clearing of their contracts. However, this leaves a serious gap in the coverage of the scheme as the non EU legal entities are not caught which we believe undermines its effectiveness. Therefore if possible a way should be devised to capture an overview of non EU corporate transactions, even though these could not be required to go into central clearing. What the EU is able to do is to impose regulation at the point of the transaction, through oversight of the regulated firms that make markets for the unregulated (as well as the regulated) customers. Therefore we suggest that transactions entered into bi laterally with non financial counterparties domiciled outside the EU should be flagged by the financial counterparty acting as a market maker (a definition for the market makers might be drawn from MiFID 2 ). Although each market maker will not be aware of how much trading the corporate undertakes with other market makers, transaction reports that flag uncovered and/or large positions above a threshold will help to establish client activity. The market makers could also be required to report all bi lateral trades to trade repositories. And as with on exchange derivatives trades, the legislation should require the client immediately facing the market maker to be identified, on enquiry. It helps that the market makers handling significant volumes of this type of derivative transaction are few in number. 2 MiFID: Two definition have relevance: Market maker means a person who holds himself out on the financial markets on a continuous basis as being willing to deal on own account by buying and selling financial instruments against his proprietary capital at prices defined by him Dealing on own account means trading against proprietary capital resulting in the conclusion of transactions in one or more financial instruments

9 9 Lastly, we wish to point out that the clearing obligation of certain underlying clients of investment managers is unclear when these clients are not themselves regulated (eg sovereign wealth funds), and this point requires clarification. Do stakeholders share the principle and requirements set out above on the risk mitigation techniques for bilateral OTC derivative contracts? Yes. However, it would be more complete were certain further restrictions brought to bear, as follows: a. the financial counterparty acting as a market maker should be required to report the transaction to their regulator, or use the trade repository for this purpose, to ensure a full view of the market may be obtained. This reporting obligation should not be imposed on the customer, as (1) the regulator does not need to receive the report twice just because there happen to be two regulated entities entering into the transaction, (2) the regulator has no relationship with many customers as they are unregulated, and (3) the market maker is providing the service which gives rise to the concluded transaction and the obligation to report should attach to the regulated firm providing the service; and b. the financial counterparty acting as a market maker should not be able to impose terms to transfer or novate the contract without the consent of the client on a transaction by transaction basis. Some EFAMA members, however, invite the Commission to carefully consider the requirements for bilaterally cleared contracts, and believe that the implementation of such additional requirements should not lead to increased cost for buy side financial firms. II. REQUIREMENTS FOR CENTRAL COUNTERPARTIES Do stakeholders share the general approach set out above on organisational requirements for CCPs? In particular comments are sought on the role and function of the Risk Committee; whether the governance arrangements and the specific requirements are sufficient to prevent and manage potential conflicts of interest; stringent outsourcing requirements; and participation and transparency requirements? Do stakeholders consider that possible conflicts of interest would justify specific rules on the ownership of CCPs? If so, which kind of rules? We do not expect investment managers to wish to become clearing members, and a large majoriy of EFAMA members agree with the general approach set out in the Consultation for organisational requirements of CCPs. However, some of our members believe the Commission should explore alternative models, for example the possibility of non clearing memberships. In this regard, please see in Annex II a summary of an alternative proposal, while for further details (including comments regarding

10 10 default fund and default waterfall) we refer you to the submissions made to the Commission by our members BVI and Union Investments. With respect to the Risk Committee, it is not clear what independent administrators are, but in principle we support the aim of ensuring that the Risk Committee does not represent only the narrow interests of Clearing Members. Whatever the background of the people brought together on the Risk Committee, it is important that each group has sufficient numbers to make common cause with others on the committee. Otherwise, the group that share common goals, the Clearing Members, will always dominate the debate. Yes, EFAMA members believe that possible conflicts of interest justify specific rules. We single out the likelihood that the market will swiftly gravitate towards monopoly service provision, most likely on product lines but possibly also on geographic lines. This could be expected to offer considerable operational efficiency at the CCP, Clearing Member and possibly even the client level. But without competition discipline being brought to bear naturally, we recommend that rules should be made to ensure that any such monopoly services are required to be priced on a cost plus basis. This could be kept under review by giving powers to the regulators to commission value for money audits on a periodic basis (perhaps every other year). These checks and balances could of course be set aside should competition revive between CCPs. Because the proposed legislation will bring in mandatory central clearing, it is important that the legislation should incorporate within it requirements on the CCPs to respect and accommodate as far as possible the needs of end users when developing their rules, processes and documentation. It is not enough that a CCP makes this information available on request, and after the event in terms of having already adopted other rules, processes and documentation. As part of the general governance surrounding CCPs, they should be required to consult in an effective way with all their stakeholders. For example, in both France and Germany local industry has developed countryspecific master agreements, which deal with particularities of local law and practice without departing from the contractual principles embedded in the ISDA master agreements used elsewhere. It is important that CCPs should respect these differences and, to the extent that it does not cut across their broader risk management arrangements, offer the use of these contracts to French and German end users. Do stakeholders share the approach set out above on segregation and portability? We believe that the approach should go further to protect investors. As drafted the principles are intended to require better choice and better record keeping, and they acknowledge the desirability of contract portability. This is not enough. Before considering choice, policymakers should determine the minimum standards provided in the markets under their remit. Arguably too much has already been taken out of regulation and into contract, and therefore made subject to negotiation between the parties. The Lehman administration illustrated how problematic it could be to rely on the firm keeping good records. Good records were not always kept, and clients have suffered the consequences as the

11 11 administration has unfolded. Therefore we do not think that reliance on record keeping should be overstated. Nor do we believe that choice is always a good thing. In complex financial markets, the consequences of choosing low cost/low protection versus high cost/high protection outcomes are not always obvious. When markets are benign, it can be difficult to justify the high cost/high protection route to clients. As clients embrace the low cost route, the high cost route becomes more costly still as it loses economies of scale. It may be appropriate for clients such as corporates to be able to place their own money at risk when making choices between cost and protection. It is not however appropriate for markets handling investments linked to long term savings, such as pension fund, insurance and UCITS funds investments, to promote options that deny proper regulatory protections to these underlying clients. Therefore we propose that the legislation should require full segregation of all client monies, assets and positions from the house account of the clearing member; and that segregation must be offered at both the clearing house and at the clearing member level. This would not therefore be a matter of choice or negotiation, either for the clearing member, clearing house or indeed financial firm handling the client money or client relationship. Although there is a cost attached to segregation, this should reduce, on a per unit basis, when segregation is universally embraced for the client side of the market. The principles should therefore be expanded to incorporate more specific requirements for central clearing. EFAMA strongly agrees that client monies and client assets should always be segregated from those of the clearing member; Segregation should operate at clearing house level as well as at clearing member level; Clearing houses should be required to offer three types of segregation: per client; per agent; and omnibus: o o o per client would be as described (eg a single pension fund); per agent would in effect offer a single account to someone managing or controlling assets for a range of clients (eg an investment management firm grouping together the UCITS funds it manages and its segregated mandates); omnibus would be available to any clients of the bank, but not the bank for its own positions. Transfer of the assets and monies should be direct from the underlying client to the segregated account at the clearing house, rather than intermediated through the clearing broker, if the client has chosen the option to segregate at the clearing house level;

12 12 For clients who do wish to hold margin at the clearing member, the clearing member must provide segregated client accounts; Segregation should exclude the possibility of contractual or insolvency rights of set off applying to segregated accounts (this commonly occurs now, for example through general rights of set off written into ISDA documentation); The clearing member should not be able to net segregated monies and assets when calculating its overall margining/collateral exposure to the clearing house, for example by netting off against other accounts held with the clearing house. In effect, this reintroduces partial gross margining to clearing. Each centrally cleared contract entered into between the clearing member and the client should be captured within the wider clearing house default arrangements and protections, to allow a look through from the investor contract all the way through to the clearing house. This is of course easier where segregation has been taken at clearing house level. However, it can also be applied where segregation occurs at the clearing member, although the final result will carry a higher degree of uncertainty as to the outcome, for example as to whether another clearing member will take on the positions. The regulatory requirement would be to require clearing house rules to acknowledge that the clearing member s client facing contract is back to back with the market facing contract between the clearing member and the clearing house and to accept both into the net of default management. With regard to contract portability, this should be expressed to cover both ordinary business conditions and conditions of default. The first ensures a freedom to the client, the second a protection for the client. The reference to the counterparty credit risk rules 7(d) should be clarified to ensure that UCITS funds may apply a zero exposure value for counterparty credit risk rules purposes when their contracts are centrally cleared. This would apply to segregation at the clearing house level and at the clearing member level. Do stakeholders share the general approach set out above on prudential requirements for CCPs? In particular: what should be the adequate level of initial capital? Are exposures of CCPs appropriately measured and managed? Should the default fund be mandatory and what risks should it cover? Should the rank of the different lines of defence of a CCP be specified? Will the collateral requirements and investment policy ensure that CCPs will not be exposed to external risks? Will the provisions ensure the correct management of a default situation? Are the provisions above sufficient to ensure access to central bank liquidity without compromising central banks independence?

13 13 We agree that the general headings set out in respect of prudential requirements for CCPs are the correct ones. Our main comments are focused on margin requirements, default fund, waterfall and procedures and collateral requirements. A. Initial capital Although high initial capital requirements could be construed as a barrier to entry, we agree that CCPs should have permanent capital available. They will be providing a critical market function. C. Margin requirements The correct calibration of margin requirements is critical to the success of central clearing. Margin usually comprises two parts: initial margin, acting in effect as a buffer amount against the risk of counterparty default and/or extreme market movements occurring intra day; and variation margin, reflecting pricing changes in the market. A fault of implementation at many CCPs currently is that default or counterparty risk has not been factored in to the initial margin calculations but instead this has been set in relation to product risk. From a CCP perspective this is not obviously untoward, in that their exposure is to their clearing members and their relationship with each clearing member is much wider, in terms of products cleared, than contracts struck with individual clients. With no direct influence on the market infrastructure (largely owned and controlled by the banks) it is European pensioners and taxpayers who could become the long term victims by having to shoulder an unreasonable share of the costs. We believe that the cost of central clearing should be proportionate to the risks and that the consequence of not factoring in the client side of the transaction will produce perverse results. It means that asset rich long term savers, such as pension and insurance funds and UCITS, will be cross subsidising the CCPs, clearing members and leveraged market users as initial margin is set at a standard rate. Using available industry data, we have calculated that the cost of this crosssubsidy is a massive performance drag of up to 2% year on year for pension funds, and about 2.5% for insurance funds (see Annex I for further details). Consider the following. LCH SwapClear (the largest IRS CCP) estimates initial margin of 7 9% for swaps maturing in less than 30 years and 12 15% for those maturing in 50 years time. In certain stress simulations (7 day worst case, 1200 days) the initial margin could be as much as 34%, 24% and 18% for 50yr zero coupon nominal, real and inflation swaps respectively. In test portfolios it is not unusual for 20% of the investment value to be demanded just for margin. As a result a pension fund attempting to hedge 100 million of notional liabilities could face the requirement to place up to 20 million in collateral. On top of this the scheme would need to hold 10 20% in acceptable collateral (cash or near cash) to support potential future variation margin calls so the actual cost would be higher still.

14 14 Clearly, there can be no intention amongst policymakers for this transfer of value to occur. The alternative if things were to be left as they are (which in itself would not be risk free) would be a (partial) cessation in using derivatives to manage risk in the long term savings industry. There are several possible ways of resolving the problem. We urge you to explore these and ensure that one or more options are written into the legislation: Ensure proper balance between the CCP default fund and initial margin CCPs and their clearing members should contribute a far greater amount into the default fund in order to reduce the margin requirements of end users to a fairer level. Recognise that there is a wide range of end user and that central clearing should not ignore the differences between them, including their credit worthiness, investment strategy and asset holding periods. As with the balance between the default fund and initial margin, if the differences between end user are not recognised the result will again be a transfer of value, this time from the conservative long term savings industry to leveraged investors with high turnover and high default risk. Consider introducing gross margining across the system. This would require far lower levels of margin in relation to individual contracts but would spread the risks across the system according to usage and turnover, as netting is removed. We believe the first of these possibilities offers perhaps the best opportunity to ensure the cost of central clearing is not borne disproportionately by the end investor, in particular pension, insurance and UCITS funds which by their nature tend to be directional. The requirement in Section C of the consultation that margin requirements of a CCP: should be sufficient to cover losses that result from at least 99 per cent of the price movements over an appropriate time horizon leaves much to be decided (such as the appropriate time horizon and calculation method) by the clearing members and the CCPs, but with the burden carried entirely by the end clients. D. Default fund F. Default waterfall The default fund should be mandatory. It should (taken in conjunction with the treatment of initial margin) have a specified usage in the legislation, since it is a critical part of the arrangements for reducing systemic risk. A large majority of EFAMA members agree with the default waterfall and consider that it should be made mandatory for all clearing houses as otherwise it may be another avenue to reduce risk for the CCPs and clearing members at the expense of asset rich long term investors. G. Collateral requirements

15 15 I. Investment policy We understand and in part support the proposal to require CCPs to hold very high quality liquid collateral. But the proposals impose too high a collateral burden on long term investors, without reference to their risk of default (negligible). For example, liability driven investors (LDI) own swaps which commit the counterparty to pay the pension fund fixed cash amounts in the future; as such they are all one way. This is very different from a bank which may have a huge gross exposure to derivatives but minimises overall market exposure by netting offsetting positions. The result at the clearing house level is that the pension fund pays initial margin on its entire notional exposure whilst a bank which may have much bigger positions puts up a tiny fraction of that amount. It therefore means that much of initial margin that the clearing house draws on as part of their armoury against systemic risk comes from those who pose little systemic risk whilst the banks and high risk traders that the collateral requirements are meant to target escape lightly. We do not think the Working Document properly addresses the scenario where asset rich investors may wish to post collateral directly to a segregated account at the CCP. If collateral is intermediated through the clearing member, and either converted to another form of collateral or netted against the clearing member s other exposures, then clearly the CCP would want to stay out of these arrangements and leave it to the two counterparties to agree terms. But if an investor posts collateral direct, we suggest it will be necessary to substantially broaden the range of permissible collateral, covering both variation and initial margin. Non financial corporate end users have pointed out that they have few government bonds to post as collateral. This is very different from, for example, most LDI adopters who typically hold government bonds to match liabilities and for derivatives collateral purposes. But the return from these bonds is reduced materially by the charges imposed by the CCPs and clearing members who hold them as collateral. Another concern relates to the availability of cash to cover the daily variation margin calls of centrally cleared contracts. It is prudent for an LDI fund to be almost entirely invested in bonds and/or equities in order to reduce long term funding costs. For this reason it is likely that many funds will look to the repo market for the provision of short term cash to cover variation margin with the unintended consequence that central clearing introduces a new source of pension fund and systemic risk. The proposals do not reference the cost and risk associated with transferring collateral, with having to undertake collateral conversion (from a less to a more liquid form) and with the performance drag that results from having to hold low yielding assets. Further options that we ask the Commission to include in the legislation (see our general comments for more details): Permitting portfolio and fund managers to retain collateral at their existing custodian(but segregated by client/account) and held for the account of or in trust for the CCP. Collateral would thus not have to move around the system and operational risk would be significantly reduced.

16 16 Permitting a far wider range of assets to be held under this arrangement, with appropriate haircuts for different asset types. Permitting the use as collateral of money market funds compliant with the recently published CESR definition. I. Default procedures We agree with the requirements set out in relation to default procedures. However we believe these should be specified at a greater level of detail perhaps by ESMA. The provisions would be strengthened by a further requirement on the CCPs to publish in an accessible form an outline of their default procedures, so that investors and other market users can have a high degree of certainty about outcomes. It would be unhelpful were end users, in the absence of specific regulation, required to take a legal opinion for each clearing house that they used as the only way of establishing how the default procedures would affect them. We were also not clear as to the full meaning of paragraph (a) as regards the words in case the default is not established by the CCP. K. Settlement risk We believe the reference to central bank money is made with reference to payment systems, but this should be made clear as currently the reference could be read as referring to central bank repo facilities. Do stakeholders share the general approach set out above on the recognition of third country CCPs? Are the suggested criteria sufficient? Do stakeholders consider that additional criteria should be considered? Do stakeholders agree with the extension of the clearing obligation to contracts cleared by third country CCPs to ensure global consistency? We agree with the general approach set out and with the extension of the clearing obligation to contracts cleared by third country CCPs to ensure global consistency and to resist a flight to the bottom in terms of regulatory standards. III. INTEROPERABILITY Stakeholders views are welcomed on the general approach set out above on interoperability and the principles and requirements on managing risks and approval. We note the reference in paragraph numbered 2 that interoperability should at present be limited to cash instruments only. We are not clear how this relates to central clearing for OTC derivatives and suggest the reference should be the subject of a detailed explaination.

17 17 IV. REPORTING OBLIGATION AND REQUIREMENTS FOR TRADE REPOSITORIES What are stakeholders preferred options on the reporting obligation and on how to ensure regulators access to information with trade repositories? Please explain. We support the introduction of transparency through trade repositories, both for regulators and to the market. On the latter point, it would be useful if more were to be said, although in practice we expect this might be dealt with by ESMA. As regards the Reporting Obligation in Section IV (1), we support Option A rather than Option B. However we strongly oppose the suggestion that reporting should be two sided as regards the regulators need for and access to information. We believe that the reporting requirement should rest solely with the market maker (a definition could be drawn from MiFID see footnote 1). The obligation should not be imposed on the client because, firstly, and purely in respect of reporting, the trade repository (and therefore the regulator) does not need to receive the report twice, just because there happen to be two regulated entities entering into the transaction; and, secondly, the market maker is providing the service which gives rise to the concluded transaction and the obligation to report should therefore attach to that firm. Although some trade repositories may conclude contracts within their systems, and this would tend to indicate that both the market maker and the client will both wish to access the system, this is not invariable and should not be confused with services that deal just with information collection and reporting. It is important that the role and responsibilities of trade repositories are well defined. This need for careful definition is essential in relation to information disclosure, in particular in relation to disclosure to the market. Given the high value of information, disclosure provisions should be assessed on the basis of who benefits, and whether the benefit is a public or private one. It is unclear what the scope is for capturing types of OTC derivatives in trade repositories, whether clearing eligible only or all OTC derivatives. The Commission should consider whether this would be an opportune time to encourage, even place some onus, on the industry to develop and utilise a common communications language for derivatives data. Do stakeholders share the general approach set out above on the requirements for trade repositories? In particular, are the specific requirements on operational reliability, safeguarding and recording and transparency and data availability sufficient to ensure the adequate function of trade repositories and the adequate protection of the data recorded? We agree with the general approach set out.

18 18 As with the comments on CCPs and their conflicts of interest, we note that the trade repositories will similarly likely also gravitate towards monopoly service provision, most probably on product lines. We therefore support the requirement for trade repositories to have publicly disclosed and cost related prices and fees. We remain at your complete disposal for any clarification. Peter De Proft Director General 9 July 2010 [ ]

19 19 ANNEX I How central clearing impacts pension funds pursuing LDI strategies The focus of the OTC derivative market reforms is to deal with market excesses and the systemic risk that were found to be posed by the activity of banks and other high risk trading entities. However there is a real danger that European pension funds pursuing conservative LDI strategies will bear a disproportionate share of the financial burden to protect against systemic risk. With no direct influence on the market infrastructure (largely owned and controlled by the banks) it is European pensioners and taxpayers who could become the long term victims by having to shoulder an unreasonable share of the costs. Collateral burden too high LDI investors own swaps which commit the counterparty to pay the pension fund fixed cash amounts in the future; as such they are all one way. This is very different from a bank which may have a huge gross exposure to derivatives but minimises overall market exposure by netting offsetting positions. The result at the clearing house level is that the pension fund pays initial margin on its entire notional exposure whilst a bank which may have much bigger positions puts up a tiny fraction of that amount. It therefore means that much of initial margin that the clearing house draws on as part of their armoury against systemic risk comes from those who pose little systemic risk whilst the banks and high risk traders that the collateral requirements are meant to target escape lightly. LCH SwapClear (the largest IRS CCP) estimates initial margin of 7 9% for swaps maturing in less than 30 years and 12 15% for those maturing in 50 years time. In certain stress simulations (7 day worst case, 1200 days) the initial margin could be as much as 34%, 24% and 18% for 50yr zerocoupon nominal, real and inflation swaps respectively. In test portfolios it is not unusual for 20% of the investment value to be demanded just for margin. As a result a pension fund attempting to hedge 100 million of notional liabilities could face the requirement to place up to 20 million in collateral. On top of this the scheme would need to hold 10 20% in acceptable collateral (cash or near cash) to support potential future variation margin calls so the actual cost would be higher still. Market fragmentation excludes netting Under current bilateral arrangements pension funds are able to gain some netting benefits from counterparties by offsetting risks between their Interest Rate Swap portfolio and other portfolios (e.g. Inflation Swaps). This same effect could be achieved under central clearing but only where the clearing house concerned covers the full range of asset classes. Since not all LDI transactions are suitable for central clearing and CCPs product range will be fragmented for some time the scope for a pension fund to net exposures is minimal. Performance drag from CCP charges and cash demands Non financial corporate end users have pointed out that they have few government bonds to post as collateral. This is very different from most LDI adopters who typically hold government bonds to match liabilities and for derivatives collateral purposes. But the return from these bonds is reduced materially by the charges imposed by the CCPs and clearing members who hold them as collateral.

20 20 Another concern relates to the availability of cash to cover the daily variation margin calls of centrally cleared contracts. It is prudent for an LDI fund to be almost entirely invested in bonds and/or equities in order to reduce long term funding costs. For this reason it is likely that many funds will look to the repo market for the provision of short term cash to cover variation margin with the unintended consequence that central clearing introduces a new source of pension fund and systemic risk. Market infrastructure cost There has been some discussion on whether or not the proposed CCPs should be built as businesses or utilities. In both cases the largest share of the cost will fall on investors and in the case of LDI strategies, European pensioners. The CCPs and clearing member banks look set to pass on their own costs by way of clearing and execution fees, haircuts and intraday funding fees. How much would they be? A charging structure proposed by a major derivatives clearing member is as follows: o o Transaction fee of 8 per 1 million notional with a 250 minimum on each side of the transaction (i.e. new, assign, unwind etc.) In addition there are asset servicing charges at the CCP levied on collateral posted to them. LCH for instance charges at least 0.25% on cash and 0.10% on bonds. It seems unlikely that competition from the limited number of clearing member banks will prove to be enough to reduce these fees to utility levels given that regulations are likely to force asset managers to centrally clear a large proportion of their transactions.

21 21 Adding up the cost to pensioners (A Typical LDI Pension Mandate) Total Assets 1.0bn OTCs for LDI Strategy Gov Bonds 0.1bn Notional of Inflation Swaps 0.7bn Index linked Gov Bonds 0.4bn Notional of Interest Rate Swaps 0.8bn Floating Rate Notes 0.3bn Asset Backed Securities 0.1bn Equities 0.1bn Optimistic Pessimistic Investment Leakage Investment Leakage million million Initial Margin Required 175 MILLION LCH FACILITY FEE : 0.10% ON BONDS & 0.25% ON CASH Optimistic Variation Margin 100 MILLION Pessimistic Variation Margin 300 MILLION YIELD LOSS BETWEEN GILTS AND CASH : 3.5% LCH FACILITY FEE : 0.25% ON CASH Fund Held Potential Variation Margin 200 MILLION YIELD LOSS BETWEEN GILTS AND CASH : 3.5% 7 7 CLEARING FEES Total Cost Investment Strategy Yield Drag circa 1.1% circa 1.9%

22 22 ANNEX II CCPs should offer a non clearing membership with participation requirements which can be met by most of the market participants, including investment managers and investment funds. The applicable terms and conditions should allow OTC derivatives between the non clearing member and the CCP. The model could work as follows: an electronic trading system would match two corresponding offers to a trade (OTC derivative), with one OTC contract being created between Party A (the nonclearing member) and the CCP and another OTC contract, corresponding to the first one, between the CCP and Party B (the clearing member). When the electronic trading system matches the order of a non clearing member, an additional assumption of debt of the relevant clearing member should take place automatically. The CCP shall only ask the respective clearing member, but not the non clearing member, to provide margin to collateralize the claim of the CCP against the clearing member arising from the additional assumption of debt. Such system would ensure that the CCP is secured at the same level as if it was facing the clearing member as its counterparty of the OTC contract. The non clearing member would be obliged to provide its clearing member with the assets required for the fulfillment of the CCP s margin call. In case of insolvency of the clearing member, any claims of the non clearing member arising from the OTC derivative with the CCP would be protected. An overview: