Federation of Finnish Financial Services represents banks, insurers, finance houses, securities dealers, fund management companies and financial employers operating in Finland. Its membership includes employee pension, motor liability and workers compensation insurers, all three providers of statutory insurance lines that account for much of Finnish social security. The Federation has about 460 members who employ a total of 43,000 people. EBA, ESMA and EIOPA European Supervisory Authorities REF. JC/DP/2012/1 JOINT DISCUSSION PAPER ON DRAFT REGULATORY TECHNICAL STANDARDS ON RISK MITIGATION TECHNIQUES FOR OTC DERIVATIVES NOT CLEARED BY A CCP UNDER THE REGULATION ON OTC DERIVATIVES, CCPS AND TRADE REPOSITORIES The Federation of Finnish Financial Services (hereinafter FFI ) welcomes the opportunity to respond to the joint discussion paper on draft regulatory technical standards on risk mitigation for OTC derivatives not cleared by a CCP under the Regulation on OTC Derivatives, CCPs and Trade Repositories. GENERAL REMARKS The FFI appreciates the market based analysis taken by the European regulators in drafting the draft regulatory standards. We also welcome the opinion taken by the ESAs where they deem it appropriate not to establish capital requirements through regulatory technical standards, thus ensuring a level regulatory playfield. We agree that counterparties should be encouraged to use CCPs whenever it is economically justified (e.g. due to hedging need, prevailing liquidity or transaction size). However, we do not agree on the view that market participants should be encouraged to use standardized transactions at all times. The foundation of derivatives market and product development is to find an optimal product to a given (mostly hedging) need. Now the emphasis seems to be on finding suitable risk management needs that could be tackled with standardized derivatives and/or trying to eliminate uncovered exposures in the bilateral market at any cost. This approach is in our opinion quite contrary to the original aim of the market and should be re-considered.
The FFI recognizes that banks need to manage their credit and counterparty risks effectively and in a prudent manner. In addition, they also provide an important service to their clients and to the economy in general by warehousing some of these risks. In our opinion, regulation should remain neutral in terms of different product types (standardized vs. non-standardized). In a case where the regulation leads to a situation that the most adequate product type is made too expensive for the end user, the end user may shy away from hedging. This would naturally increase the systemic vulnerability as hedging levels could generally decrease, thus leading to a situation that is quite the opposite from what the EMIR regulation is trying to achieve. Even in an overall level we are afraid of that the additional cost and liquidity implications in particular in options 1, 2 and to a lesser extent 3, could create barriers for a number of derivatives users and therefore might add systemic risk. The FFI finds it difficult to properly analyze collateral requirements to be applicable to NFC+ since the thresholds for NFC+ are still open and therefore the scope of the collateral requirements is also open. As a result, we would like to see more data and information in the later consultations where possible. However, in an OTC derivative transaction not cleared by a CCP and entered into with a NFC+ the requirement to post collateral should in our opinion be limited to transactions that are done explicitly for non-hedging purposes. We believe that even in these transactions the focus should be on the most risky products. These limitations would have the effect of maintaining trading as otherwise the costs arising from collateral arrangements would increase, directly affecting client trading. Intragroup transactions are generally considered a special category where the entities in a group can and should be allowed to be jointly responsible for their obligations. RESPONSES TO SPECIFIC QUESTIONS Q1. What effect would the proposals outlined in this discussion paper have on the risk management of insurers and institutions for occupational retirement provision (IORPs)? Q2. What are your views regarding option 1 (general initial margin requirement)? The FFI agrees that requiring an initial margin should, at least to some extent, prevail. Any losses that a non-defaulting counterparty may incur following a default should be avoided as they are key elements in building a systemic risk. As the ESAs agree, the loss of initial margin shall affect the defaulting party only. Further, as margin requirements may be tailored to reduce risks attributable to a particular transaction, we do believe that the defaulter pays concept is more purposeful than the more broadsided capital requirement regime.
However, it is important to note that the counterparty to a PRFC is less exposed to risks relating to the insolvency of the PRFC and, for such purpose, IM requirement of the PRFC should inherently be less extensive than that for a NPRFC or NFC+. To the extent capital requirements are relating to the details of a particular transaction, the IM requirement should be reduced proportionally, since there would otherwise be a double counting of risks resulting in unnecessary capital and transaction costs. Correspondingly, IM posted for the purpose of mitigating the same risk that the capital requirements is said to reduce should have the effect of minimizing any such capital requirement. However, we are not certain of that the rules on capital requirements are able to recognise this. Finally, we believe that this option cannot be supported as it would imply additional costs associated with the transactions that would potentially make the use of derivatives too expensive for clients. Q3. Could PRFCs adequately protect against default without collecting initial margins? In our opinion, the absence of capital requirements for NPRFCs and NFCs+ would lead to a situation where PRFCs would not be protected against a default by those counterparties. Such a scenario where the consequences would apply only to the PRFCs does not seem sensible. Q4. What are the cost implications of a requirement for PRFC, NPRFC and NFCs+ to post and collect appropriate initial margin? If possible, please provide estimates of opportunity costs of collateral and other incremental compliance cost that may arise from the requirement. Our members foresee that an increased cost on derivative transactions will increase the total borrowing costs for corporates. This is mostly due to the fact that the hedging costs on derivatives in the interbank market will increase. Q5. What are your views regarding option 2? The FFI welcomes in general the approach to consider the defaults more widely and in connection with the relevant U.S legislation. In our view, the default of a PRFC may not automatically endanger the stability since the capital requirements set for PRFCs would to some extension limit the consequences of the default of such a party. Of course, as recognized by the ESAs, this could affect the nondefaulting party s balance sheet. However, choosing this option would most likely lead to additional cost and liquidity risk for the client. These increased costs and liquidity risks could in turn reduce the use of derivatives for hedging purposes, thus increasing the possibility of systemic risk.
Q6. How in your opinion - would the proposal of limiting the requirement to post initial margin to NPRFCs and NFCs+, impact the market / competition? The posting of margin limits to some extend the business possibilities at the market when liquidity is bound to margins. Thus the proposal to limit the requirements to post IM would impact the level playing field between PRFCs and NPRFCs/NFCs+, leading to a situation where the NPRFCs and NFCs+ would have more capital to invest and take use of. Q7. What is the current practice in this respect, e.g. - If a threshold is currently in place, for which contracts and counterparties, is it used? - Which criteria are currently the bases for the calculation of the threshold? Our members, the Finnish market participants, use in most cases a fixed threshold for collateralization. In addition to this, the use of haircuts is connected to the collateral that is eligible for margining. Any limitation on the type of collateral renders the use of haircuts less important and, correspondingly, if various types of collateral are allowed, it is extremely important to apply the correct haircut. Q8. For which types of counterparties should a threshold be applicable? Q9. How should the threshold be calculated? Should it be capped at a fixed amount and/ or should it be linked to certain criteria the counterparty should meet? The FFI believes that a fixed amount threshold should be used as it would imply simplicity benefits to all parties to the contract. The threshold should be set to a relevantly high level where it shall correspond to the risks arising from the transaction. Q10. How in your opinion - would a threshold change transactions and business models? The approach in option 3 is in our opinion the most reasonable as it would require actions from the parties that are significant enough for the systemic risk. Further, we appreciate the approach where this threshold could only be used by PRFCs for their counterparties. Q11. Are there any further options that the ESAs should consider? The FFI proposes not to apply initial margin requirements for NFC+. Our members already calculate the credit exposure and allocate balance sheet/risk capital based on the changes of market value in the exposure. Collecting of the variation margin further improves risk mitigation to a sufficient level whereas application of IM requirements for NFC+ would only lead to additional costs and tie up capital. However, it is of course difficult to completely understand the impact of this proposal before the clearing threshold for non-financial counterparties is set.
Q12. Are there any particular areas where regulatory arbitrage is of concern? Q13. What impacts on markets, transactions and business models do you expect from the proposals? We are worried that all of the proposed options (1 to 3) create barriers to hedging of financial risk for the NFC+. Under the proposed regulation market risk would simply be converted to liquidity risk due to margin requirements. Q14. As the valuation of the outstanding contracts is required on a daily basis, should there also be the requirement of a daily exchange of collateral? If not, in which situations should a daily exchange of collateral not be required? Daily exchange of collateral is useful when underlying positions can be meaningfully re-valued on a daily basis. However, this may not be done at a reasonable burden and cost in markets which are lacking observable price data. In general, we propose that the daily exchange of collateral should be subject to minimum transfer requirements in order to maintain proportionality between probability of systemic risk and the costs that are imposed on market participants. Q15. What would be the cost implications of a daily exchange of collateral? Q16. Do you think that the Mark-to-market method and/or the Standardised Method as set out in the CRR are reasonable standardised approaches for the calculation of initial margin requirements? We do not agree with what is stated on the drawbacks of internal models in paragraph 40. Internal models will not produce lower margins than CCPs as the overall objective of those models should be cost-effective margining that is sufficient to maintain confidence in the market. These principles should and will always be the basis for using an internal model, instead of principles that aim to set the margins so high that some potentially inefficient CCP margin processes are sheltered from competition. Q17-Q18 regarding Initial margin No further comments at this stage
Q19. Should the scope of entities that may be allowed to use an internal model be limited to PRFCs? In our opinion, the use of internal models should be limited to PRFCs as they shall have the operational capabilities to implement such models. Q20. Do you think that the Internal Model Method as set out in the CRR is a reasonable internal approach for the calculation of initial margin requirements? The Internal Model Method is a reasonable solution for us. In general, we believe that internal models should be preferred over standardised approaches when calculating IMs. Q21. Do you think that internal models as foreseen under Solvency II could be applied, after adequate adjustment to be defined to the internal model framework, to calculate initial margin? What are the practical difficulties? What are the adjustments of the Solvency II internal models that you see as necessary? The FFI recommends an approach by the authorities to make sure that applying CRR and Solvency II frameworks simultaneously by different market participants will not distort pricing and cause market imbalances. Q22-Q23 regarding Incremental compliance costs and Methods No further comments at this stage. Q24. Do you see practical problems if there are discrepancies in the calculation of the IM amounts? If so, please explain. This could lead to practical problems where the counterparties would like to ensure the calculation of the IM. If same model is to be used, any dispute relating to the calculation would be easily solved. Q25. Would it be a feasible option allowing the party authorised to use an internal model to calculate the IM for both counterparties? The FFI believes that the using of internal models to calculate initial margin requirements for both counterparties could prove to be feasible, especially when calculated for a non-financial counterparty. However we see some challenges that would need to be studied more carefully. Q26-Q29 regarding Differences, Segregation and Tri-Party transactions
Q30. What are current practices regarding the re-use of received collateral? At the moment collateral is typically transferred on a Transfer of Title -basis and the transferee has the right to re-use the collateral received. Q31. What will be the impact if re-use of collateral was no longer possible? We understand that the question is about the consequences of prohibiting re-hypothecation. If this is the case and as this practice still continues extensively, though at lower levels than before the crisis, we believe that the economic impact of prohibiting re-use of collateral requires further consideration and analysis. Secondly, if the re-use of cash collateral will not be allowed according to the Transfer of Title, this could lead to a further deduction in the amount of cash available in the markets. Q32. What are, in your view, the advantages and disadvantages of the two options? Q33. Should there be a broader range of eligible collateral, including also other assets (including non-financial assets)? If so which kind of assets should be included? Should a broader range of collateral be restricted to certain types of counterparties? The FFI supports two options for defining eligible collateral in an effective way. 1) ESAs should create principles for eligible collateral Our first option would be a principle based approach where, for example, the ESAs would create certain principles for the maintaining of collateral. These principles would base on the fact that provided collateral can be valued effectively, on a sufficiently frequent basis, and particularly in times of market stress, thus creating a system where the eligible collateral would not have to be based on asset classes. 2) Introduction of a broader range of collateral We support the introduction of a broader range of eligible collateral. NFCs+ are typically liquidity constrained, which makes CSA type of collateral agreements very difficult to enter into if not entirely unrealistic. However, many companies possess highly stabile property that could be pledged as collateral instead of cash or other financial instruments. Typical such property in Finland is for example land, machinery, real estate etc. At the moment they are already widely and successfully used in e.g. finance agreements.
Financial institutions balance sheets are built in a way that they take into account the monetary value of these assets thus enabling the funding for the clients against this physical collateral. NFCs + could be granted credit risk lines against physical collateral which does not differ from traditional funding, excluding the challenge to estimate adequately the Exposure at Default (EAD). However, the CRR will give a powerful framework even for EAD estimation. Q34. What consequences would changing the range of eligible collateral have for market practices? In our view, a situation where only cash would be seen as eligible collateral would lead to a significant change that is not welcomed by the market participants. Functioning markets require liquidity and thus it should not be widely soaked into collateral agreements as this would increase the systemic risks especially in times of market stress. Q35. What other criteria and factors could be used to determine eligible collateral? Please have a look at our response to Q33. Q36. What is the current practice regarding the frequency of collateral valuation? The frequency of valuation depends on the type of collateral. For example financial collateral is currently valuated daily. Q37-38 regarding Daily collateral valuation Q39. Do you think that counterparties should be allowed to use own estimates of haircuts, subject to the fulfilment of certain minimum requirements? Yes they should. Widely accepted methods for defining haircuts for financial collateral are already in place and the self-discipline has been working well. In case of non-financial collateral the financial institutions have a strong tradition of sophisticated valuation methods that are approved by local FSAs. Further, we would like to stress that the use of haircuts is connected to the collateral eligible for margining. If the types of eligible collateral are very limited, the use of haircuts gets less important. On the other hand, if various types of collateral are eligible, it is extremely important to apply the correct haircut. Q40-Q42 regarding Haircuts and Operational processes. Do you support the use of own estimates of haircuts to be limited to PRFCs? No further comments at this stage.
Q42. What incremental costs do you expect from setting up and maintaining robust operational processes? To some extend our members already have such processes set up. Q43. What are your views regarding setting a cap for the minimum threshold amount? How should such cap be set? The FFI welcomes the proposal for setting a cap for the minimum threshold amount while otherwise leaving the issue to the counterparties. Such a cap should be based on a detailed analysis of the markets and be set to a relevantly high level where it corresponds to the risk that the counterparties will take. Q44-Q45 regarding Caps and Impediments Q46. What is the current practice regarding the collateralisation of intragroup derivative transactions? Generally speaking and with regard to intragroup transactions the collateral arrangements on group level should be limited only to one centralized entity. The risk that may arise from intragroup transactions is conveyed out from the group through this centralized legal entity, which in practice trades with the whole market on behalf of the group s many entities (e.g. 200) that are hedging their own balance sheets. Under Finnish Act on Amalgamation on Deposit Banks the central institution shall be liable for the debts of a member credit institution which cannot be paid using the member credit institution s capital. Due to joint liability of member credit institutions under national law, OTC-transactions made within the group are not collateralized.
Q47. What is the impact of the presented options on the capital and collateral requirements of the counterparties affected by the relevant provisions and the span of time necessary to comply with the Regulation? These regulatory technical standards shall inevitably lead to changes in the back office IT systems that will require some time before they can be launched. Therefore we propose that at least a time span of one year (12 months) from the approval of the technical standards should be allowed. Yours faithfully FEDERATION OF FINNISH FINANCIAL SERVICES Lea Mäntyniemi Director