ESMA opinion on UCITS counterparty risk exposure limits: good news for cleared OTC derivatives but a sting in the tail for ETDs
On 22 May, ESMA published its views on how counterparty risk exposure limits should apply to UCITS entering into cleared OTC derivatives transactions. Unfortunately, it doesn't look good for exchange-traded derivatives.
When calculating the counterparty risk exposure limits applicable to a UCITS under the UCITS Directive, there is currently a divergence between the rules applicable to exchange-traded derivatives (ETDs) and OTC derivatives. In short, exchange-traded derivatives are not subject to the counterparty risk exposure limits (save in respect of initial margin posted to, or variation margin received from, brokers in respect of those ETDs where the margin is not protected by client money rules). Conversely, all OTC derivatives are subject to the counterparty risk exposure limits, such that the UCITS' exposure to a particular OTC derivatives counterparty cannot exceed 5% of its assets (or 10% if the counterparty is a credit institution).
With the advent of mandatory central counterparty clearing for certain classes of OTC derivatives in EMIR, it has become apparent that in many respects, cleared OTC derivatives share more characteristics (from counterparty credit risk perspective at least) with ETDs rather than non-cleared OTC derivatives.
As a result, in July 2014, ESMA released a discussion paper seeking stakeholders' views on how UCITS should treat cleared OTC derivatives for the purposes of the counterparty risk exposure limits imposed by the UCITS Directive. The deadline for responses to the discussion paper was October 2014.
On 22 May, ESMA published its opinion on the issues considered in the discussion paper. The key point arising from the opinion is that ESMA's view is that the distinction between OTC and ETD is no longer the correct one from a counterparty credit risk perspective. Instead, the distinction should be drawn between cleared and non-cleared derivatives. This means that cleared OTC derivatives will be treated in the same way as ETDs from a counterparty credit risk perspective. So far, so good.
However, there is a sting in the tail. Given that the purpose of the counterparty risk exposure limits is to address the risk to the UCITS of losses on a default of the counterparty, ESMA has noted that a distinction must be drawn between the segregation arrangements offered by the clearing brokers. Its view is that cleared OTC derivatives or ETDs which benefit from an individual client segregation model should be treated as having no counterparty credit risk to the clearing member and therefore be exempt from the counterparty risk exposure limits. Transactions which are subject to an omnibus client segregation model, on the other hand, should be subject to appropriate counterparty risk exposure limits based on the proportion of the assets which are not passed up to the central counterparty (CCP). If the UCITS cannot ascertain how many assets remain with the clearing member, ESMA's view is that the limits should apply to all assets passed to the clearing member.
Since the vast majority of the ETD market is based on an omnibus model, this could have an enormous impact on UCITS with a large, or polarised, ETD book. ESMA has acknowledged this in the opinion, and have recommended further assessment of the impact of this approach. ESMA has also acknowledged that the level of the limits needs to be carefully considered, bearing in mind the relatively limited number of clearing members available.
Other opinions expressed by ESMA in respect of the counterparty exposure limits include:
- Where other segregation models are offered by clearing members (such as gross omnibus arrangements), the limits should apply proportionately to the degree of protection the arrangement offers to the UCITS. It is not clear to what extent the limits for those alternative segregation models will be prescribed or how they will be determined.
- Non centrally-cleared OTC derivatives are unaffected by the opinion and should continue to be subject to the full scope of the existing counterparty risk exposure limits.
- Counterparty risk in respect of the CCPs themselves (provided that they are either EU CCPs or non-EU CCPs recognised by ESMA) is considered to be relatively low but not non-existent. Therefore certain exposure limits are likely apply to positions cleared with those entities, but the limits should be set at a high level. These limits would need to be observed in addition to any limits relating to the clearing member.
"Conflict" between liquidation requirement and standardisation of cleared OTC derivatives
Finally, ESMA took the opportunity to express an opinion on a further thorny issue in the context of UCITS entering into cleared OTC derivatives.
Article 50(1)(g)(iii) of the UCITS Directive provides that a UCITS can only enter into OTC derivatives transactions if they can be "sold, liquidated or closed by an offsetting transaction at any time at their fair value at the UCITS' initiative". Due to the relative illiquidity of many OTC derivative products, most UCITS took the view that this required an express optional early termination right to be included in their ISDA Master Agreements.
In order to be suitable for clearing, transactions need to achieve a high level of standardisation, which has led some CCPs to reject any attempt by UCITS to include similar optional early termination rights in cleared OTC derivatives documentation. ESMA is concerned that this creates an inherent conflict between the UCITS Directive and the operation of EMIR in the context of OTC derivatives entered into by UCITS.
We wonder if such a conflict exists. As ESMA have highlighted, one key feature of the cleared OTC derivatives market is that products which become subject to mandatory clearing must be highly standardised. In order for a clearing service to be commercially justifiable, there needs to be sufficient demand for the standardised product for clearing. Therefore it is very likely that any products which are subject to mandatory clearing will, by their nature, also be liquid and possibly highly liquid. On this basis, it should be possible to satisfy Art 50(1)(g)(iii) without any express optional early termination right. In essence, the reasoning should be no different from that applicable to ETDs – and UCITS have not commonly sought to include optional early termination rights in terms of business with their ETD clearers.