From the very early days of Regulation (EU) 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories "EMIR"1, as amended by Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 20192 ("EMIR Refit"), being discussed, the enormous difficulties that mandatory clearing would pose in respect of pension scheme arrangements ("PSA") were obvious. It surprised no one that pursuant to Article 89(1) of EMIR, pension scheme arrangements were eventually excluded from the clearing obligation and were subject to a transitional period of three years.
Recital 26 of EMIR expressly acknowledged that to avoid the likely negative impact of such a requirement on the retirement income of future pensioners, the clearing obligation should not apply to pension schemes until a suitable technical solution for the posting of non-cash collateral as variation margin ("VM") had been developed by Central Counterparties ("CCPs") to address pension funds' lack of cash for use as collateral.
Article 85(2) of EMIR required the EU Commission to prepare a report, after consulting the European Securities and Markets Authority ("ESMA") and the European Insurance and Occupational Pensions Authority ("EIOPA"), to assess the progress and effort made by CCPs in developing technical solutions for the posting by PSAs of non-cash collateral as VM, as well as the need for any measures to facilitate this solution. However, as numerous extensions will attest, finding a solution that addresses the issues around mandatory clearing and PSAs has taken longer than EMIR initially anticipated.
EMIR Refit only clarified that the EU Commission should be allowed to extend the two-year period referred to in Article 89(1) twice, each time by one year, provided it concludes that no viable technical solution has been developed and that the adverse effect of clearing derivative contracts on the retirement benefits of future pensioners remains unchanged.
In view of the fact that no technical solution has been found to address clearing by PSAs, on 2 April 2020, ESMA published its First Report for Consultation on Central Clearing Solutions for Pension Scheme Arrangements3 (the "Report").
The problem with PSAs
EMIR makes clearing mandatory for certain types of counterparties and in respect of certain types of derivatives. In addition, financial counterparties and non-financial counterparties are subject to risk mitigation measures, which include the posting of VM. VM means the collateral posted or collected by a counterparty to reflect the results of the daily marking-to-market.
Under EMIR, PSAs are defined as institutions for occupational retirement provision, including any authorised entity responsible for managing such an institution and acting on its behalf as well as any legal entity set up for the purpose of investment of such institutions, acting solely and exclusively in their interest.
As EMIR recognises4, the main challenge to make clearing mandatory for entities operating PSAs is that requiring such entities to clear OTC derivative contracts would lead to their divesting a significant proportion of their assets for cash in order to meet the ongoing margin requirements of CCPs.
Since posting cash as VM is the main issue for PSAs, the Report's starting premise is that CCPs' operational models only permit VM to be posted in cash by their clearing members.5 This contrasts with PSAs who are asset-rich and allocate little in cash. It is also not possible to increase their cash holdings to the level required as this would have multiple negative impacts.
As the Report illustrates,6 PSAs would find it difficult to hold liquid cash buffers as this does not match well with a PSA's liability profile and cash deposits may expose PSAs to concentrated credit risks to the banking sector.
Fundamentally, the main problem to address is how PSAs can access cash or use their own cash to post VM when the very nature of their business is driven by acquiring and selling securities. The Report highlights7 two main features that define the structure of PSAs and which form the crux of the problem:
- PSAs' derivatives portfolios may be long-dated and unidirectional and are usually subject to investment strategies that prevent PSAs from increasing their cash holdings and limit access to liquidity through banks
- Technical and legal risk management considerations, which introduce significant complexities for CCPs to move away from their current cash margin protocols.
ESMA is very clear that it is a matter of time before PSAs become subject to the clearing obligation, not only because the exemption will expire (and there are no indications that it will be extended) but because it is expected that liquidity will shift to clearing due to clearing obligations, bilateral margining requirements and capital requirements.8 Therefore, the following four options are discussed in detail:
- CCPs accepting non cash collateral for VM settlement
This option assumes that PSAs become direct clearing members and are permitted to post high quality bonds, with an appropriate haircut instead of cash for their VM calls directly to the CCP. But if debt securities were to replace cash, this would result in a number of issues.
The Report9 recognises that one of the main issues with this option is that, as opposed to cash, which has a stable value, the nominal value of bonds will always be subject to market volatility. This would require developing valuation protocols for posted collateral.
The Report concludes that this option would entail significant operational and legal risk resulting from the fact that VM needs to be passed through daily between counterparties on either side of back-to-back trades, which would leave counterparties with a negative mark-to-market VM with a shortfall in meeting their VM obligations to those counterparties that have a positive mark-to-market.10
Since this option generated reservations from many stakeholders, CCPs and regulators, it was eventually discarded.
- Relying on the ancillary services of collateral transformation by clearing members
This option focuses on the collateral transformation services already provided by clearing members to their direct clearing clients. It has the benefit of not requiring PSAs to increase their cash buffer and relies at the same time on the ancillary services of collateral transformation already offered by clearing members.11
However, this option was also rejected on the grounds that if collateral transformation services may be negotiable by clients with their clearing members, such services would expose clearing members to additional risks and costs, including related capital requirements covering collateral and repo market transactions.
Clearing members are thus more reluctant to extend collateral transformation to VM flows, concerned by the impact on their balance sheet or their capital adequacy requirements – non-cash VM is not eligible as risk-reducing in all prudential ratios.12
- The market-based repo solution
This option looks to provide PSAs with reliable sources of liquidity to fund cash margins, enabling PSAs to source cash through providers other than CCPs or their clearing member by turning to the wider market.
While there is market consensus that the repo market is generally in good health and permits collateral transformation and access to liquidity, a significant problem could emerge if the repo market ever becomes unavailable or not deep enough to deal with the PSAs' liquidity needs for their VM, in which case, a PSA may not have the liquidity access as and when needed. This issue could also be aggravated by a CCP triggering defaults of those PSAs unable to provide cash VM, thus increasing potential systemic risk.13
The Report highlighted that the main challenge is to establish the impact of temporary limitations on access to the repo markets, for example, due to stress events so further analysis will be required to understand whether repo markets would be able to absorb PSAs' liquidity demands in both normal and stressed circumstances.14
- Access to alternative emergency liquidity arrangements
This option considers how a PSA subject to the mandatory clearing obligation could access (emergency) liquidity arrangements in order to avoid becoming a source of systemic risk under conditions of market stress.
Since PSAs have no direct access to liquidity arrangements provided by central banks, this option looks at alternative liquidity arrangements. It remains unclear whether CCPs without a banking licence, which may access only emergency central bank liquidity facilities under certain conditions, can facilitate such emergency arrangements for PSAs.15
Since the G20 derivatives clearing mandate and subsequent volumes of cleared swaps have turned CCPs into systemically important risk hubs, regulators have turned their attention towards ensuring that a failing CCP can recover or be resolved without impacting financial stability. At the height of the global pandemic on 4 May this year, the FSB published long-awaited draft guidance16 addressing the treatment of CCP equity when a failing CCP is in resolution. The consultation paper sets out a framework for resolution authorities to evaluate and calibrate the exposure of CCP equity to losses in recovery, liquidation and resolution.
Its publication immediately reignited the perennial debate around the alignment of incentives between CCP equity, CCP management, clearing members and end users in the loss-absorbing default waterfall layers at these former market utilities, which have become for-profit entities.
There's moral hazard risk, where CCP management might be perceived to be incentivised to let the losses fall into the deeper pockets of clearing members via their rulebook-required funded and unfunded member contributions to the mutualised default fund, without the mitigating factor of more CCP SIG being potentially mandated at different points in the default waterfall.
And clearing participants are quick to point out the successful bypassing of CCP equity as a full loss-absorbing layer via the FSB's assumption in its Key Attributes of Effective Resolution Regimes for FMI17 of the full application of the CCP's loss allocation rulebook when deciding if a CCP participant is worse off as a result of resolution measures than liquidation and thus should get statutory compensation. That is because – due to CCPs' history as market utilities – the rulebooks generally pass on most of the losses to participants.
Adding to this issue – itself partly caused by extreme volatility in oil prices in global markets in recent months – a working paper18 published two weeks later by two more BIS staffers, titled Model risk at central counterparties: Is skin-in-the-game a game changer?, considered how CCPs' balance sheet characteristics impact their modelling of counterparty credit risk and thus their IM models. The paper focuses on model risk, which arises when a CCP underestimates potential credit losses in its IM model. Their conclusion:
"When a CCP's IM model fails on a large scale, the CCP could fail too, losing its skin-in-the-game capital. We find that higher skin-in-the-game is significantly associated with more prudent modelling, in contrast to profits and forms of capital other than skin-in-the-game. The results may help to inform the ongoing policy debate on how to incentivise prudent credit risk management at CCPs."
ESMA will be submitting its first report to the European Commission and will also launch a public consultation based on the questionnaire annexed to the Consultation. It is envisaged that the second report will be published by December 2020.