Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry

Proposals for Better Management of Non-Financial Risks within the European Fund Management Industry - December 2012

Appendix: Illustration of Good Practices for the Management of Non-Financial Risks

collateral” for other OTC derivatives. 81 The technical standards pertaining to risk mitigation techniques for OTC derivatives that are not centrally cleared will be worked out by the ESAs. Margin requirements on non-centrally-cleared derivatives will promote central clearing; further incentives for central clearing will come from higher capital charges for non-centrally cleared trades, as proposed under CRD IV. The posting of cash collateral results in higher funding costs for counterparties and complications for funds that do not usually hold cash. If non-cash collateral can be used, restricting eligible collateral to only the highest-quality and most liquid assets, while facilitating liquidation in times of stress, will artificially increase demand for these assets and will have a strong impact on the liquidity of the counterparties. Our recommendation (Amenc and Sender, 2010) has been to permit a broader set of eligible collateral with appropriate haircuts. This is consistent with CCP practices and this is now the recommendation of the Working Group on Margining Requirements of the Basel Committee on Banking Supervision (BCBS) and the International Organisation of Securities Commissions (IOSCO) (BIS BCBS and IOSCO, 2012). For collateral to serve its purpose, it should be readily available to the collecting counterparty in the event of a default by the posting party while protecting the interests of the latter should the former default. The global financial crisis has demonstrated a need to reappraise the potential conflicts between bankruptcy laws and the protection of collateral. 82

If a counterparty to the original trade is not a clearing member of the CCP, then it will have to work through a clearing member which will be its new counterparty (as well as that of the CCP); this counterparty will be an indirect client of the CCP. The CCP nets offsetting exposures, requires initial and ongoing margining of collateral from its members (collateral transfers between the CCP and its members are managed by providers of settlement services, delivery versus payment reduces risk for non-cash collateral), and has mechanisms in place to deal with the default of its members and providers of settlement services. CCPs are systematically important counterparties and require close prudential oversight. The recently adopted EMIR (Regulation (EU) No 648/2012) clarifies the requirements for CCPs and final technical standards should be adopted by the end of 2012 (on the basis of ESMA/2012/600). The Bank for International Settlement (BIS) Committee on Payment and Settlement Systems (CPSS) and the International Organisation of Securities Commissions (IOSCO) have released detailed principles to enhance the robustness of the essential infrastructures of financial markets (i.e. payment systems, CSDs, securities settlement systems and CCPs (CCPs) and made their own recommendations on OTC derivatives counterparty risk mitigation. Capital charges for exposure to CCPs that comply with the BIS CPSS-IOSCO standards will be extremely limited under the Basel III framework (e.g. BIS BCBS, 2012). EMIR also makes it mandatory for counterparties to clear standardised OTC derivatives through an authorised CCP and to have “risk-management procedures that require the timely, accurate and appropriately segregated exchange of

81 - In 2011, the G20 agreed to add margin requirements on non-centrally-cleared derivatives to the reform program and called upon the BCBS and IOSCO to develop, for consultation, consistent global standards for these margin requirements. 82 - As previously mentioned, the UCITS V proposal expects Member States to ensure that client assets are protected in the event of insolvency of a depositary and required depositaries to verify that

this guarantee applies in the jurisdictions of their sub-custodians.

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An EDHEC-Risk Institute Publication