ESMA should confirm the exemption of covered bond derivatives from central clearing obligations, the ECBC said in a response to a consultation on draft technical standards for the European Market Infrastructure Regulation, which proposes that covered bonds be the only own name securities eligible as collateral by clearing members.

The Regulation on OTC derivatives, central clearing parties and trade repositories, as EMIR is also known, is due to come into effect at the end of this year and on 25 June the European Securities & Markets Authority (ESMA) launched a consultation on draft technical standards (regulatory and implementing) in relation to the regulation, on which trilogue political agreement was reached in February.

Rachel Kent, partner in Hogan Lovells’ financial institutions group, described the EMSA publication as “a doorstop of a consultation paper”, and said that it sets out the detailed rules that derivatives traders, clearing houses and trade repositories will need to comply with when EMIR comes into force next year.

In a consultation response finalised on Friday the European Covered Bond Council (ECBC) noted that European regulators have agreed recitals on EMIR that advocate that certain specificities of covered bonds should be taken into account when establishing the draft technical implementation measures.

ECBC, Brussels

The European covered bond industry body said that it “would like to seize the opportunity of this consultation paper to highlight some important points concerning ESMA implementation of the two recitals… and to present the ECBC’s views regarding the inclusion of own name covered bonds as eligible collateral and the proposed investment policies for CCPs [central counterparties]”.

One of the specificities of covered bonds that was recognised by EU regulators, said the ECBC, is that derivatives in a cover pool are designed to survive an issuer’s insolvency, a design that would be undermined by a requirement for derivatives in covered bond cover pools to be cleared centrally. This is because, according to the ECBC, CCPs are at present unable to differentiate between the derivative contracts of an insolvent issuing bank and those of the cover pool, so that derivatives within the cover pool would automatically be terminated in the event of a default of the issuer.

Whereas recital 16 of EMIR calls for an exemption for covered bonds from central clearing obligations, ESMA is silent on this in its consultation paper on the draft technical standards, leading the ECBC to call for it, too, to make an exemption.

“We would like to invite ESMA,” said the ECBC, “to also take into account the legal and technical obstacles faced by issuers of covered bonds when establishing its technical standards and to confirm the exemption of covered bonds from central clearing obligations.”

Also informing the ECBC’s call for ESMA to make such an exemption is what it refers to as a particular risk mitigation technique in European covered bond legislative frameworks, namely the unilateral posting of collateral for cover pool derivatives.

Although derivatives in cover pools are collateralised bilaterally, said the ECBC, the counterparty posts collateral but not the issuer, with the counterparty benefitting from a preferential claim over the cover assets.

“Unfortunately, this technique does not fit central clearing systems which require bilateral exchange of collateral and, therefore, impedes these privileged derivatives used for covered bond hedging purposes from being cleared through CCPs,” said the ECBC. “Therefore, in determining the classes of derivatives subject to the clearing obligation, we urge ESMA to allow special treatment for derivatives used within covered bonds’ cover pool where legal and technical provisions impede central clearing of the derivative transaction.”

Such an exemption would not, it added, increase the risk profile of these derivatives and should not be compensated by higher risk weightings.

On a more welcome note for the industry, the technical standards proposed by ESMA would allow own name covered bonds to serve as collateral for central clearing, with the ECBC saying that it agrees with the ESMA position set out in the consultation paper.

This involved ESMA noting that “a significant number” of respondents to an earlier discussion paper (DP) had cautioned against CCPs accepting clearing members’ own name covered bonds as collateral, citing the potential for wrong-way risk, with others suggesting that CCPs should not accept any type of security issued by a clearing member in order to guard against cross-collateralisation, and others yet again, mainly from the buy-side, generally favouring a more liberal approach that would permit clearing members to post own name covered bonds to CCPs.

“In light of the diversity of responses”, said the EU authority, “ESMA intends to retain the broad approach outlined in the DP, with own name covered bonds permitted as collateral subject to certain conditions that will be aligned with the CPSS-IOSCO Principles.

“In particular, the collateral underlying a covered bond should be eligible in its own right and fully segregated from the default of the issuer. All other securities issued by the clearing member seeking to provide the collateral will not be accepted.”

The ECBC said that it agrees that the proposed criteria regarding a CCP not accepting as collateral financial instruments issued by the clearing member should not apply to covered bonds given their bankruptcy remoteness and that it is appropriate to accept owned name covered bonds as collateral by the clearing members.

Its response to the ESMA consultation also set out the ECBC’s position that covered bonds should be included within the definition of highly liquid financial instruments, with minimal market and credit risk, in which a CCP shall invest its financial resources.

Work on measures to implement the high level principles and requirements of EMIR is also being carried out by the European Banking Authority, which was consulting on draft regulatory technical standards on capital requirements for central counterparties. That consultation closed at the end of July.

Hogan Lovells’ Kent said that although EMIR has as its genesis a perceived need to address risks in trading of OTC derivatives, it has a wider impact on market infrastructure, introducing significant new regulatory requirements in three main areas: requirements for certain OTC derivative contracts to be cleared through a central counterparty; pan-European requirements for the authorisation, supervision and operation of clearing houses; and requirements for derivatives contracts to be reported to trade repositories, together with requirements for the operation of trade repositories.