Proposals from ESMA for conditional exemption of covered bond swaps from mandatory central clearing under EMIR are credit positive, Moody’s said on Thursday, while the ECBC has responded to a parallel swaps consultation with suggested amendments.

As previously reported, the European Securities & Markets Authority (ESMA) on 11 July launched a consultation that proposed excluding swaps used in covered bonds from a central clearing obligation under the European Markets Infrastructure Regulation (EMIR), on the proviso that the derivatives/covered bond programmes meet certain conditions.

ESMA's premises in Paris

Moody’s on Thursday said that the exemption is credit positive for those covered bonds that would face higher levels of interest rate risk if they are unable to utilise swaps for hedging purposes. It noted that that the market practice, and in some jurisdictions a legal requirement, is for interest rate swaps not to terminate upon an issuer’s insolvency if the cover pool can service payments on the swap, but that clearing requires that the swap terminate if the issuer is insolvent. As a result, the swap cannot protect the cover pool after this time, increasing the risk of losses as a result of close-out payments and subsequent cashflow mismatches.

According to Moody’s, the exemption set out in ESMA’s consultation, which complements an earlier proposed exemption for covered bond issuers from posting margin under non-cleared swaps (see below), is a positive signal that regulators are looking to support the covered bond market, according to the rating agency.

“However, the exemption contains some limitations and drafting ambiguities,” it said. “An important limitation applying to both exemptions is that a covered bond programme must benefit from a legal minimum 2% overcollateralisation, which is not the case for all programmes.”

The rating agency added that if the provision is implemented in its present form there would be a reduction in the credit positive effect of the exemption unless national legislators adapt their covered bond law to accommodate it.

Moody’s said that the programmes that would benefit from an exemption from mandatory clearing would be those in jurisdictions where interest rate swaps are typically used, namely France, the UK, the Netherlands, Italy, and Nordic countries excluding Denmark. It highlighted the UK, the Netherlands and France as jurisdictions where swaps are particularly beneficial because the law does not provide for a net present value test to measure whether future asset cashflows will cover covered bond liabilities in the instance of issuer default.

The rating agency said that interest rate swaps also take on heightened importance for cover pools that include a large number of loans with long dated fixed rate periods. Moody’s noted that such cover pools are typical in France, the Netherlands, and to some degree in the UK. Mortgage loans in cover pools in jurisdictions such as Sweden and Norway are more likely to be floating or will have short fixed periods so they can more easily achieve “a natural” hedging, according to Moody’s.

“Nevertheless, all these jurisdictions and many others currently utilise interest rate swaps,” said the rating agency. “So the removal of these swaps would lead to increased risk to investors where alternative solutions are not adopted or are less effective at removing interest rate risk.”

Room for improvement in non-CCP cleared regime

Meanwhile, the European Covered Bond Council has welcomed a carve-out for covered bonds under draft regulatory technical standards (RTS) on risk-mitigation techniques for derivatives that are not centrally cleared, but still sees problems with what the European supervisory authorities (ESAs) have proposed.

The industry body set out its views in a consultation on the draft RTS that finished on 14 July. It welcomed the ESAs’ move to allow covered bond-related derivatives to be excluded from bilateral collateral posting of initial variation and variation margins, while ensuring derivative counterparties a degree of protection by outlining specific conditions that have to be met for this exemption.

However, the ECBC raised several issues with the draft RTS and made suggestions as to how these should be dealt with. Some are quite technical and can be read about in more detail in the ECBC’s consultation response. The points raised include that derivatives satisfying the requirements for exclusion from the bilateral margin posting requirement also be excluded from counting toward group thresholds for non-centrally cleared derivatives, and that Article 52 (4) UCITS rather than Article 129 of the Capital Requirements Regulation (CRR) should be the EU-harmonised classification that covered bonds must fulfil in order for covered bond-related derivatives to be exempt from the margin posting requirements.

Under the draft RTS, one of the other conditions for the carve-out is that the covered bond programme in question is subject to a legal collateralisation requirement of at least 102%. The ECBC said that it “would encourage the ESAs to set the same minimum requirement across the different regulatory files that are currently addressing this topic”.

“In addition, considering the timing implications if the various national covered bond legislations need to be amended to include a minimum OC, we would strongly suggest a grandfathering period before this requirement becomes mandatory,” it said.

The industry body also recommended that “the scope of the contemplated carve-out regime to the benefit of covered bonds should be broadened in order to take into account issues raised by bespoke derivatives performed for hedging purposes, such as back-to-back swaps.”