# EUR-Lex - 52015DC0039 - EN

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# 52015DC0039

**REPORT FROM THE COMMISSION TO THE EUROPEAN PARLIAMENT AND THE COUNCIL under Article 85(2) of Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories, assessing the progress and effort made by CCPs in developing technical solutions for the transfer by pension scheme arrangements of non cash collateral as variation margins, as well as the need for any measures to facilitate such solution /* COM/2015/039 final */**

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INTRODUCTION

Regulation
(EU) No 648/2012 on OTC derivatives, central counterparties and trade
repositories (EMIR) was published in the Official Journal of the European Union
(EU) on 27 July 2012, and entered into force on 16 August 2012.

Under
EMIR, OTC derivatives that are standardised (i.e. that have met predefined eligibility
criteria), including a high level of liquidity, will be subject to a mandatory
central clearing obligation and must be cleared through central counterparties
(CCPs).

CCPs
are entities that interpose themselves between the two counterparties to a
transaction and thus become the 'buyer to every seller', as well as the 'seller
to every buyer'. As a counterparty to every position, the CCP bears
counterparty credit risk in the event that one of its counterparties fails.

CCPs
are designed to withstand the default of a clearing member or client
principally through the use of frequent and conservative collateral – or
‘margin’ – requirements, calculated to cover any potential losses upon a
default. CCPs accept only highly liquid assets, generally cash, as collateral
to meet variation margin (VM) calls in order to allow for a rapid liquidation
in the event of a default.

Pension
Scheme Arrangements (PSAs)[i]
in many Member States are active participants in the OTC derivatives markets.
However, PSAs generally minimise their cash positions, instead holding higher
yielding investments such as securities in order to ensure strong returns for
their beneficiaries - retirees. The inability of CCPs to accept non-cash assets
as collateral to meet VM calls means PSAs would need to generate cash on a
short term basis either by borrowing cash or selling other assets in order to
meet the CCP margin calls. This is not currently the case in the framework of
bilateral relationships, where PSAs are able to post non-cash assets to their
bilateral counterparties, to the extent that margin is required. Such a
maintenance of cash reserves leads to high opportunity costs for PSA's because
of the low level of interest that is earned on cash collateral. The costs of
central clearing would therefore ultimately reduce the retirement income of the
relevant pensioners if PSAs were required to post cash to meet VM calls.

The
Commission, the Council and the Parliament therefore agreed a three-year
temporary exemption from the clearing obligation for PSAs meeting certain
criteria[ii],
provided in Article 89(1) of EMIR. The exemption can be extended by up to a
further three years in total. This transition period was explicitly provided
for under EMIR in order to provide further time for CCPs to develop technical
solutions for the transfer of non-cash collateral to meet VM calls.

PURPOSE
  OF THE REPORT

In
accordance with Article 85(2) of EMIR, the objective of this report is to present
an assessment of the progress and effort made by CCPs in developing technical
solutions for the transfer by PSAs of non-cash collateral as VM, as well as the
need for any measures to facilitate such solution.

Article
85(2) of EMIR also provides that, if the Commission considers that the
necessary effort to develop appropriate technical solutions has not been made
by CCPs and that the adverse effect of centrally clearing derivative contracts
on the retirement benefits of future pensioners remains unchanged, it shall be
empowered to adopt delegated acts in accordance with Article 82 to extend the
three-year period referred to in Article 89(1) once by two years and once by an
additional one year.

In
order to assess the current situation fully, the Commission ordered a baseline study
on whether necessary efforts have been made by CCPs to develop appropriate
technical solutions for the transfer of non-cash collateral as VM by PSAs. This
baseline study also provided analysis of potential and alternative solutions.
Finally the baseline study analysed the impact of removing the exemption in the
absence of a solution, calculating the reduction in retirement income for the
pensioner beneficiaries of the affected PSAs[iii].

In
accordance with Article 85(2), the European Commission has consulted with the European
Securities and Markets Authority and the European Insurance and Occupational
Pensions Authority in the process of preparing this report.

EFFORTS
  BY CCPs

3.1.
     A PSA’ “REPO” SERVICE

At
this stage, only one CCP has demonstrated any notable effort to develop a
solution for the posting of non-cash assets in order to meet VM calls.

The
relevant CCP is actively developing a service (hereinafter ‘the PSA repo
service’[iv])
which could address PSAs’ needs to use non-cash assets in order to meet the
cash VM calls it requires.

The
proposed service would allow a limited range of non-dealer market participants
(including PSAs) to become members of its repurchase (repo) transaction trading
and clearing service. Under a repo transaction, one party sells an asset
(usually fixed-income securities) to another party and commits to repurchase
the asset at an agreed price at a future date. The asset serves as collateral
and mitigates the counterparty credit risk that the buyer has on the seller.
Repos are therefore a means for PSAs to transform their existing non-cash
assets into the cash that CCPs require to meet VM calls, whilst retaining
ownership and – critically - investment returns of the assets long term. Under
the proposed PSA repo service, PSAs would enter into repo transactions with
other market participants of the trading service using the securities that it
already holds in the ordinary course of its investments. These transactions
would be executed on the CCP’s repo trading platform and would automatically be
cleared through its clearing service.  The cash raised by the repo transactions
could then be posted to the CCP to meet its VM calls.  The repos themselves
would be cleared through the CCP and therefore the PSA’s counterparty credit
risk on this transaction would be mitigated by the CCP.

This
service would enable PSAs to execute repos whilst centralising the management
of the positions at the CCP and mitigating any residual bilateral counterparty
credit risk in the repo transactions by facing the CCP instead of the repo counterparty.

As
the PSA repo service is still under development, certain important questions as
to the viability of such a service remain at this stage. As detailed further
below at section 4.3, it is considered that there may be insufficient capacity
in the bilateral repo markets for PSAs to ensure the ability to source the cash
needed to meet VM calls from the CCP in times of market stress. It must
therefore be questioned whether cleared repo markets will develop to provide
the extra capacity needed by PSAs. The ability of the bank providers of repo
liquidity to remove bilateral risks from their transactions and to instead face
the CCP may result in lower capital charges which could incentivise increased
repo activity. However, other regulatory factors may influence the development
of the repo markets in the short to medium term, including regulatory
initiatives under Basel III as well as the proposed EU Financial Transaction
Tax, and possible principles on mandatory haircutting of assets pursuant to the
Financial Stability Board’s Workstream on Securities Lending and Repos. It is
possible that repo markets may become less attractive for liquidity providers
and may therefore shrink as a result.

Further,
the ability of all – or even the majority of - PSAs that have difficulty in
meeting cash VM calls to utilise this service is questionable. This is because
participants in the service will need to access the CCP under a special access
membership agreement which would oblige the PSA to make contributions to a
special default fund. The default fund would not be used to cover losses of
other clearing members as with conventional membership agreements; it would be
provided to cover only direct losses caused by the potential default of the PSA
itself. It is therefore not exposed to losses caused by other clearing
participants defaulting However it will involve a commitment of additional
security upfront which may not be tolerable to all PSAs and their managers or trustees.

Finally,
at this stage of development, the costs for PSAs of using the potential repo
service are unknown. It is possible that the costs of entering into cleared
repo transactions will be higher than the costs of entering into bilateral repo
transactions. This is because the PSA will have to maintain a default fund, as
described above, as well as a clearing fee being attached to the transaction.
There will also be implementation costs for the PSA to set up operational
connections to the service, as well as legal agreements.

This
potential service is still under development. It is planned to be launched in
the first half of 2015.  The Commission will continue to engage with the CCP in
question and PSAs as the service comes to the market in order to assess its
ability to serve the needs of PSAs.

The
Commission will also explore with interest the ability of other CCPs to develop
similar services.

As
the proposed service is yet to be launched, the Commission has explored
additional potential technical solutions in order to identify whether there are
other measures which might be taken by CCPs in enabling PSAs to post non-cash
assets to meet VM calls. These potential technical solutions are outlined
below. The viability of each option is assessed, taking into account associated
legal, commercial, policy and practical obstacles, associated risks, and any
identifiable likely costs to PSAs.

The
baseline study also explored whether alternative solutions may exist outside of
the CCP infrastructure for PSAs to be able to centrally clear without
negatively affecting retirement incomes. These alternative solutions are also
outlined below, with an analysis of their viability.

Any
resulting risks of the technical or alternative solutions must of course be
balanced against the level of systemic risk mitigation that central clearing
provides.

3.2.
     POTENTIAL ALTERNATIVE SOLUTIONS

(i) 
 Collateral transformation by CCPs

This
would entail a repo service offered by CCPs to PSAs in which the CCP would be
the principal counterparty to the repo transaction, providing cash to the PSA
in return for securities. In this sense, the core concept is comparable to the
PSA repo service under development by the CCP outlined above. However, this
potential solution does not assume the ability of the CCP to also create an
offering for an organised repo trading platform and associated clearing
service.

The
relevant CCP would then need to execute a back-to-back repo with a third party
concurrently in order to raise the cash. This third-party would be either a
dealer bank in the repo market or a central bank.

It is questionable
whether an arrangement in which the central bank is the only provider of
liquidity for repo would be acceptable to that central bank therefore this
discussion assumes a solution whereby the CCP expects to use the commercial
banks in ‘normal’ conditions and only uses the central bank in adverse market
scenarios.

Currently not all CCPs
have routine access to central banks’ facilities. Certain EU CCPs currently
have access to intra-day credit and, under defined conditions, to overnight
credit. However, this access could not be suitable to implement a standard
collateral transformation facility based on repo. To do so, CCPs would at least
need access to overnight facilities or even to credit operations with longer
maturities in order to avoid rolling over short-term repos on a daily basis.
This would involve a change in practice between CCPs and central banks which
central banks and their stakeholders would need to consider carefully.

This potential solution
entails CCPs assuming an increased level of risk in terms of repo transaction
volume and consequent exposure to counterparty and market risk. This in turn
increases the systemic risk posed by CCPs.

Additional obstacles include
the need for investment by the CCP in the necessary trading and treasury
management capability as well as operational and legal changes – most notably
in its default procedures where repo transactions with a defaulting clearing
member may need to be liquidated at the same time as the affected OTC
derivative portfolios.

(ii) 
Direct acceptance of non-cash assets
with pass through to receivers of VM

Here
the CCP would allow PSAs to post and receive VM in the form of non-cash assets
that it is already holding, such as Government bonds. Those assets would then
be passed through to the in-the-money counterparty to the transaction.

A CCP would have to
offer for clearing two parallel sets of products with the same fundamental
economic terms – one for which VM would be paid and received in cash and the
other for which it would be posted and received in specified eligible
securities.   This would reduce market liquidity, with the probability of wider
trading spreads and less flexibility in porting or liquidating the positions of
a defaulting participant at the CCP. There would also be an inability for
collateral calls to be netted across the two products.

Timely settlement is
another principal obstacle to this option being made viable. Participants
posting non-cash VM would have to be able to transfer the securities into the
name of the CCP on the same day as the collateral call is made.  However, this
would be difficult to achieve in practice since same-day settlement is not
standard practice at central securities depositories currently.  A further
difficulty is that securities can only be exchanged in transferable units.
Since the VM amounts payable or receivable will be calculated by the CCP in
monetary values the CCP would need to set a market convention for how these
values are to be converted into the deliverable quantity of whatever security
the VM payer chooses to post resulting in rounding differences and cash
adjustments made between the CCP and the clearing members.

Additionally costs
amounting to several million euros would be incurred by CCPs, clearing members,
Custodians, asset managers and PSAs in order to provide the necessary
operational capabilities on this front.

In terms of legality,
there is also doubt over whether passing securities through to the receiver of
VM would meet some PSAs’ requirement to keep control of their assets.

(iii) 
 Acceptance of non-cash assets with
security interest passed through to receivers of VM

The
CCP would again allow PSAs to post VM in the form of securities, as under (ii).

However,
instead of passing on the securities to the counterparties due to receive VM,
the CCP would create a security interest over the posted securities, in favour
of the VM receiver.

Under
this solution, the assets posted to meet the VM call are not transferred to the
VM receiver and so the risk in the contract is not actually settled.  There
simply exists a legal claim that will vary in value over time.  In the event of
default, the value of the claim would be uncertain until its liquidation. This
additional risk would lead to the contract needing to be priced differently
making it more expensive than regular cash settled contracts, and again
creating a bifurcation of cleared products with less liquidity in the PSA
tailored product.

Legal
risk is also an obstacle to this solution, as security interests are not always
subject to the same legal frameworks across the EU.  This potentially leads to
legal uncertainty as to what would happen in a default situation

(iv) 
Quad-party collateral for VM security
interest

This
is a variation of the previous solution in which the securities would be held
with a custodian according to an agreement between itself, the PSA, the
counterparty to the original transaction and the CCP.

This
arrangement would enable PSAs to post non-cash assets as VM without needing to
transform them into cash. Collateral would instead be provided in the form of a
security interest in favour of the counterparty.  The PSA would outsource its
collateral management to a custodian in an arrangement formalised between the
four parties involved - the PSA, the counterparty, the CCP and the Custodian. The solution would build on
existing tri-party collateral management services.

This
solution presents the same challenges as the previous solution in that it
results in unsettled counterparty credit risk, which is counterintuitive to the function of VM and
may cause concern for clearing members, counterparties and regulators.

It would again
create a bifurcation in products, with liquidity and netting complications.

(v) 
Collateral Transformation by Clearing
Members

This
first alternative to a technical solution at the CCP is the possibility for
PSAs to raise cash by executing repo transactions with their clearing members,
outside of the CCP’s own infrastructure.

Clearing
members of OTC derivatives CCPs generally belong to banking groups that are
also active in the repo market. This means that clearing members are seemingly
well placed to offer repo services to their PSA clients for this purpose
without investing in new business operations. Such a service could also be
provided to PSAs independently of their designated clearing brokers by a third
party bank.

However
the current size of the bilateral repo markets may have insufficient capacity
to provide the cash that PSAs would need to meet their VM liabilities. In any
case, repo lines would not be guaranteed by dealers and may be withdrawn in
times of stress.

According
to the findings of the baseline study (see, in particular, section 5.7.3), the
repo market would however not be able to cope with the aggregate demand from
PSAs seeking to fund in full cash VM calls due to a severe interest rate
movement (e.g.100 basis points) and PSAs would, as a result, not have access to
funding needed to meet VM calls if they were to rely on the bilateral repo
market. This would result in unpaid margin calls putting PSAs into default and
causing knock on effects across the markets.

Under
this arrangement, the PSA’s clearing broker would be exposed to the
consequences of the default of the PSA in that it may be contractually obliged
to meet VM calls on its PSA client’s behalf. Clearing brokers are generally
top-tier banks and so pose significant risk to the wider financial system.

(vi) 
     Agency stock lending

Under
a model of agency stock lending, the PSA would lend securities from its own
portfolio to third parties and receive collateral in the form of cash from the
borrower which could be used to meet VM calls.

Stock
lending is already used by many PSAs through established operational and legal
arrangements.  However, the ability of the PSA to lend depends on the needs of
other market participants to borrow the offered assets at any given time.
Whether counterparties actually want to borrow stock and for what duration is
outside the control of the PSAs.  Stock lending cannot therefore be viewed as a
reliable source of funding. As with the arrangement above, this would have the
potential to result in unpaid margin calls with the potential to lead to the
default of the PSA’s clearing broker.

(vii) 
 Secured lending by non-financial
entities

The
baseline study identifies that many large corporate entities presently have
large cash reserves that they may be looking to lend securely

This
alternative option would involve the PSA posting securities under a repo
transaction and receiving cash from the corporate entity as collateral against
the repurchase, similar to the potential alternative solution outlined under
(v).

There
is currently no established market for secured corporate lending to PSAs so
whilst conceptually corporates may have means to provide cash to PSAs in order
to meet CCP VM calls, the capacity and volatility of such a market is
impossible to assess. This alternative also raises questions as to whether the
establishment of such a market would call for regulation, and the impact that
this would have on costs and availability. It cannot therefore be deemed as a
viable alternative option.

CONCLUSIONS

4.1.      PROGRESS
AND EFFORT MADE BY CCPS

It
can be concluded that, with the exception of the proposed PSA repo service
identified in section 3, no sufficient progress appears to have been made by
CCPs in order to develop technical solutions for the transfer of non-cash
collateral as VM. None of the infrastructure based potential alternative solutions
analysed outlined under points (i) to (iv) of section 3.2 appear to be being
pursued by any CCPs. It can be concluded that this is due to the obstacles that
this report identifies. Nonetheless, CCPs should continue to consider ways in
which the obstacles identified to the implementation of the potential
alternative solutions could be overcome in practice.

The
lack of progress in identifying and developing viable solutions may be
attributable to the fact that those CCPs that have not developed solutions are
currently not well placed to provide such services as they do not already
operate any  trading or clearing services in the repo markets that could be
built on to facilitate collateral transformation. It can also be assumed that
CCPs have focussed their resources over the past two to three years on bringing
their services into compliance with the newly implemented requirements under
EMIR, as well as other aspects of EU and international regulatory reforms.[v]
Considerable resources have also been expended by CCPs on developing client
clearing solutions generally, as clearing obligations under EMIR will extend to
small and medium sized market participants (including PSAs) which are unable to
clear directly as clearing members. The lack of efforts in developing technical
solutions could therefore also be attributed to the fact that CCPs have been
unable to prioritise new developments in this area.

4.2
      MEASURES REQUIRED

The
Commission will continue to monitor development of the repo-based service
proposed by the relevant CCP, in order to assess whether this focus is
maintained and the solution is implemented smoothly in 2015 as anticipated. The
successful implementation of this proposed service will also depend on the
continued cooperation of the potential PSA participants.

The
Commission will also continue to engage with other EU CCPs clearing the
relevant OTC derivative transactions (interest rate and/or inflation swaps) in
order to assess whether similar solutions could be adopted by those CCPs. As
identified above, this may depend on the ability of other CCPs to offer
services in repo trading and clearing as well as OTC derivatives clearing.
Nonetheless, the Commission strongly urges all EU CCPs, in cooperation with
their clearing members and with PSAs, to continue their consideration of how
the obstacles analysed in this report may be overcome to achieve clearing
solutions that – either individually or in combination – could provide the
necessary capacity for PSAs to centrally clear their OTC derivative
transactions, with a lesser impact on their yields. An appropriate solution
will enable PSAs to pursue their OTC derivatives activity without inhibitive
cost whilst providing the benefits of central clearing to their counterparties
and the wider financial system.

However,
the Commission recognises that, in the absence of a solution, PSAs will
ultimately be required to substitute securities for cash in order to maintain a
sufficient cash buffer to meet potential VM calls, from August 2018 at the
latest. It should also be considered that, though none of the potential
alternative solutions seem to provide a comprehensively satisfactory solution
for PSAs, a combination of collateral transformation may need to be utilised.
The Commission would also encourage the industry to consider what longer term
financing opportunities (such as covered bonds or asset backed securities) may
be available to PSAs which, individually or in combination, could provide a
sufficient source of funding with confidence, including in times of stress. It
is recognised that such financing opportunities may be dependent on the ability
of the PSA to maintain legal title and/or control over the securities being
exchanged for cash and flexibility would therefore be required.

4.3       POTENTIAL ADVERSE EFFECT OF CENTRALLY
CLEARING DERIVATIVE CONTRACTS ON THE RETIREMENT BENEFITS OF FUTURE PENSIONERS

In
the absence of an exemption from the clearing obligation being available, PSAs
would be forced to hold cash reserves instead of higher yielding assets that
they commonly hold, such as Government bonds. Continuing to hold non-cash
assets and relying on the open repo markets on an ad-hoc basis does not provide
sufficient certainty. As indicated in the baseline study, the main identifiable
obstacle to doing so is the fact that the current repo bilateral repo markets
do not appear to hold sufficient liquidity to withstand the needs of EU PSAs in
stressed scenarios. This conclusion is based on analysis of the EU Government
bond markets. The baseline study indicates that the aggregate VM call for a 100
basis point move would be €204–255 billion for EU PSAs.  Of this, €98–123
billion (£82–103 billion) would relate to UK PSAs, and predominantly be linked
to sterling assets, and €106–130 billion would relate to euro (and perhaps
other currency) assets.

Even
if PSAs were the only active participants in these markets, the total VM
requirement for such a move would exceed the apparent daily capacity of the UK
gilt repo markets and would likely exceed the  relevant parts of the EU Government
bond repo market — i.e. primarily that in German Government bonds (bunds). 
Repo liquidity does exist in other less liquid but still high grade securities
although the markets for these instruments are much more susceptible to shrinkage
in times of stress.

Holding
cash reserves to cover potential market movements will reduce the overall
yields earned on the investments made for the benefit of the pensioners
belonging to the schemes, which may ultimately reduce the total amounts paid
out by the PSAs as retirement income to those beneficiaries.

According
to the baseline study, the costs of moving from bilateral collateralisation to
posting cash VM with CCPs impact of requiring PSAs could consequently amount to
a cumulated percentage reduction in retirement incomes of up to 3.1 per cent in
the Netherlands and 2.3 per cent in the UK based over a 40 year period. The
total expected impact on retirement incomes across the EU over 20-40 years
would be up to 3.66%. This is directly attributable to the reduction in
investment returns anticipated by being required to hold cash reserves instead
of non-cash securities.

This
is a significant impact which is likely to affect pensioners across the EU and
can be considered disproportionate to the benefits served by requiring PSAs to
clear at this stage. This conclusion takes into account the fact that
transactions will in any case be required to be collateralised on a bilateral
basis under the forthcoming bilateral margin requirements under Article 11(3)
of EMIR, thereby mitigating the counterparty credit risk in transactions to
which they are counterparty, both from the perspective of the banks and the
PSAs.

It
is possible that PSAs at the higher end of the scale of this impact may choose
not to hedge their liabilities in order to maintain current levels of
retirement income for beneficiaries. This would create the risk of losses on
investments as a result of unhedged market volatility which would equally lead
to a reduction in retirement incomes.

However,
it should be noted that, as the significant majority of standardised OTC
derivative contracts move to central clearing, non-cleared contracts may become
less liquid over time. This in itself would narrow the overall cost
differential between cleared and non-cleared contracts in the future.

4.4       PROPOSAL
FOR A DELEGATED ACT

The
Commission considers that the necessary effort to develop appropriate technical
solutions has not been made at this point in time and that the adverse effect
of centrally clearing derivative contracts on the retirement benefits of future
pensioners remains unchanged.

The
Commission therefore intends to propose an extension of the three-year period
referred to in Article 89(1) of EMIR by two years through means of a Delegated
Act. The Commission shall continue to monitor the situation with regards to
technical solutions for PSAs to post non-cash assets to meet CCP VM calls in
order to assess whether this period should be extended by a further one year.

[i] As defined under
Article 2(10) of EMIR.

[ii] Article 89(1) and (2)
of EMIR, the exemption shall apply only to OTC derivatives that that are
objectively measurable as reducing investment risks directly relating to the
financial solvency of pension scheme arrangements and where the PSA encounters
difficulties in meeting the VM requirements.

[iii] The baseline study
will be made available on the European Commission website
http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm#maincontentSec2

[iv]    It should be noted
that the service under development would not be limited to PSAs but may be
offered to other market participants with similar needs.

[v]     Several EU CCPs
are authorised and operative in third country jurisdictions.