EU banks seek last-minute margin reprieve for equity options

European dealers want exemption rolled over, to avoid handing US firms a regulatory advantage

Trying to win a race can be almost impossible if your car is carrying a much heavier load than other competitors. Europe’s dealers are sounding the alarm that, in under six months’ time, they will be weighed down by posting non-cleared margin on some trades, while their US competitors will be exempt.

The affected trades involve equity options, and European banks are hoping regulators will either extend an existing exemption or adopt a permanent exemption, to ensure a fair contest.

“If this derogation expires in the European Union, then some firms may simply give up equity option trading with European market participants because it will be so costly that it is not going to be worth it,” says Katalin Dobranszky, a director in the European public policy team at the International Swaps and Derivatives Association.

Global derivatives margin rules require counterparties to post initial and variation margin against non-cleared trades. The European Market Infrastructure Regulation – transposing the non-cleared margin rules into EU law – granted firms subject to margin requirements a three-year period where they would not have to post collateral against single stock options and index options, as the same contracts are not subject to the US version of margin rules.

Emir’s exemption is set to expire on January 4, 2020 but the US rules have not changed, and are unlikely to in the near future, leaving market participants braced for a regulatory divergence.

“Any fragmentation will provide arbitrage opportunities that will put EU firms at a disadvantage with any jurisdiction that excludes equity options from margin rules,” says a legal expert at a global investment bank.

A regulatory expert at a European dealer says the exemption removal would put the firm at a competitive disadvantage to US banks as clients not subject to Emir’s margin requirements would be more likely to trade with US dealers to avoid costs incurred from margining.

Deepak Sitlani, a partner at Linklaters, says: “A Cayman Island hedge fund would have to have an Emir-compliant arrangement if its counterparty is subject to Emir. In that scenario it could choose not to trade with an EU dealer but instead trade with a dealer that is, for example, subject only to the US rules and not the EU rules. Then you have a trade that doesn’t have to be margined under one regime but would need to be margined under another.”

Under Emir, firms must post variation and initial margin if they and their counterparty are directly subject to the rules. For trades where one entity is based outside the EU, but would be subject to the rules if they were established in the bloc, the rules also apply. Variation margin is exchanged by all entities that are classed as financial counterparties, while initial margin is exchanged if counterparties’ outstanding non-cleared swaps exceed a certain average aggregate notional amount – in line with international standards.

The current threshold is set at $1.5 trillion but will drop to $750 billion in September this year. Subsequently the threshold will drop to $50 billion in September 2020, after international regulators decided to delay the final threshold of $8 billion by a year to September 2021 and introduce an intermediate stage.

Margin costs

The potential cost to firms from the exemption lapse is significant. Equity derivatives may only represent 1.3% of total derivatives notional, but these trades are particularly expensive to margin. In fact, recent analysis shows that equity derivatives have become the largest consumer of initial margin, despite interest rate and foreign exchange derivatives representing a much bigger portion of the underlying market.

Initial margin across product types can be calculated using a margin-efficient method known as the standard initial margin model (Simm), which allows risks to be offset against each other. Alternatively, users can employ a more punitive grid-based methodology, which applies different percentages to notional amount based on the product type and tenor.

“For equity products in general the percentage of margin needed to be posted can be as high as 15% [of the notional amount of the derivative] under the grid-based methodology,” says Veeral Manek, head of product specialists at derivatives analytics firm OpenGamma. “That is a huge requirement. Simm is most likely to be less than 15% due to risk offsets within the methodology.”

However, there is less netting available in equity portfolios compared to rates and forex due to the diversity of the underlyings.

Large dealers – and hedge fund Brevan Howard – are the only firms subject to initial margin rules as their outstanding over-the-counter derivatives notional exceeds the current threshold. These firms are more likely to use Simm than buy-side firms, corporates and regional banks, which are expected to be caught in future phases of the rules.

“A lot of [smaller] market participants are choosing to use the grid methodology for some of the equity products because Simm is an extremely operationally heavy mechanism,” Manek says.

Dealers are now preparing to charge clients up front for the associated funding costs of posting margin on non-cleared derivatives. Practices currently vary between banks for calculating the so-called margin valuation adjustment.

In the US, though, dealers do not have to worry about passing on costs for margin on equity options. The trades are not in scope under US rules – outlined in Title VII of the Dodd-Frank Act – as options on equities are classed as securities rather than swaps. In Dodd-Frank, non-cleared margin rules apply only to swap contracts.

“When legislators were writing Dodd-Frank, they generally left ‘securities’ transactions out of Title VII,” says Nihal Patel, special counsel at Cadwalader, Wickersham & Taft. “A ‘swap’ doesn’t include securities or options on securities. So the US regulators didn’t really have a choice when they were drafting their rules as to what contracts to include. They didn’t have the ability to say: treat these options on securities as swaps.”

The only way for equity options to be included in Dodd-Frank’s non-cleared margin rules would be for US Congress to bring them in scope. It would then be down to the appropriate domestic regulator to write margin rules for the contracts.

Not so unified

European dealers are lobbying the three European Supervisory Authorities (ESAs) to reopen secondary legislation on margin requirements to extend the derogation for equity options.

Legislators had the chance to extend the reprieve in a review of Emir, known as the Regulatory Fitness and Performance Programme (Refit), which came into force on June 17.

Two French members of the European Parliament, Anne Sander and Alain Lamassoure, had earlier put forward an amendment that would have permanently exempted equity options from the non-cleared margin rules. But the amendment wasn’t included in the parliament’s draft version of Emir Refit, nor the final version.

A token amendment was instead added to one of the recitals in the final text. Recitals set out the principles of the legislation, and so do not constitute binding law.

The recital explains the EU decided to exempt physically settled foreign exchange forwards and swaps from variation margin requirements to avoid international regulatory divergence as the US also exempts these contracts from their margin rules.

The recital then states: “International regulatory convergence should also be ensured with regard to risk management procedures for other classes of derivatives.”

The legal expert at the global investment bank says this mission statement “potentially paves the way for relief from margining” for single stock equity and index options. However, an exemption – whether temporary or permanent – faces potential hurdles.

There is said to be reluctance from the ESAs to reopen the relevant regulatory technical standards and draft the changes, as the recital doesn’t clearly give them a mandate to change the rules in this manner. ESAs are supposed to be technocratic bodies and so are only supposed to write the technical details of rules rather than make policy decisions. Exempting a group of contracts from margin rules would appear to be a policy decision.

The regulatory expert at the European investment bank says the ESAs also point out that, while the US exempts equity options, Australia, Brazil, Canada and Japan all include equity options in their margin rules. The regulatory expert, however, argues: “We don’t compete with them.”

The three ESAs told Risk.net they were aware of the issue but could not comment further.

Not all European national regulators, who sit on the boards of the ESAs, are on the same page either. Two regulators on the board of one of the ESAs, the European Securities and Markets Authority, are known to be in favour of some form of reprieve.

At a conference held in London on June 4, the chairman of French supervisor Autorité des Marchés Financiers, Robert Ophèle said: “Just to mention one concern currently is the differences between some major jurisdictions, meaning the US and the EU, for exchanging bilateral margin for equity options. That is something which should be addressed swiftly.”

One source says the Financial Conduct Authority has also indicated it supports an exemption. However, the FCA and other UK authorities will have to give up their seats on the boards of the ESAs if the UK leaves the EU on October 31 or soon after.

The FCA declined to comment on whether it supports an exemption.

Other European supervisors aren’t yet convinced an exemption is in the interest of Europe’s financial markets.

“There are some jurisdictions where they support an extension, but others are not really convinced how significant this business segment is for the European financial sector,” says Benoît Gourisse, a senior director in the European public policy team at Isda.

World is watching

If the ESAs decide to rewrite the regulatory technical standards, the legislation would then have to be approved by the European Commission, European Parliament and Council of the EU within a period that typically lasts six months. But they can rush laws through if all three legislatures back the amendment.

With five months left until the January 4 deadline, there isn’t much time for regulators to get changes through in time.

ESAs could, however, issue notice to national regulators asking them not to prioritise enforcement action on this particular rule – effectively turning a blind eye – until an exemption is passed.

As some non-European jurisdictions, for example Switzerland and several jurisdictions in Asia, had set their own temporary exemptions after the EU decided to exempt equity options, the decision of Europe’s regulators could have a knock-on effect for what happens overseas.

For example, Isda’s Dobranszky says authorities in South Korea have already indicated they will follow in the EU’s footsteps as to whether they will extend the country’s own exemption once it lapses eight months after the EU’s in September 2020.

South Korea’s Financial Supervisory Service did not respond to a request for comment.

Singapore’s temporary exemption will be the first to expire on August 31 this year but it is still possible for Singaporean counterparties to avoid margining equity options by trading with US counterparties.

The Monetary Authority of Singapore recognises the EU and US as having comparable rule-sets to their own, which means a Singaporean entity can follow the foreign counterparties’ home rules rather than their own.

If Singaporean firms trade an equity option with an EU dealer, then it means they would have to post margin, while they wouldn’t if they trade the same contract with a US dealer.

Editing by Alex Krohn