Dealers seek equity derivatives carve-out from margin rules

Emir requirements may force dealers to reinvent synthetic equity finance trades

Proposed EU margining requirements: a cause for concern

Dealers are lobbying for a number of widely used equity derivatives contracts to be exempted from proposed new margining requirements from European regulators, fearing the proposals in their current form could hamper their ability to offer certain types of equity finance transactions.

If implemented as proposed, the European Supervisory Authorities' (ESAs) draft regulatory technical standards (RTSs) for non-centrally cleared derivatives – part of the European Market Infrastructure Regulation (Emir) framework – would place stringent concentration limits on eligible collateral for many equity financing plays, such as derivative-format margin loans.

For instance, a financial or non-financial counterparty large enough to be caught by the uncleared margin requirement would be unable to post a block of single-name equities or a basket of closely related stocks as collateral for an equity derivative that does not come under the mandatory clearing obligation.

"If you are doing a derivative-format margin loan – or any derivatives transaction that is linked to equities – and you take security over the equities that the loan or derivative is referencing, that type of transaction is going to fall foul of the collateralisation requirements," says Kerion Ball, counsel in the securities and derivatives group at law firm Ashurst.

In its response to the consultation on the draft RTSs, which closed on July 10, the International Swaps and Derivatives Association pushed for an exemption from the margining requirements for equity derivatives, saying the risks in these instruments are best mitigated by margin in the form of the relevant underlying equity: "If the concentration or eligibility limits prevent the use of this type of collateral, such limits will increase risk rather than reduce it," wrote the association.

The draft RTSs propose rules governing the exchange of margin on derivatives transactions that fall outside the mandatory clearing requirement, as well as the levels and type of collateral and segregation arrangements.

A central plank of the proposed rules are limits on the amount certain assets can be used as collateral for initial and variation margin. The ESAs argue diversified collateral baskets are more likely to hold their value in the event of a liquidity freeze.

Proposed concentration limits are set at 10% for single stocks, with an aggregate 40% limit on the stock of credit institutions and investment firms for non-financial counterparties above the Emir clearing threshold – known as NFC positives.

The consultation paper lays out three options for imposing concentration limits: abolishing them; applying them only when collected margins represent a significant proportion of overall exposure for the collecting counterparty; and keeping them in full as defined in the draft RTSs. The ESAs "propose a variant of option three as the preferred option," according to the consultation paper.

In its response to the consultation, the Association for Financial Markets in Europe wrote that the proposed concentration limits are "unduly restrictive" and would impose severe restraints on smaller firms, and therefore should only apply to systemically important institutions.

Workarounds mooted

Lawyers say the industry has been pushing the ESAs to moderate their stance on collateral, in particular arguing that concentration limits should only apply to the biggest players in the market – those that are already required to post initial margin under the rules, says Doug Shaw, a derivatives lawyer at Linklaters.

"As presently drafted, concentration limits pose a particular problem for smaller entities that are classified as financial counterparties due to their regulatory status. They may not meet the volume threshold to trigger an initial margin requirement, but they are required to diversify the variation margin that they post," says Shaw.

If the ESAs get their way, however, and the third mooted option is imposed, there are several workarounds large corporates and equity derivatives desks could explore for equity financing transactions, dealers say.

The first involves using a special purpose vehicle (SPV) to face the dealer as counterparty to the deal. If the SPV disintermediates a corporate and the aggregate notional amount of its group's outstanding derivatives positions is below the Emir clearing threshold, both sides can opt out of the margining requirement.

Market participants could also consider swapping their equity collateral with another institution for other assets – though adding these transactions on top of the original trade is likely to affect pricing, says Daniel Franks, a partner at Norton Rose Fulbright.

Another solution is structuring such transactions as something other than a derivative – as a repo or secured lending agreement, for instance. Ashurst's Ball says: "It is increasingly common in the London market for these transactions to be documented under a Loan Market Association form agreement with specific share-related features and triggers built into it so that economically you have a loan secured on the relevant shares."

Others take a more sanguine view. One source at a large European dealer says the number of equity financing transactions captured by the margining requirements should be small, as large scale deals are typically structured as non-recourse loans or repos, and derivatives used for synthetic prime brokerage activities are incorporated as part of a larger portfolio of products, meaning the risk of concentration is remote.

The ESAs issued a first consultation on the RTSs in April 2014, and the second in June this year to address industry concerns with several aspects of the proposals. Following the close of the second consultation the ESAs will present the technical standards to the European Commission, expected sometime in September or October this year.

The margining requirements are anticipated to be phased in from September 2016.