12 April 2011

AIMA: Asset segregation in OTC markets

The Alternative Investment Management Association director of government and regulatory affairs, Jiri Krol, says he has some concerns with the European Commission's EMIR proposals on asset segregation in the over-the-counter derivatives market and sets out his wish list.

In the over-the-counter derivatives market today, clients of derivative dealers trade outside regulated markets and bilaterally clear their contracts.

The dealer is often able to use the assets as their own - a 'rehypothecation' of assets. In this situation, if the derivative dealer were to become insolvent, the client's margin under insolvency law would form part of the insolvent estate of the dealer, and the client would be left with a creditors' claim over their assets and could expect a reduced return on the value of assets provided (a pro rata creditors claim), and significant delay in receiving those assets whilst the dealer's business is wound up.

To address this issue, some buyside firms have negotiated (at reasonable cost) for their asset to be held independently of the dealer in a single account with a third party custodian ('fully segregated'), and for the dealer to have rights over the assets only as provided for under a tri-party custodian agreement (i.e. where a client is 'out of the money' under the derivatives contract). Should the dealer become insolvent, the assets would not be subject to insolvency proceeding and may be returned to the client promptly.

The European Commission has proposed in the European Market Infrastructure Regulation (EMIR) - which introduces mandatory clearing for eligible OTC derivatives - that the client assets posted as margin must be segregated from the assets of the derivatives dealer. This presumably could be a range of models, including the omnibus model, where the client's assets are separated from the dealer but not from other clients. CCPs and dealers will also need to offer a more detailed 'full segregation' whereby clients will be able to choose to segregate their collateral from that of the dealer's other clients. AIMA believes there is a unique opportunity to address one of the most fundamental lessons the industry has learned in the crisis, and attempt to formulate a segregation regime which is safe, clear and provides a high level of legal certainty. Otherwise, we could end up with a central clearing model which provides less, not more, protection than the current bilateral model with tri-party segregation arrangements.

The main features of segregation under the newly planned regulation should therefore include the following:

• A basic requirement for physical segregation of client assets (margin and excess payments given forming the position) from the assets of the derivatives dealer ('basic segregation');

• Ensuring that physical segregation creates effective legal segregation, resulting in assets not being available, to the administrators of an insolvent derivatives dealer, for payment to creditors or otherwise being considered the derivative dealers own assets, and subject to any national insolvency provision;

• For derivative dealers (with whom the client contracts) to offer, and for the clients to have the right to choose, full segregation of assets where the clients' assets are held independently, and physically and legally separate from the assets of:

- the derivative dealer;
- the clearinghouse;
- another client of the derivative dealer.

• To achieve full segregation at reasonable cost;

• To recognise that not all clearinghouses are credit institutions and thus are not able to hold client assets themselves. Sufficient flexibility should be given to allow the parties to make use of whichever structures or arrangements are convenient and cost effective (including the use of third party custodians), to achieve the goals of basic segregation or full segregation;

• That whichever model is used, segregation of client collateral should be recognised and retain its protection from provision in:

- conflicting national insolvency law;
- the financial collateral directive;
- the default waterfall of the clearinghouse;

• For the segregation structures and the resulting costs for clients to be made clear to the client prior to trading;

• To provide that segregation should allow, within a short time-frame, on the insolvency of the derivatives dealer, for either:

- transfer of the assets and position to a second derivatives dealer ('porting'); or
- close out of the position and the return of all client assets separately held;

• To recognise that under basic segregation, as well as double default risk, clients face risk of having to provide additional margin resulting from a deterioration of the value of assets provided. Such additional margin would be required pro rata between the clients. Margin should therefore be sufficiently high quality to prevent deterioration during stressed market conditions, e.g. cash or highly liquid and creditworthy government securities;

• Similar basic segregation should be provided to derivative dealers segregating:

- the clearinghouse's assets from those of the derivatives dealers;
- the derivative dealer's assets from those of other derivative dealers. 

Benefits of segregation

Successful implementation of segregation provisions will allow:

• easy and fast porting of positions on derivative dealer insolvency;

• protection of client positions, meaning they are less likely to pull trades from dealers in stressed market conditions and therefore produce the undesirable pro-cyclical behaviour the central clearing legislation is meant to encourage;

• clients, which are answerable to their shareholders or investors, will have more confidence in retaining the value of their collateral;

• equal protection to that currently available in the uncleared OTC derivatives market;

• increased confidence for clients in the OTC derivative markets, encouraging greater participation in the markets.

Full segregation in single accounts is possible and administratively workable in the uncleared derivatives market at relatively low cost for the buyside, and we believe this would also be possible for the cleared market.

Making segregation mandatory or at least a viable option will increase its use, and we believe that clearinghouses and derivative dealers will be able to benefit from economies of scale from the increased volumes.

A flexible framework on the models which may be used for segregation is also hoped to provide a competitive and innovative market where firms compete on both prices and level of service to the client. The loss of the right to rehypothecate collateral is expected to be off-set in most cases by both increased numbers of trades being demanded by the buyside (and thus increased clearing fees), and favourable capital treatment where the derivative dealer's counterparty is the clearinghouse. Full segregation is likely to be affordable for many, and clients who demand this model are willing to pay a reasonable cost to gain this extra protection.

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