Article 30 of the EMIR Margin Rules and the Covered Bond Exemption | White & Case LLP International Law Firm, Global Law Practice
Article 30 of the EMIR Margin Rules and the Covered Bond Exemption

Article 30 of the EMIR Margin Rules and the Covered Bond Exemption

Introduction

The new rules that implement the margin requirements under the risk mitigation obligations as set out in EMIR, create a specific regime for hedging arrangements that are entered into in relation to covered bonds. This article discusses the main aspects of the covered bond exemption and its legal and practical implications.

 

Background

Covered bonds (each a "CB"), being securities issued by financial institutions (each a "CB Issuer") pursuant to legislative CB regimes that are secured by pools of collateral, have become one of the largest growing asset classes in the European bond market and an important source of finance for mortgage lending. The defining feature of CBs is the dual nature of protection offered to investors, i.e.  CB bondholders have direct recourse to the cover pool typically composed of mortgage loans or public-sector debt as preferred creditors, while remaining entitled to a claim against the CB Issuer as ordinary creditors for any residual amounts not fully settled with the liquidation of the cover pool.

Article 11 of Regulation No 648/2012 of the European Parliament and of the Council ("EMIR") requires FCs and NFC+s to have in place risk management procedures to ensure the timely, accurate and appropriately segregated exchange of collateral in connection with non-cleared OTC derivatives. This legal framework has been further developed by Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 ("Margin RTS"). On 15 December 2016, the Margin RTS was published in the Official Journal and entered into force on 4 January 2017.

 

The Covered Bond Exemption

Specific treatment in the Margin RTS is provided for OTC derivatives entered into in connection with CBs. The rationale behind this special treatment is the legal impediments that CB Issuers or cover pools may encounter when providing collateral. The main legal impediment is that variation margin ("VM") transfers may be considered a preference that ranks senior to CB holder claims. On the other hand, there are no constraints on a CB Issuer or cover pool returning cash previously posted to it as VM by a hedging bank counterparty to an OTC derivative. VM posting by a hedging bank counterparty to an OTC derivative with a CB Issuer upon its downgrade below certain triggers is also a requirement in rating agency criteria for CBs.[1]Therefore, Article 30(1) of the Margin RTS provides that, subject to satisfaction of a set of requirements listed in Article 30(2) of the Margin RTS (the "CB Requirements"), CB Issuers or cover pools are not required to post collateral (the "Covered Bond Exemption").

Article 30 of the Margin RTS sets outs the Covered Bond Exemption for CB Issuers and cover pools which exempts CB Issuers from posting any initial margin ("IM") and VM.

The Covered Bond Exemption will apply to CB Issuers or cover pools provided that all of the following CB Requirements are met

1

No insolvency termination

the OTC derivative contract is not terminated in case of resolution or insolvency of the CB Issuer or cover pool[2]

2

Pari Passu with CB holders

hedging banks rank at least pari passu with the CB holders except where  the relevant hedging bank is the defaulting or the affected party[3] or waives the pari passu ranking

3

Registration in the cover pool

the OTC derivative contract is registered or recorded in the cover pool of the CB in accordance with national CB legislation

4

Cover pool hedging

the OTC derivative contract is used only to hedge the interest rate or currency mismatches of the cover pool in relation to the CB

5

Only OTC derivatives related to CBs

the netting set does not include OTC derivative contracts unrelated to the cover pool of the CB Issuer

6

Eligible collateral of the CBs

the CB to which the OTC derivative contract relates is collateralised by any of the following eligible assets (as further described in paragraphs (1), (2) and (3) of Article 129 of Regulation (EU) No 575/2013):

  • exposures to or guaranteed by central governments, central banks that belong to the European System of Central Banks, public sector entities, regional governments or local authorities in the EU
  • exposures to or guaranteed by third country central governments, third-country central banks, multilateral development banks, certain international organisationsand exposures to or guaranteed by third-country public sector entities, third- country regional governments or third-country local authorities that are risk weighted as exposures to institutions or central governments and central banks in accordance with the Regulation (EU) No 575/2013
  • exposures to institutions that qualify for certain credit quality in accordance with the Regulation (EU) No 575/2013

7

Minimum overcollateralization

the cover pool of the CB to which the OTC derivative contract relates is subject to a regulatory collateralisation requirement of at least 102%

 

Hedging Structure under CB Transactions

The hedging arrangements of a CB issuance are usually structured by entering into:

(a) a front swap transaction entered into by the CB Issuer and the relevant hedging bank counterparty (which hedges the exposure to interest rate or currency mismatches of the cover pool); and

(b) a back swap transaction entered into by the CB Issuer and the relevant hedging bank counterparty (which hedges the exposure of the CB Issuer and the hedging bank to free assets).

 

Front Swap

The Covered Bond Exemption only applies in respect of the front swap transaction (assuming satisfaction of all of the CB Requirements). Importantly, CB Issuers incorporated in jurisdictions where OTC derivative contracts are not registered or recorded in a cover pool register or where no overcollateralization requirement applies will not benefit from the Covered Bond Exemption.

The Covered Bond Exemption (i.e. no posting of IM or VM) applies only to CB Issuers or cover pools such that hedging bank counterparties to CB Issuers will have to post VM in cash only in accordance with the Margin RTS, daily and from the effective date of the transaction.

VM can only be posted in cash (so the list of eligible collateral set out in Article 4 of the Margin RTS will not apply and parties cannot deliver any securities).

 

Back Swap

The back swap transaction will not benefit from the Covered Bond Exemption, since not all CB Requirements will be met.

It follows that back swaps that are entered into in respect of front swaps relating to a CB issuance will be subject to the general EMIR margin framework. Therefore, VM posting will be bilateral and in addition, the parties will need to establish whether IM posting requirements apply and comply if indeed applicable.

Article 36 of the Margin RTS sets out the phase-in period of the IM obligation depending on the average notional amount of each party[4].

Hedging banks that face CB Issuers under the back swap will need certain disclosure from CB Issuers to understand when and if the obligation to post IM comes into force.

In addition, a consequence of the normal regulatory treatment will be that parties are not restricted to cash collateral in respect of the collateral they are permitted to post and may make use of the broader asset classes of collateral that the Margin RTS allows.

In relation to any existing CB hedging it is worth noting that counterparties may continue to apply their current risk management procedures they have in place provided that the relevant OTC derivative contracts were entered into between 16 August 2012 and the relevant dates of application of the Margin RTS[5]. Therefore, counterparties are not required to effect changes in respect of such existing transactions. Margin RTS VM obligations apply as of 1 March 2017 whereas IM will be phased-in in accordance with Article 36 of the Margin RTS.

The traditional discretion of parties to include bespoke features[6] in their back swap documentation (since they are not subject to rating agency criteria) may now be more limited since they will need to comply with the Margin RTS. Parties will carefully need to assess whether any bespoke provision may interact with or affect any of their EMIR margin obligations. Parties are free to include any features or specific wording as long as they remain EMIR-compliant.

 

Rating Agency Criteria

To date, risk mitigation in swaps relating to CB issuances has been driven in part by rating agency criteria. The main difference between the EMIR margin obligations and the rating criteria insofar as it applies to such swaps is that that the requirement to post collateral in the latter case only applies once the hedging bank is downgraded below the "first trigger". VM posting from the effective date of the transaction should not contradict these triggers. No rating criteria in respect of swap counterparties in CB issuances have been modified as yet and since EMIR generally and the Margin RTS specifically provide a stricter regime for collateral posting, it is not entirely clear whether we should expect changes in the near future.

 

CB Swaps – Main aspects to consider

 

Front Swap

Back Swap

Obligation to post IM

Not applicable to either party

Applicable to both parties provided that each party satisfies the thresholds requirements set out in Article 36 Margin RTS

Obligation to post VM

Only the hedging bank

Both parties

Eligible collateral

Only cash

Any Eligible Collateral set out in Article 4 Margin RTS

Minimum Transfer Amount

EUR 500,000

EUR 500,000

Valuation Frequency

Daily

Daily

Independent Amount

Not applicable to CB Issuer but non-regulatory Independent Amount may apply to the hedging bank

Subject to the relevant thresholds as specified in Article 36 Margin RTS and in any case, it must be calculated in accordance with the IM models satisfying the requirements set out in Article 14 Margin RTS

 

THE DELTA REPORT
Derivatives Newsletter
May 2017

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[1] Unilateral collateral posting is also one of the main reasons why CB swaps may not be cleared through a clearing house.
[2] This requirement rests on a fundamental feature of the CB market, its double recourse nature (i.e. CB holders have claims against the CB Issuer and the cover pool). In the event of an insolvency of the CB Issuer the hedging arrangements must remain in place since payments will be made out of the cover pool.
[3] The wording "except where the relevant hedging bank is the defaulting or the affected party" is a consequence of a so-called flip cause which triggers the loss of the senior ranking in the priority order when the hedging bank counterparty is in default. If such flip clause applied, condition (2) above could otherwise not be met, hence the foregoing qualification.
[4] 4 February 2017 IM: If aggregate month-end notional amount is greater than €3 trillion
1 September 2017 IM: If aggregate month-end notional amount is greater than €2.25 trillion
1 September 2018 IM: If aggregate month-end notional amount is greater than €1.5 trillion
1 September 2019 IM: If aggregate month-end notional amount is greater than €0.75 trillion
1 September 2020 IM: If aggregate month-end notional amount is greater than €8 billion
[5] See above dates and Article 36 Margin RTS.
[6] For example, exposure calculation based on reference trade, longer periods for collateral postings, return pass through features between the swaps, etc.

 

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