Covered win swap concessions, but law changes for OC seen

ESMA released final draft RTS on central clearing requirements for OTC derivatives on Wednesday of last week (1 October) that featured several concessions to the covered bond industry, but the regulator did not make all the requested changes and related changes to Norwegian and Swedish laws are now in store.

The European Securities & Markets Authority (ESMA) released proposals in July whereby derivatives related to covered bonds that met certain conditions would be exempt from central clearing obligations under the European Market Infrastructure Regulation (EMIR).

During a consultation on proposed Regulatory Technical Standards (RTS) that ran until mid-August, the European Covered Bond Council and others argued that covered bond-related derivatives should be fully exempt from such obligations, with no qualifying criteria being necessary, given that they cannot be cleared by central counterparties, and they also raised issues with several of the conditions that ESMA had put forward as criteria for exemption.

In conjunction with releasing the final draft RTS, ESMA summarised comments it received during the consultation and gave its feedback as to why it did or did not make changes in response. However, it does not appear to have done so in relation to an ECBC argument for an unconditional exemption for covered bonds.

“It’s very strange that they didn’t say anything about the market’s view,” said a covered bond banker.

ESMA nevertheless noted that market participants had welcomed its recognition of the “specific nature” of covered bond derivatives.

“Getting an exemption for covered bond specific derivatives from central clearing requirements is an important and positive decision for the covered bond market,” said Florian Eichert, senior covered bond analyst at Crédit Agricole CIB. “Centrally cleared swaps automatically accelerate once the counterparty defaults but for covered bond derivatives to be an effective protection for investors they have to be able to survive the default.

“And since there is no way yet for clearing houses to distinguish between ordinary and covered bond related derivatives, it was vital to get an exemption.”

Luca Bertalot, secretary general of the EMF-ECBC, described ESMA’s final position as a “success story” for the industry’s lobbying.

ESMA amended the wording of some of the six criteria in response to technical issues raised by the industry that would have unnecessarily caused problems for issuers in certain jurisdictions. For example, in its first condition it changed a reference to “default” of a covered bond issuer to “resolution or insolvency”, and added “or recorded” to a condition that derivatives be “registered” in a cover pool. A condition relating to derivative counterparties being pari passu with covered bond was also relaxed.

But changes proposed by the ECBC to two other conditions were not made.

ESMA clarified that a reference to a requirement for a “legal” collateralisation level of at least 102% refers to a regulatory minimum and cannot be contractually-based, and hence changed the requirement to being “regulatory”. Jurisdictions that are faced with addressing the final OC requirement include Norway and Sweden.

Torkil Wiberg, analyst, banking and capital markets, at Finance Norway, said that a proposal has already been put forward by the Norwegian government whereby the Ministry of Finance will have the authority to set a quantitative OC level. This is part of a new act on financial institutions that is expected to be dealt with in the Norwegian parliament (pictured) this autumn, he said.

“OC-limits, if not necessarily regulatory, are now increasingly being incorporated into other central parts of EU regulation, such as the LCR,” said Wiberg. “It was also highlighted by the EBA, in its report, as a possible area for harmonisation.

“Of course one can argue over the specificities in the ESMA criteria,” he added, “but overall the exemption is positive.”

Jonny Sylvén, senior advisor at the Association of Swedish Covered Bond Issuers (ASCB), said that Swedish legislation will probably have to be changed.

“The Swedish issuers do not have any problems with that kind of OC requirement today,” he said. “There are discussions of other requirements in some other new regulatory changes, such as LCR, large exposures and the harmonisation project, and we have asked authorities to coordinate this.”

According to another Swedish market participant, the possibility of the ESMA requirement being met through changes to regulations set by the Swedish FSA (Finansinspektionen) has been explored, but issuers’ preferred and expected route is an amendment to Swedish covered bond legislation. He said that this should be achievable within the necessary timeframe, with the bigger Swedish issuers expected to have to comply with the RTS in the next nine to 10 months.

Crédit Agricole CIB’s Eichert noted how OC is becoming an issue across regulatory initiatives.

“ESMA rules will require covered bonds to have a minimum legal OC of 2%,” he said. “While minimum OC is becoming a topic in a number of regulatory documents, the actual levels as well as the nature of it differs across regulatory dossiers. Basel large exposure limits talk about voluntary OC, the draft LCR act doesn’t specify the 2% and 7% levels for 1B and 2A levels further, and EBA is aiming for unspecified legal minimum levels.

“The diversity across regulatory documents is clearly not ideal for countries aiming to change their legal frameworks. Regulators are pushing for transparency and harmonisation — it would be good they did the same.”

The ECBC had also argued that covered bonds should only have to be UCITS and not CRR-compliant, but ESMA did not change its position, preferring the tighter criteria.

“For derivatives to be outside the scope of central clearing they have to be CRR-compliant,” said Eichert. “This rules out UCITS but not CRR-compliant programmes, such as NordLB’s aircraft Pfandbriefe.

“However, with the exception of the LCR, regulators have in recent months started to tighten eligibility criteria for covered bonds to continue to benefit from preferential regulatory treatment.”

Some Danish issuance is also not CRR-compliant, although a market participant said that ESMA’s move is not expected to be a significant problem for the Danes.