ESMA covered swaps carve-out ‘a positive signal’

The European Securities & Markets Authority (ESMA) has proposed exempting covered bond derivatives from a central clearing obligation under EMIR if certain conditions are fulfilled, and market participants said the proposal sends a positive signal.

ESMA launched two consultations on 11 July, one on interest rate swaps and another on credit default swaps, with the former open until 18 August and the latter until 18 September. The consultations will inform regulatory technical standards (RTS) that ESMA has to develop under the European Markets Infrastructure Regulation (EMIR), which introduces an obligation that certain classes of OTC derivatives be cleared in central clearing houses.

The European Covered Bond Council (ECBC) has been lobbying for covered bond swaps to be exempt from such an obligation, and managed to secure a statement in EMIR, in Recital 16, that ESMA should take into account the specific nature of covered bond OTC derivatives. However, as this did not represent an exemption, the industry has continued to push the case for this, and ESMA’s proposal for dealing with covered bond swaps was welcomed by Boudewijn Dierick, head of covered bond and flow ABS structuring at BNP Paribas and chair of the ECBC rating agency approaches working group, who in the latter capacity heads a taskforce set up to deal with EMIR.

“It looks good,” he said. “Some rewording may be necessary to prevent misunderstanding, but that is a normal part of the process and at least the signal of having an exemption for covered bond swaps is positive.”

ESMA is proposing that covered bond derivatives be exempt from mandatory central clearing as long as certain conditions are met.

In setting out the rationale for its proposal, ESMA cited feedback it received in response to a discussion paper on the central clearing obligation and the specific nature of covered bond derivatives that this feedback emphasised. The EU authority said that it took the feedback into account and further analysed the specific nature of covered bond derivatives in the context of the clearing obligation, and “has come up with a proposal which leverages on the analysis performed in the context of the current consultation on draft RTS on risk-mitigation techniques for OTC derivative contracts not cleared by a CCP (bilateral margins)” (see below for more).

The end result is a proposal that interest rate OTC derivatives used in relation to covered bond programmes not to be required to be centrally cleared if the swap contracts meet six conditions. These are, in ESMA’s words, that:

(a) they are not terminated in case of default of the covered bond issuer;

(b) the counterparty to the contracts, which counterparty is not the cover pool or the covered bond issuer, ranks at least pari passu with the covered bond holders;

(c) they are registered in the cover pool of the covered bond programme in accordance with national covered bond legislation;

(d) they are used only to hedge the interest rate or currency mismatches of the cover pool;

(e) the covered bond programme to which they are associated meets the requirements of Article 129 of Regulation (EU) No 575/2013; and

(f) the covered bond programme to which they are associated is subject to a legal collateralisation requirement of at least 102%.

According to Dierick, the need for some rewording relates to the first two conditions. The second, for example, could be problematic for programmes with swaps initially provided by the originator, which is common practice in Canadian, Australian, Dutch, French, UK and various Nordic programmes, he said.

Moody’s last Thursday said that the exemption is credit positive for those covered bonds that would face higher levels of interest rate risk if they are unable to utilise swaps for hedging purposes. It agreed that the consultation represents a positive signal that regulators are looking to support the covered bond market, but also noted similar outstanding issues to Dierick.

“However, the exemption contains some limitations and drafting ambiguities,” it said. “An important limitation applying to both exemptions is that a covered bond programme must benefit from a legal minimum 2% overcollateralisation, which is not the case for all programmes.”

The rating agency added that if the provision is implemented in its present form there would be a reduction in the credit positive effect of the exemption unless national legislators adapt their covered bond law to accommodate it.

Moody’s said the programmes that would benefit from an exemption from mandatory clearing would be those in jurisdictions where interest rate swaps are typically used, namely France, the UK, the Netherlands, Italy, and Nordic countries excluding Denmark. It highlighted the UK, the Netherlands and France as jurisdictions where swaps are particularly beneficial because the law does not provide for a net present value test to measure whether future asset cashflows will cover covered bond liabilities in the instance of issuer default.

The rating agency said that interest rate swaps also take on heightened importance for cover pools that include a large number of loans with long dated fixed rate periods. Moody’s noted that such cover pools are typical in France, the Netherlands, and to some degree in the UK. Mortgage loans in cover pools in jurisdictions such as Sweden and Norway are more likely to be floating or will have short fixed periods so they can more easily achieve “a natural” hedging, according to Moody’s.

“Nevertheless, all these jurisdictions and many others currently utilise interest rate swaps,” said the rating agency. “So the removal of these swaps would lead to increased risk to investors where alternative solutions are not adopted or are less effective at removing interest rate risk.”

Meanwhile, the ECBC has welcomed a carve-out for covered bonds under draft regulatory technical standards on risk-mitigation techniques for derivatives that are not centrally cleared, but still sees problems with what the European supervisory authorities (ESAs) have proposed.

The industry body set out its views in a consultation on the draft RTS that finished on 14 July. It welcomed the ESAs’ move to allow covered bond-related derivatives to be excluded from bilateral collateral posting of initial variation and variation margins, while ensuring derivative counterparties a degree of protection by outlining specific conditions that have to be met for this exemption.

However, the ECBC raised several issues — some quite technical — with the draft RTS and made suggestions as to how these should be dealt with. The points raised include that derivatives satisfying the requirements for exclusion from the bilateral margin posting requirement also be excluded from counting toward group thresholds for non-centrally cleared derivatives, and that Article 52 (4) UCITS rather than Article 129 of the Capital Requirements Regulation (CRR) should be the EU-harmonised classification that covered bonds must fulfil in order for covered bond-related derivatives to be exempt from the margin posting requirements.

Under the draft RTS, one of the other conditions for the carve-out is, again, that the covered bond programme in question is subject to a legal collateralisation requirement of at least 102%. The ECBC said that it “would encourage the ESAs to set the same minimum requirement across the different regulatory files that are currently addressing this topic”.

“In addition, considering the timing implications if the various national covered bond legislations need to be amended to include a minimum OC, we would strongly suggest a grandfathering period before this requirement becomes mandatory,” it said.

The industry body also recommended that “the scope of the contemplated carve-out regime to the benefit of covered bonds should be broadened in order to take into account issues raised by bespoke derivatives performed for hedging purposes, such as back-to-back swaps.”