The UK Investment Management Association wants to talk about clearing and segregation of client assets

The UK’s Investment Management Association released today a response to ESMA’s recent guidelines on UCITS and ETFs. Aside from the technical points, they brought up some new issues regarding the segregation of client accounts at CCPs and an assumption that ESMA made regarding the principal to principal model in European derivatives trading. This is about the most proactive thinking on CCPs and collateral accounts we have seen coming from a buy-side organization in any country and wanted to highlight the more interesting parts.

Highlights from the IMA’s response, dated August 3, follow (bolded text is our emphasis):

IMA is the UK based trade association for investment managers. Our members manage investments worth more than £4 trillion for their clients, who are UCITS and other authorised funds, pension funds, insurers, sovereign wealth funds and individuals. Ultimately, much of what they manage belongs to the man in the street through their savings, insurance products and pensions. Their interest in this consultation is therefore in their role as the “buy side” of the market, accessing capital markets on behalf of their clients.

Highly liquid collateral should be specified in more detail and should (as mentioned at the Open Hearing) include regulated money market funds. We also believe that it should not be an option for CCPs to require the delivery solely of cash for Initial Margin purposes.

We urge ESMA to consider the enormous volume of repapering that will be required across the market in order to bring participants into line with EMIR, and allow appropriate time to achieve this.

We also have a new, but central, point to make. The ESMA draft standards appear to be based on the premise that the current principal to principal market model will subsist in the future. In Europe it is widely (if not exclusively) used in the listed derivatives markets. However we do not agree that it is necessarily the best or should be the only model for the future, in particular having regard to the scale of business that will move from the OTC derivatives markets into central clearing. We note also that EMIR does not distinguish between market models, whether agency or principal based.

EMIR helpfully brought in both individual client segregation and omnibus client segregation, requiring clearing houses to offer choice in both. Omnibus client segregation is used now in clearing for listed derivatives and, with pre-specified fungible contracts traded on exchange, can work well. In the much larger OTC derivatives market the proper introduction of individual client segregation is critical.

The practical effect of individual client segregation is likely to be the introduction of gross margining into the market. If gross margining becomes the norm for individual client segregated accounts, it becomes questionable whether the use of a principal to principal legal structure should be sustained, or be the only model used. An agency model would by contrast recognise that the principals are the CCP and the client, and the role of other parties pertained to the carrying out of the transaction but not to legal ownership of the positions, assets and money.

The concept of individual client segregation is closely connected to the concept of being able to port trades in the event of a clearing member default. A key difficulty in the principal market model is that for a CCP to be able to port client positions, assets and money, it must know the identity of the client in advance of a default, know, exactly all the positions, assets and money attributable to that client and be entirely clear on ownership and other relevant property rights in relation to the assets and money. The use of title transfer as the preferred mechanism for posting collateral to meet margin requirements sits uneasily with the concept of individual client segregation and the porting obligations.

We therefore ask ESMA to:
• make any changes necessary to the Technical Standards to ensure that there are no barriers to clearing using an agency model; and
• encourage the market and competent authorities to support the introduction of an agency model for clearing OTC derivatives, by rigorous scrutiny of the degree of investor protection offered by CCPs in relation to segregation of clients’ assets, money and positions, and their ability to carry out porting.

The IMA press release is here.

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