The European Commission’s proposed changes to European Market Infrastructure Regulation (Emir), could have a serious impact on the securitisation market. Some market participants are concerned the amended framework, published on May 4, will increase risk in that sector by reclassifying issuing special purpose vehicles (SPVs) as financial counterparties and submitting them to new obligations.
The review of Emir focuses on streamlining and simplifying reporting and clearing processes for over-the-counter (OTC) derivatives which have been in place since the regulation came into effect in 2012. But a number of draft provisions, which are aimed at reducing costs and burdens for smaller financial institutions, corporates and pension funds, could have the opposite effect.
Why it’s controversial
The revision of the statute as it pertains to SPVs used in the securitisation process has been met with criticism. While the categorisation is still based on the type of entity involved in the transaction – meaning SPVs are excluded from the regulation’s scope – the changes could mandate that all counterparties which clear above a certain threshold will have to comply with Emir – regardless of legal status.
This would include having to clear their derivatives and post margin, and would require SPVs to provide collateral against their trades, potentially weakening Europe’s €230 billion (€252 billion) securitisation market.
"The only way SPVs can get collateral is to get it from somewhere else - if they can’t they won’t be able to comply so hedging won’t be possible"
“The proposed change as it pertains to securitisation SPVs is a surprise,” said Norton Rose Fulbright partner Nigel Dickinson. “Although some corporates felt it was unfair that securitisations benefit from an exemption, that basis for change is a poor one, and there are no advantages from a systemic risk perspective.”
The EU Commission’s main aim is to standardise all processes across the regulation to reduce costs and increase flexibility in the OTC derivatives market. The same logic applies under the upcoming Markets in Financial Instruments Directive II (Mifid II) directive, where commodities trading houses will be reclassified as financial counterparties and subject to that legislation’s provisions.
- The EU Commission is reviewing the 2012 European Market Infrastructure Regulation framework, with a view of reducing the compliance burden on smaller financial institutions;
- It has re-classified securitisation SPVs as financial counterparties, subjecting those that trade above €3 billion in derivatives to clearing and margin requirements;
- There is a risk that securitisation could decrease because of these heightened compliance rules, as SPV typically don’t hold any cash;
- The move is part of a wider strategy by the EU executive to streamline and simplify trading process across member states.
The new Emir mandated reclassification would have a specific impact on smaller financial institutions and non-financial counterparties which would be exempt from the mandatory clearing requirement under a certain threshold (currently set at €3 billion).
But in the case of SPVs, funds are all applied to buy receivables in the event of a securitisation – the issuer typically has illiquid assets and no cash left over after these are acquired. In comparison, pension funds, which typically also hold assets in illiquid firm, have been granted a three-year clearing exemption under the proposed new Emir framework.
Any transaction for an SPV would be uneconomic, said David Shearer, partner at Norton Rose Fulbright.
“It’s going to increase risk and the costs of hedging,” he said. “The only way SPVs can get collateral is to get it from somewhere else - if they can’t they won’t be able to comply so hedging won’t be possible.”
If implemented, the proposed framework would align the EU with the US where the Dodd-Frank Act treats SPVs as financial counterparties.
“But some US investment banks have been looking at existing structures so they fall outside of US margin requirements,” said Dickinson.
A wider change in attitude
The changes to securitisation SPVs are part of a wider move to streamline trading compliance across the European Union. The review into Emir, while not a complete overhaul of the regulation, did call for some adjustments to be made, according to Jyrki Katainen, European Commission vice-president for jobs, growth, investment and competitiveness.
The Commission expects the proposed changes to save market participants up to €2.6 billion in operational costs and up to €6.9 billion in one-off costs. Among some of the key reform points will be the requirement that a trade only be reported by the financial counterparty when dealing with a non-financial counterparty. This would in effect align the reporting obligation on global standards. Other changes also include scraping the need for historic transactions to be reported.
“Many of these changes have been requested by the market,” said Baker McKenzie of counsel Phung Pham. “The Commission, with input from the European Securities and Markets Authority, seems to be looking to adopt more flexible results based regulatory reform, rather than just carrying out a box ticking exercise.”
The potential exemption of smaller financial counterparties from some of the Emir obligations is expected to have a big impact: there will be fewer non-financial counterparties by number and caught within the scope of certain rules, and potentially a lower regulatory burden for those who do qualify. At the same time, the overall systemic risks posed to the wider market would not be materially increased by removing such smaller financial counterparties from scope. Pham expects there could be a return of previous levels of participation for smaller institutions that had previously stayed away due to operation and regulatory cost of compliance.
“In time, it may be that the relevant clearing thresholds themselves could be adjusted if such small financial counterparties become systemically important,” he said.
While Dickinson noted that the big banks had the key Emir requirements pretty much in place, a market participant said that authorities are repeatedly reviewing regulations that have come into force because they are not as good as initially thought.
“A few weeks after they’ve come into force authorities are actually amending those regulations for so-called improvements,” the market participant noted. “But in reality, this is an admission that they have cocked up the initial rules.”
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