Unintended consequences are coming to light with respect to the EMIR framework, which aims to push all trading in OTC derivatives through central clearing.

In article 47.3 of the EMIR technical standards, the European Securities and Markets Authority (ESMA) recommends that initial margins for derivatives trades be held with securities settlement systems – which are operated by central securities depositories (CSDs) – to ensure the “full protection” of those financial instruments.

As part of new central clearing requirements, pension funds have urged clearing-houses (CCPs) to hold their collateral in segregated accounts with a custodian bank or a CSD. Pension funds are unhappy, concerned that their securities could be treated as part of the bankruptcy estate of a defaulting counterparty.

Most CCPs are now offering such facilities. Renaud Huck, head of UK buy-side relations at the CCP house Eurex Clearing in London, explains that Eurex has put in place tripartite agreements with the clearing members and the end-user clients. This enables Eurex to transfer collateral posted by a pension fund to a new clearing member in the event that the existing member defaults. This, of course, implies that the pension fund’s collateral needs to be protected in the first place by being placed in a segregated account, which is available for users of the Eurex’s Individual Clearing Model (ICM).

Eurex can offer such facilities to its clients. The CCP is part of Deutsche Börse group, which itself owns Clearstream. Clearstream is not regulated as a global custodian but as a CSD. The result is the same, since Clearstream can hold the collateral posted by Eurex’s clients.

The distinction between a CSD and a custodian bank used to be simple. The CSD was seen as a market facility, tracking how many securities had been issued and by whom and marking each change in the holding. In comparison, the custodian bank aimed to put in place segregated accounts to hold the security on behalf of clients.

However, EMIR’s article 47.3 and Brussels’ attempt to regulate CSDs mean the distinction is blurred. In March 2012, the European Commission introduced a new regulation emphasising that those entities are currently only regulated at the national level, which suggests cross-border settlement is not as safe as domestic settlement. The regulation therefore aims to introduce common standards across the EU. This is certainly the reason why ESMA gives the priority to CSDs over custodians in article 47.3 of EMIR’s technical standards since the latter are still regulated at the national level.  

But, by introducing article 47.3, market players fear the new EMIR could force traditional custodian banks to register as CSDs if they want to keep offering segregated accounts. Some have already done so. One of the most recent is BNY Mellon. It launched a CSD business line this January, allowing it to provide clients with more efficient ways of transacting across continents.

However, while large custodian banks are likely to register as CSDs, smaller regional counterparts do not necessarily seek to go through all the legal documentation required to become a CSD. This is precisely where the problem lies for some clearing-houses, since not all of them deal with CSDs. Many, instead, have signed agreements with those smaller custodian banks.

Andrew Lamb, chief executive at CME Clearing Europe, fears that article 47.3 could prevent CCPs from using collateral safe-keeping arrangements unless those arrangements are provided by CSDs. But this, he says, depends on the stance ESMA takes. “CCPs would not have the discretion of using their existing custody agreements only if policymakers in Brussels read this article in a narrower sense,” he says.

In the end, the article could have an impact on pension funds, experts say. As Mark Higgins, managing director of clearing and collateral management at BNY Mellon, concludes, if an asset manager wanted to pursue full segregation of collateral with its traditional custodian on behalf of a pension fund, it might have no option but to revise its position if the scheme is not registered as a CSD.