EUROPE – The European Securities and Markets Authority (ESMA) has reiterated the need for clearing houses to hold non-cash collateral posted by derivatives users such as pension funds with securities settlement systems, as opposed to traditional custodian banks, but has allowed some room for manoeuvre.

As part of article 47.3 of the technical specifications of the European Markets Infrastructure Regulation's (EMIR), ESMA recommended that initial margins for derivatives trades be held by securities settlement systems – also known as central securities depository (CSD) – that ensure the "full protection" of those financial instruments.

Following complaints received by a number of market players, including clearinghouse CME Clearing Europe, about the impact the article could have on end-user clients such as pension funds, the Paris-based authority has published its response.

It said that depositing non-cash collateral posted by end-user clients with a CSD through a custodian did not "constitute a deposit with an operator of a securities settlement system", as required in Article 47.3.

However, ESMA also granted clearing houses – also called central counterparties (CCPs) – some flexibility, allowing them to hold securities posted as collateral with a custodian bank in the case where a CCP could not access a CSD, and where the protection of the CCP itself or of its clients was not ensured.
"If a CCP is able to demonstrate that it cannot access a security settlement system that ensures the full protection of financial instruments, then the CCP can deposit financial instruments through highly secured arrangements with authorised financial institutions," ESMA added.

Additionally, ESMA refuted the argument put forward by some market players that CSDs, contrary to custodians, could not offer segregated accounts to hold non-cash collateral posted by end-user clients, as this had previously been requested by pension funds.  

ESMA said: "Individual segregation within the meaning of article 39(3) of EMIR applies to assets and positions held at CCP level.

"Hence, individual segregation does not have to be necessarily reflected at the level of the security settlement system."

Therefore, the authority concluded, a CSD that ensured the full protection of the financial instruments could not be considered out of bounds simply because it did not offer individual segregation of client assets.

Under the new EMIR rules, market players using derivatives will be required to centrally clear their trades, at least those for which clearinghouses have put in place clearing platforms such as interest rate swaps and credit default swaps (CDS).

Clearinghouses are likely to allow initial margins to be posted as cash and securities.

However, pension funds have voiced concerns over the risk of losing their non-cash instruments if a clearing member – usually a bank – defaults and have required CCPs to place their collateral into segregate accounts.

A number of CCPs such as CME and Eurex Clearing are therefore offering such facilities to meet their new clients' requirements.

But Andrew Lamb, chief executive at CME Clearing Europe, told IPE last month that if ESMA allowed CSDs only to hold non-cash collateral, this could have an impact on the tri-party agreements CCPs have already put in place with custodian banks to offer segregated accounts to their clients.

"Not all custodian banks would wish to obtain a CSD status", he said at the time.

"Article 47 is fine, but we are aware some people could read this article in a narrower sense, meaning clearinghouses do not have the discretion and would be prevented in any circumstance from using collateral safe-keeping arrangements unless those collateral arrangements are provided by CSDs."