Dealers rail at 'absurd' EU margin rules

European banks fume after regulators clarify that draft rules would force them to collect margin from non-EU corporates

European Banking Authority headquarters

European banks have reacted with dismay after regulators confirmed they would be expected to collect margin from non-EU corporates when executing uncleared trades – a requirement that does not apply to their rivals, and would also not affect trades with European corporates. Critics argue the draft rules – which are the EU version of internationally agreed standards on compulsory bilateral margining - will result in third-country corporates shunning European banks.

"It is absurd and would effectively disincentivise third-country non-financial entities from trading with EU counterparts," says one derivatives risk manager at a US bank in New York.

"It is fairly obviously not acceptable," says a risk manager at a UK bank in London. "The bicycle exporter from Mexico may now have to swallow variation margin and possibly initial margin posting as well."

Corporate swaps users typically do not post collateral because many do not have the cash required to handle large potential swings in the mark-to-market value of the trades. In Europe and the US, this has resulted in an exemption for corporate hedgers from new clearing rules.

The exemption is copied across for Europe's draft rules on the margining of non-cleared trades – published on April 14 by the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority and the European Securities and Markets Authority – but it only applies to EU corporates.

The bicycle exporter from Mexico may now have to swallow variation margin and possibly initial margin posting as well

Under the terms of the clearing exemption contained in the European Market Infrastructure Regulation (Emir), non-financial counterparties (NFCs) do not have to count hedging transactions towards the threshold that triggers the requirement to use a central counterparty (CCP) for clearing-mandated trades.

A so-called NFC-minus – a non-financial company operating below the threshold – is also not subject to the bilateral margining rules as long as it is incorporated in the EU. But the rules state that EU entities would have to collect margin from all third-country entities, "even from those that would be classified as non-financial entities below the threshold if they were established in the EU".

This was clarified at a meeting held by the EBA in London on June 2. Three attendees say there was pointed criticism of the policy from a number of bank representatives, after regulators confirmed the treatment of third-country NFC-minuses.

"The rules indicate regulators intend all assumed NFC-minuses – meaning entities that would be NFC-minuses if established in the EU – to post variation margin and initial margin if they are above the €8 billion threshold. This is in contrast to an EU-established NFC-minus, which would not be required to post variation margin or initial margin. This is a surprising result," says Matthew Dening, a partner at law firm Sidley Austin in London.

Lawyers say the approach is inconsistent with Emir – the so-called Level 1 text that the EBA and the other standard-setters are now fleshing out – which in Article 4 only applies the clearing requirement to third-country entities that would be subject to the obligation if they were established in the EU. Regulators refer to these non-EU entities as hypothetical NFCs and hypothetical NFC-minuses.

"It does not make any sense as it is inconsistent with Emir's approach on clearing and because it would treat a hypothetical NFC-minus more stringently than a real NFC-minus. I am not sure it is justified by the wording in the Level 1 text either," says Allan Yip, a partner at law firm Simmons & Simmons in London.

The reference to third-country entities in Article 4 does not appear in Article 11 of Emir, which governs risk mitigation techniques including collateral posting. And according to three market participants who attended the EBA meeting, one of the regulators present argued that because the Level 1 text was silent on the issue, the authorities are constrained in their ability to interpret the text as exempting third-country NFC-minuses.

Lawyers are not convinced. "Because it is not clear how Article 11 should be applied in this instance, it should be interpreted in line with international standards, and those standards do not seem to suggest NFC minuses should be caught by these requirements," says Emma Dwyer, partner at law firm Allen & Overy in London.

Asked to comment, the EBA said it would respond to concerns following the consultation period for the draft rules, which ends on July 14.