Issuers pleased as Esma proposes exemption for covered bond hedges; trades would still need to pass six-point test European regulators today proposed a clearing carve-out for covered bond derivatives, so long as six conditions are satisfied - potentially ending issuers' long-running fears that they would be required to clear their trades. The covered bond industry had agued it would be difficult or impossible to make initial and variation margin payments if it was caught by the clearing regime. The six conditions mirror those set out in draft margining rules for non-cleared trades in April, so are not a huge surprise, but issuers were quick to welcome the news. "I think it's in line with what we were expecting, but we're certainly pleased. I think if they had demanded that covered bond swaps be cleared, the practical difficulties of complying with that would be a headache for the industry," said Andrew Turvey, head of liquidity planning at the Coventry Building Society in Coventry. Today's proposals from the European Securities and Markets Authority (Esma) lay out the details of Europe's clearing obligation in two draft regulatory technical standards (RTSs) - the first covering interest rate swaps and the second covering credit default swaps. Together, they put flesh on the bones of the clearing requirement contained in the European Market Infrastructure Regulation (Emir) and lay out crucial phase-in proposals that could see some derivatives users given as much as three years' grace before they have to start clearing. Emir requires Esma to "take into account the specific nature of OTC derivative contracts which are concluded with covered bond issuers or with cover pools for covered bonds" when making these proposals, but just a year ago it appeared the regulator was considering - at best - a limited exemption. Today's proposals should put those fears to bed. Under the draft RTS, any derivatives trade associated with a covered bond transaction will not be subject to obligatory central clearing in the EU so long as it meets six conditions. Those conditions include that the swap would not be terminated in the event that the covered bond issuer bank defaults, that the transactions are used only to hedge the interest rate or currency mismatches of the cover pool, and that the covered bond programme with which the derivatives positions are associated is subject to a legal collateralisation requirement of at least 102%. When almost identical conditions appeared in Esma's draft RTS on margining non-cleared trades, lawyers and issuers said the majority of the industry should have no trouble complying. Covered bonds are debt instruments issued by banks in which the bond is secured by a pool of assets, most typically mortgages. Covered bond issuers use derivatives to hedge the interest rate and forex risk presented by the underlying assets in the covered pool in order to pay a fixed coupon to bond investors. The swap documentation underpinning the bond transactions includes a one-way credit support annex that favours the bond vehicle - meaning it receives collateral when the trade is in-the-money for the bond programme, but does not have to post collateral to its counterparty when the value of the trade moves against the issuer. Had Esma compelled these derivatives to be cleared, covered bond issuers would have been forced to post both initial and variation margin, but since the covered bond pools only contain residential mortgages, the issuers themselves would have had no eligible collateral such as cash or government bonds to pledge to a clearing house to meet margin calls. In the consultation document, Esma noted covered bonds are an important source of funding for European issuers and listed other reasons why it would be difficult for the industry to be subject to the clearing obligation. The consultation period for the interest rate swap RTS runs until August 18....
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