EU gives one-year margin reprieve on equity options

Regulators point to possible systemic risk in margin loophole, as industry urges parity with US

European Union regulators have proposed giving non-cleared derivatives users a one-year exemption from posting margin on equity options, essentially keeping the bloc in alignment with US rules, but only until the end of 2020.

The EU regulators explained their decision by cautioning that the more generous margin treatment could pose dangers to the financial system. Industry sources, however, argued that the exemption should be made permanent due to US inaction on incorporating the instruments into their own margin rules.

“We will have to go back to them in 2020 for a further extension, but it might be difficult to get,” says an industry source. “In principle, European prudential regulators don’t like exemptions from the margin requirements because they always feel that it is creating the conditions for increasing risks in the system.”

The global derivatives margin rules written by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (Iosco) require counterparties to post initial and variation margin against non-cleared trades. The European Market Infrastructure Regulation (Emir), which brought those margin rules into EU law, granted firms a three-year grace period during which they would not have to post collateral against single-stock options and index options. This was done to give European firms parity with US firms subject to more forgiving rules.

The exemption in Europe would have ended on January 4, 2020. But, as anticipated, the three European Supervisory Authorities (ESAs) – the European Securities and Markets Authority, the European Banking Authority and the European Insurance and Occupational Pensions Authority – proposed putting off the deadline by a year. 

The proposal, dated December 5, could not have moved through Europe’s bureaucracies in time to reset the deadline. So regulators asked that relevant authorities apply the EU framework in a “risk-based and proportionate manner” until the exemption does become effective – essentially bringing it into force immediately. 

The European authorities gave only a year’s extension due to concerns of creating regulatory fissures that could expose firms to greater counterparty risk.

“The ESAs reiterate the view that, from a prudential point of view, the international framework agreed on by all the participant authorities in the BCBS and Iosco discussions is a crucial pillar in ensuring safer derivatives markets, limiting the counterparty risk between counterparties trading derivatives, and thus that its coordinated implementation is key in reaching this objective.”

Pauline Ashall, a partner at Linklaters, says that for market participants a permanent exemption is unlikely to create systemic risk.

“I understand that some supervisors were concerned about extending the derogation even for 12 months because of concerns about systemic risk,” says Ashall. “But I think the view of the industry was that shouldn’t be a significant concern because the scale of the market is small, and if there were defaults it wouldn’t create systemic problems.”

Opposite interpretations

However, another reason supervisors were reluctant to extend the exemption was because it would take the EU out of alignment with other jurisdictions that do require firms to post margin on equity options. Those include Australia, Brazil, Canada, Japan and Singapore.

In contrast, Hong Kong, Switzerland and South Korea all have temporary exemptions in place for equity options. The exemptions expire within the next year, but could be extended if local regulators want to follow the EU’s lead. Katalin Dobranszky, a director in the European public policy team at the International Swaps and Derivatives Association, has noted that authorities in South Korea have indicated they would emulate the EU.

In their proposal, the European authorities hammered home the idea that all countries should be using the same playbook. In their summary on the extension for equity options, they drew on a passage in the legislative update of Emir, known as the Regulatory Fitness and Performance Programme (Refit).

The Emir Refit explained legislators’ rationale for exempting physically settled foreign exchange forwards from the margin rules as being due to the US exempting the trades – which they objected to:  “International regulatory convergence should also be ensured with regard to risk-management procedures for other classes of derivatives.” 

In principle, European prudential regulators don’t like exemptions from the margin requirements because they always feel that it is creating the conditions for increasing risks in the system

Industry source

In the proposal, regulators quoted this passage to bolster their goal of full implementation of the margin rules, including on equity options: “… the same Recital 21 of the Emir Refit text that mentioned in the section on physically settled FX forwards and swaps also comes in support of this objective of an implementation of the international framework across the range of derivatives.”

But some market participants interpret the Emir Refit’s position the other way around – that equity options should be exempt from the EU’s margin rules so as to remain aligned with the US.

“You could read that statement in the Emir Refit either way,” says Ashall. “I had read it and the industry had read it as almost giving support to an exemption for equity options to the extent it applies in other jurisdictions, and notably the US, and therefore to make the current exemption permanent.

“I certainly don’t think that statement was intended by legislators to indicate that the exemption for equity options should be taken away,” she adds.

Staying aligned

Despite Japan and Singapore applying margin rules to equity options, it is more important the EU align itself with the US, as the two jurisdictions have the largest markets of equity options, the industry source maintains.

“The fact is that in terms of market share, the EU and the US is more than 95% of the equity options market,” he says. “So the other jurisdictions are very incidental, and the EU should focus on staying aligned with the US.”

A legal expert at a global investment bank claims the need to stay aligned with the US is beyond evident.

“I can’t see why it would be anybody’s interests not to extend the equity options derogation further,” complains the legal expert. “Any exemption that is product-specific and is being done with a view to creating consistency with other jurisdictions seems to be a no-brainer to me.”

The cost to firms from the exemption’s lapse could be significant for some EU firms. Equity derivatives may only represent 1.3% of total derivatives notional, but these trades are particularly expensive to margin. In fact, a recent analysis showed equity derivatives have become the biggest consumer of initial margin, despite interest rate and forex derivatives being a much bigger portion of the underlying market.

The proposal on margin rules would normally need to be approved by the three European bodies – the European Commission, European Parliament and Council of the EU – to become law. However, the proposal’s call for “risk-based and proportionate” implementation, pending the completion of the exemption, has been used in the past and is viewed as a form of forbearance.

The December 5 release contained other changes to margin rules, among them an extended exemption on firms having to post margin on intragroup trades between an EU entity and a non-EU entity in the same company. If a non-EU entity is in a jurisdiction with rules not deemed equivalent to Emir by the European Commission, then an intra-group trade would otherwise be subject to margin requirements. The exemption will now end on December 21, 2020, instead of January 4, 2020.

The statement also gave smaller buy-side firms more time before they face initial margin ‘big bang’ rules, in keeping with the Basel Committee and Iosco revisions to phase-ins of different-sized firms. Firms with exposures of more than $50 billion in average aggregate notional of non-cleared derivatives will be caught in phase five in September 2020, in line with the original schedule. But smaller firms, with exposures down to $8 billion, will not enter the newly minted phase six until 2021, a full year later than previously planned.