Central counterparties wary of covered bonds despite ESMA proposal

LCH.Clearnet and Eurex will not accept clearing members’ own-name covered bonds as collateral despite a proposal to allow it from the European Securities and Markets Authority (ESMA).

A consultation paper, released on June 25, said clearing members should be allowed to post covered bonds they have issued as long as the underlying securities would themselves be eligible collateral and the debt is ring-fenced from a default by the issuer.

That would broaden the range of assets member firms can use – a key consideration as collateralisation will be the norm for both uncleared and cleared trades – but central counterparties would still have discretion about what to accept, and they are sceptical: “It’s not something we do today, and it isn’t something we are considering,” says Chris Jones, chief risk officer of LCH.Clearnet in London.

“A CCP must be able to cover the default of its two largest clearing members, so from our perspective it doesn’t make sense for a bank to give its own securities as collateral as they would be worthless when we need them,” he adds.

While the assets in a covered bond pool are usually legally ring-fenced in the event of the insolvency of the issuer, the bonds would become illiquid at the time of default, says Jones – and if a decision is taken to liquidate the cover pool, it can take time for the proceeds to reach bondholders, says Jones.

Thomas Book, a member of the executive board for clearing at Eurex, says he was surprised at the inclusion of own-name covered bonds in the ESMA proposal, noting it doesn’t comply with Eurex’s current policy.

LCH.Clearnet’s Jones says the clearing house is willing to accept a certain amount of wrong-way risk – receiving gilts as collateral from UK banks and US Treasury bonds from US banks, for example – but own-name bonds would be too risky.

A comment letter by Eurex to the ESMA discussion paper that first raised the idea of using covered bonds as collateral noted that the key characteristic of acceptable collateral is that its value should remain stable in extreme situations if the collateral provider defaults.

“In the case of own issues or closely linked securities this is not ensured because of the pro-cyclical effects of the collateral provider default on the value of the provided collateral,” Eurex said. “For this reason, we strongly advise to exclude those securities to be eligible as collateral.”

Luca Bertalot, head of the European Covered Bond Council – an industry group that represents 95% of covered bond issuers in the European Union – says it is too early to comment on ESMA’s proposal. A council working group is looking at how the proposal will affect different jurisdictions, he says.

Separately, the consultation paper proposes that initial margin should be calculated to a minimum confidence level of 99.5%, with discretion given to CCPs to extend this further if necessary.

That is higher than the 99% minimum suggested in principles for CCPs and other financial market infrastructures (FMIs) that were published in mid-April by the Committee on Payment and Settlement Systems and the International Organization of Securities Commissions. Esma notes that the FMI principles specifically single out OTC derivatives as an example of a product that requires more conservative margin models.

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