CP11/22 - Margin requirements for non-centrally cleared derivatives: Amendments to BTS 2016/2251

Overview

1.1 This Consultation Paper (CP) sets out the Prudential Regulation Authority’s (PRA) and Financial Conduct Authority’s (FCA) proposals to update the list of instruments as eligible collateral for bilateral margin, to introduce fall-back transitional provisions for certain firms who come into scope of the requirements for the first time, and to update the application of the requirements to central counterparties (CCPs).

1.2 The proposals in this CP would result in changes to the UK version of Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016, the regulatory technical standards for risk-mitigation techniques for over-the-counter (OTC) derivative contracts not cleared by a central counterparty (hereafter Binding Technical Standards (BTS) 2016/2251). This BTS supplements Article 11(15) of Regulation (EU) No 648/2012 on OTC derivatives, central counterparties, and trade repositories (UK EMIR) (Appendix 1).^{footnote [1]}

1.3 This CP is relevant to banks, building societies, and PRA-designated investment firms in scope of the margin requirements under UK EMIR. In addition, this CP is relevant to all FCA solo-regulated entities and non-financial counterparties in scope of the margin requirements under UK EMIR (FCA firms).

1.4 The purposes of these proposals are to:

• specify the treatment of third-country funds as eligible collateral, including European Economic Area (EEA) Undertakings for Collective Investment in Transferable Securities (UCITS);
• provide a fall-back transition period to address practical issues where firms face immediate application of the bilateral margining requirements; and
• update the criteria for a CCP to be excluded from the requirements.

1.5 The PRA and FCA do not expect firms to incur material additional costs as a direct result of these proposals. Costs for the PRA, FCA and for the firms in implementing these requirements are expected to be minor, as they do not impose any new mandatory requirements on firms.

1.6 The PRA considered the interaction between its primary and secondary objectives and the ‘have regards’. Overall, the PRA considers its proposals to be necessary to advance its objectives, while having regard to proportionality, competitiveness, and competition. The FCA considers that the proposals will advance its strategic objective of protecting and enhancing the integrity of UK financial markets

1.7 By updating the list of eligible collateral and introducing a fall-back transition period where the margin requirements would otherwise become applicable immediately in some cases, the proposals ensure that the margin requirements would be applied proportionately and that they would promote the competitiveness of UK firms. By updating the criteria for a CCP to be exempted from the requirements, the proposal provides transparency on the requirements.

Background

1.8 In 2011, to mitigate the risks associated with non-centrally cleared OTC derivatives, the Group of Twenty (G20) agreed to add uncleared margin requirements to its reform programme, and tasked the Basel Committee on Banking Supervision (BCBS) and International Organisation of Securities Commissions (IOSCO) to jointly develop relevant standards.^{footnote [2]} In 2013, BCBS and IOSCO published the standard on ‘Margin requirements for non-centrally cleared derivatives.^{footnote [3]} The introduction of the bilateral margining requirements is a key aspect of the post-crisis reforms aimed at mitigating systemic risk and incentivising central clearing. These requirements are implemented in the UK by the onshored EMIR and BTS 2016/2251.^{footnote [4]}

1.9 The standard requires counterparties to exchange variation margin (VM) and initial margin (IM) on uncleared derivatives. VM protects the transacting parties from changes in the mark-to-market value of the contract after the transaction has been executed. IM protects the transacting parties from the potential future exposure that could arise, in the event that one counterparty defaults.

1.10 The European Union (EU) BTS, which implement the substantive aspects of the BCBS and IOSCO framework in the EU, were published in the EU Official Journal on Thursday 15 December 2016. The EU Exit Instruments that amended the BTS to make them operable in a UK context, in line with the default treatment of the EU as a third-country to the UK, removed the eligibility of EEA UCITS as collateral and added UK UCITS to the list of eligible collateral.^{footnote [5]} However, to avoid any cliff edge risk for UK firms immediately following the end of the transition period, EEA UCITS temporarily remained as eligible collateral until March 2022 under a transitional provision. Policy Statement (PS) 27/20 ‘The Bank of England’s amendments under the European Union (Withdrawal) Act 2018: Changes before the end of the transition period’ noted an intention to consult on the implementation of the final phases envisaged in the updated BCBS and IOSCO standards. It also noted that the consultation would consider whether other pending amendments should be adopted into the UK framework.

1.11 PS14/21 ‘Margin requirements for non-centrally cleared derivatives: Amendments to BTS 2016/2251’ made amendments to extend the temporary eligibility of EEA UCITS as collateral until Saturday 31 December 2022. ^{footnote [6]} In PS14/21, the PRA and FCA agreed to consult on the longer-term treatment of EEA UCITS as collateral.

1.12 In addition, responses to CP6/21 ‘Margin requirements for non-centrally cleared derivatives: Amendments to BTS 2016/2251’ (CP6/21) raised an issue relating to application of the margin requirements for CCPs that is also being considered as part of this CP.

1.13 More recently, the PRA and FCA have been made aware that the current BTS does not provide a transition period for firms who, in certain circumstances, would require an immediate application of the margin requirements. The PRA and FCA propose to address this issue in this CP.

Summary of proposals

1.14 This CP proposes to amend the UK bilateral margining requirements in the onshored BTS 2016/2251 by:

• updating the list of instruments eligible to be used as collateral for meeting the margin requirements;
• introducing a fall-back transitional provision for firms that would otherwise come into immediate scope of the requirements; and
• updating the scope of application of the margin requirements to CCPs.

Implementation

1.15 The PRA and FCA propose to amend BTS 2016/2251 using the making and amendment powers under Article 11(15) of EMIR, and under Section 138P of the Financial Services and Markets Act 2000 (FSMA). The proposed changes would be effective on publication of the final technical standards instrument. Consistent with the respective mandates under EMIR, the PRA is proposing amendments with respect to PRA-regulated firms, and the FCA is proposing amendments to all other firms covered by the requirements. For the purpose of this consultation, the proposals are identical.

1.16 This is a joint PRA and FCA consultation. The PRA and FCA have also consulted with the Bank of England (Bank) and HM Treasury (HMT) as part of the development of these proposals.

1.17 The PRA and FCA propose that the implementation date for the changes resulting from this CP would be on publication of the final technical standards instrument.

Responses and next steps

1.18 This consultation closes on Wednesday 12 October 2022. The PRA and FCA invite responses on the proposals set out in this consultation. PRA-regulated firms should address any comments or enquiries to CP11_22@bankofengland.co.uk. FCA solo-regulated firms should address any comments or enquiries to cp22-13@fca.org.uk. Other respondents should submit responses to both authorities. Please indicate in your response if you believe any of the proposals in this CP are likely to impact persons who share protected characteristics under the Equality Act 2010, and if so, please explain which groups and what the impact on such groups might be.

1.19 Following consideration of any responses, the PRA and FCA will submit the updated BTS 2016/2251 to HMT for approval, in accordance with section 138R of FSMA. Assuming HMT provides approval, the PRA and FCA will make and publish the amendments to the technical standards for the firms they regulate.

1.20 Unless otherwise stated, any remaining references to EU or EU-derived legislation refer to the version of that legislation which forms part of retained EU law.^{footnote [7]}

Proposals

2.1 This chapter sets out the PRA’s and FCA’s joint proposals to:

• update the list of instruments eligible to be used as collateral for meeting the margin requirements;
• introduce a fall-back transitional provision for firms that would otherwise come into immediate scope of the requirements; and
• update the scope of application of the margin requirements to CCPs.

List of instruments as eligible collateral

2.2 The PRA and FCA propose to update the list of eligible collateral for meeting the initial margin requirements by:

• not extending the expiry date of EEA UCITS eligibility as collateral;
• setting out a set of principles that all third-country funds would be required to meet in order for their units or shares to be eligible to be used as collateral. This broadens the eligibility criteria, where non-EEA funds are currently not eligible at all; and
• limiting the eligibility of units or shares of third-country funds to only those that invest in government securities and cash.

2.3 The PRA and FCA consider that the existing risk management principles that apply to UK UCITS are sufficiently prudent. The PRA considers this advances the PRA’s primary objectives. However, the PRA and FCA also consider that many third-country funds may meet equivalent risk management criteria, but not be eligible as collateral as the existing requirements limit eligibility to funds authorised as UCITS.

2.4 The PRA and FCA propose to remove the term EEA UCITS from the list of eligible collateral in line with the standard third-country treatment, but update the list to include certain funds from all third-countries instead. The PRA and FCA also propose to introduce risk management requirements directly into the text, but limit relevant funds to those investing only in government securities and cash. Under these proposed risk management requirements, firms would need to have sufficient information about the individual underlying exposures of relevant funds and be able to access the daily price quote of those funds. The proposed set of principles for eligible funds seeks to maintain the existing risk management principles of UK UCITS. It would require firms to assess whether the collateral they accept has similar risk safeguards to UCITS around the funds legal framework and the underlying assets. Therefore, PRA considers the proposals would advance the PRA’s primary objective.

2.5 Where firms accept third-country funds as collateral, the PRA and FCA would expect firms to be able to demonstrate they have completed the risk assessment. This assessment would confirm that a jurisdiction’s legal framework for the relevant funds provides comparable risk management protections to those applied to UK UCITS. The PRA and FCA would consider advice from internal or external counsel, or a similar approach, would meet these requirements.

2.6 Given the proposed broadening of the geographical scope of eligible funds as collateral, the PRA and FCA consider that these assessments will become in many cases more difficult for firms and supervisors where the fund invests in more risky assets. As such, the PRA and FCA consider it appropriate to limit the eligibility as collateral to units or shares of those third-country funds investing only in public debt otherwise acceptable under the BTS, and cash holdings.

2.7 The proposal would result in some categories of EEA UCITS that were previously eligible collateral when the UK was an EU member to become ineligible as collateral. The proposal would also expand the list of eligible collateral to a much wider set of third-country based funds. On balance, the PRA and FCA consider that expanding the list of eligible collateral to a wider set of third-country based funds, with an appropriate risk assessment, would enable high-quality assets to be used as collateral, regardless of jurisdiction. This would ensure the most relevant collateral remains eligible. This would promote the relative standing of the UK as a financial centre, while ensuring that the requirements would be applied in a proportionate manner, and that the PRA’s and FCA’s resources would be used in the most efficient way.

Fall-back transitional provisions

2.8 The PRA and FCA propose to introduce a fall-back transitional provision of a six months period for circumstances where firms come into scope of the margin requirements for the first time, and the rules would otherwise apply immediately. This period is to enable counterparties to establish, and internally validate, margin arrangements in line with the BTS’s requirements. For clarity, the proposed transitional provision is not intended to replace, supplement, or be in addition to, any existing transitional provisions contained within the BTS.

2.9 The existing requirements in the BTS contain a number of transitional provisions in relation to firms coming into scope of the requirements and the application dates of those requirements. These reflect the time that firms and their counterparties would need to implement the legal and operational requirements in order to be compliant overall. However, there may be instances under the current BTS where a firm would immediately come into scope of the requirements. This could be a result of existing derogations ceasing to apply, or when a firm or contractual counterparty comes into scope of the BTS for the first time. The absence of a transition period would not leave enough time for firms to operationally implement the margin requirements. In extremis, firms may have to cease trading until they were able to meet the requirements.

2.10 The PRA considers its proposals would advance the PRA’s primary objective for promoting the safety and soundness of UK firms by retaining market access for firms, which in turn prevents market dislocation. The FCA similarly considers that the proposal would advance its market integrity objective by reducing the risk of market disruption. The proposals would introduce a fall-back transitional provision on relevant margin requirements that applies to firms when they become subject to those requirements for the first time. For the avoidance of doubt, this proposal does not change timelines for the Phase 6 implementation of margin requirements in September 2022.

2.11 Instances where firms may immediately come into scope of the margin requirements include when a firm changes status under UK EMIR (eg a non-financial counterparty below the clearing threshold subsequently breaches that threshold as a result of corporate restructuring ), or where external events such as changes in jurisdictional legal environment (eg a jurisdiction’s status changes from one where netting is not legally enforceable to one where netting is legally enforceable). As the number of firms and regions implementing the margin requirements increases, these events may occur more frequently.

2.12 The PRA and FCA note the challenges for firms in implementing the requirements with counterparties from jurisdictions that only recently receive enforceable netting opinions. The PRA and FCA considers that the proposed six month fall-back transition period would be appropriate in such circumstances. The period would only begin after the firm has individually assessed that the netting agreements and operational arrangements for that firm would be legally enforceable in those jurisdiction as required when entering into a netting or exchange of collateral agreement.

2.13 The PRA and FCA consider that the immediate application of the margin requirements would not be proportionate. The concept of providing time for market participants to prepare is embedded in the policy. But there may be edge cases where the current requirements do not provide this transition period. By proposing to introduce a general fall-back transitional provision for complying with margin requirements which would otherwise apply immediately, the PRA and FCA consider the proposal would ensure the margin requirements are applied proportionately and ensure that firms have time to establish risk management procedures which meet margining requirements under UK EMIR.

Application of the margin requirements to CCPs

2.14 The PRA proposes to exempt trades from the margin requirements CCPs that are recognised by the Bank, rather than authorised by the PRA as a credit institution, where those trades link to the CCP’s activities. This would prevent CCPs from unintentionally being captured by the margin requirements. In the unlikely event that a CCP is engaged in non-centrally cleared derivatives for purposes not specified in its recognition order^{footnote [8]}, these trades would be subject to the margin requirements.

2.15 The existing requirements exclude CCPs authorised by the PRA as credit institutions from the margin requirements. The current formulation may create ambiguity and unintentionally scope in some CCPs. The PRA considers the proposal would remain prudent and continue to advance the PRA’s primary objective as the policy is not to apply the bilateral margining requirements to CCPs when they are conducting activities listed in their recognition orders. These include contracts in respect of activities which are carried on for the purposes of, or in connection with, the services or activities specified in the CCP’s recognition.

2.16 The PRA considers the proposal would ensure the requirements are applied in a proportionate manner by not capturing risks that are not intended to be captured by the margin requirements. The PRA considers the proposal ensures the PRA exercise its function transparently.

The PRA’s statutory obligations

3.1 In carrying out its policy making functions, the PRA is required to comply with several legal obligations. The PRA has a statutory duty to consult when changing standards instruments (FSMA s138S). When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so. When not making rules, the PRA has a public law duty to consult widely where it would be fair to do so.

The PRA fulfils its statutory obligations and public law duties by providing the following in relation to the proposed policy:

• a cost benefit analysis;
• compatibility with the PRA’s objectives: an explanation of the PRA’s reasons for considering that making the proposed rules is compatible with the PRA’s duty to act in a way that advances its general objective,^{footnote [9]} insurance objective^{footnote [10]} (if applicable), and secondary competition objective;^{footnote [11]}
• FSMA regulatory principles: an explanation of the ways in which having regard to the regulatory principles has affected the proposed rules;^{footnote [12]}
• impact on mutuals: a statement as to whether the impact of the proposed rules will be significantly different to mutuals than to other persons;^{footnote [13]}
• HM Treasury recommendation letter: the Prudential Regulation Committee (PRC) should have regard to aspects of the Government’s economic policy as recommended by HMT; ^{footnote [14]} and
• equality and diversity: the PRA is also required by the Equality Act 2010^{footnote [15]} to have due regard to the need to eliminate discrimination and to promote equality of opportunity in carrying out its policies, services, and functions.^{footnote [16]}

3.2 Appendix 2 lists the statutory obligations applicable to the PRA’s policy development process. The analysis in this chapter explains how the proposals have had regard to the most relevant matters listed in Paragraph 3.1, including an explanation of the ways in which having regard to these matters has affected the proposals.

List of instruments as eligible collateral, fall-back transitional provisions and application of the margin requirements to CCPs

3.3 The PRA proposes to:

• • update the list of instruments eligible to be used as collateral for meeting the margin requirements;introduce a fall-back transitional provision for firms that would otherwise come into immediate scope of the requirements; and
  • update the scope of application of margin requirements to CCPs.

3.4 The PRA considers that its proposals would advance the PRA’s statutory objectives, would ensure the requirements remain proportionate, and would ensure the PRA’s resources are used in the most efficient and economical way.

PRA objectives

3.5 The PRA has a primary objective to promote the safety and soundness of UK firms. The PRA also has a secondary objective to facilitate effective competition in the markets for services provided by PRA-authorised persons in carrying out regulated activities.

3.6 The PRA considers its proposals to update the eligibility of funds as eligible collateral, introduce a transitional provisions for certain firms and exempt CCPs in the circumstances outlined above from the margin requirements would ensure that the bilateral margining requirements are implemented proportionately, but would remain sufficiently prudent. This would help to promote the PRA’s primary objective in ensuring the safety and soundness of UK firms.

3.7 The PRA considers the proposals introduce changes that would ensure the proportionality of the proposed requirements and appropriately capture the unique requirements of firms captured by the margin requirements. As the proposals do not make it compulsory for firms to accept funds as collateral, provide more time for firms to comply with the requirements in certain circumstances, and provide greater clarity on the treatment of CCPs, the PRA does not consider there would be any material impacts on firms that are likely to:

• materially affect the operating costs of any cohort of affected firms that compete in the relevant markets; or
• materially change the behaviour of any particular firms.

3.8 Consequently, the PRA considers that these proposals advance the PRA’s secondary competition objective, by ensuring the requirements take into account the business models of firms captured by the requirements.

Have regards

FSMA regulatory principles

3.9 In developing these proposals, the PRA has had regard to the regulatory principles. Three principles are of particular significance.

• The principle that a burden or restriction which is imposed on a person should be proportionate to the benefits which are expected to result from the imposition of that burden: The PRA considers that the proposals to update the collateral eligibility criteria for funds and to require firms to undertake their own assessment are proportionate to the cost for firms in implementing and meeting the requirements on an ongoing basis, because the requirements would be proportionate to firms’ size and complexity. The PRA also considers that its proposal to introduce a fall-back transitional provisions ensures firms would not face unwarranted burden due to unexpected changes in circumstances.
• The principle that the PRA’s resources are used in the most efficient and economical way: The PRA considers the proposals would support it in supervising firms in an efficient and effective way, by requiring firms to undertake their own risk assessment of third-country funds for it to be eligible as a collateral, rather than requiring the PRA to individually approve eligible third-country funds, or to publish, on a regular basis, the list of eligible third-country funds.
• The principle that the PRA should exercise its functions as transparently as possible: The PRA considers its proposals to update the requirements to exempt CCPs that are recognised by the Bank, rather than authorised by the PRA, from the margin requirements, ensures the PRA carries out its function as transparently as possible.

3.10 The PRA has considered the remaining FSMA regulatory principles (see references in Appendix 2), and considers that they are not of sufficient significance to merit detailed explanation when considering this proposal.

Impact on mutuals

3.11 The PRA considers that the impact of the proposed rule changes on mutuals is expected to be no different from the impact on other firms.

HM Treasury recommendation letter

3.12 HMT has made recommendations to the Prudential Regulation Committee (PRC) about aspects of the Government’s economic policy to which the PRC should have regard when considering how to advance the PRA’s objectives and apply the regulatory principles.

3.13 Competition: The PRA considers its proposals on collateral eligibility and transitional provisions relate to specific products or activities. The list of instruments in respect of the proposals collateral eligibility are most relevant to incoming participants of the margin requirements. By retaining the eligibility of funds as collateral, this would ensure that the proposed requirements do not negatively impact firms that are more likely to use funds as collateral. The PRA also considers that introducing a fall-back transitional provision for all requirements where it results in immediate application, would ensure the proposed requirements do not negatively impact firms.

3.14 Competitiveness: The PRA considers that the UK’s competitiveness would be supported by the proposals. The PRA considers the proposed extended list of eligible collateral and the fall-back transitional provision support London’s position as a leading international financial centre, and the UK’s attractiveness and competitiveness to internationally active financial institutions.

3.15 The PRA has considered the remaining aspects of government economic policy as laid out in the HMT recommendation letter (see references in Appendix 2), and considers that they are not relevant to these proposals.

Equality and diversity

3.16 The PRA considers that the proposals do not give rise to equality and diversity implications.

Cost benefit analysis

3.17 This section sets out an analysis of the costs and benefits of introducing all the changes proposed in this CP. The PRA has not included quantitative estimates for the proposals in this analysis, as it does not anticipate that the costs to firms would be material. The PRA considers that data collection to support quantitative analysis would not be proportionate.

3.18 The relevant technical standards for risk mitigation techniques for non-centrally cleared OTC derivative contracts implement, in the UK, reforms agreed at an international level following the 2008 financial crisis. The costs and benefits of the proposals need to be considered in this context. The PRA considers its proposals would:

• extend the list of eligible collateral that firms can use to meet the bilateral margining requirements;
• introduce a fall-back transition period for when a counterparty or trade comes into scope of the bilateral margining requirements for reasons other than through exceeding the aggregate month-end average notional amount (AANA) threshold calculation with some minor exceptions where such fall-back transitional provision is not appropriate; and
• allow trades with CCPs recognised by the Bank to be exempted from the bilateral margining requirements in certain circumstances.

Affected firms and markets

3.19 The proposals in this CP would apply to banks, building societies, and PRA-designated investment firms in scope of the margin requirements under UK EMIR. Not all the proposals in this CP would be relevant for all firms.

3.20 The markets that are most relevant to the proposals in this CP are non-centrally cleared OTC derivatives. With respect to the proposals on updating the list of instruments eligible for meeting the margin requirements, the PRA considers this would, on balance, expand the list of eligible collateral for firms that primarily use eligible funds as collateral.

Benefits

3.21 In the absence of the PRA’s proposed amendments, the PRA considers that:

• the list of eligible collateral would reduce when the EEA UCITS collateral eligibility expires. The PRA considers that smaller firms due to come into scope of the requirements this year are more likely to use funds as collateral, and would be negatively impacted. These firms would face increased costs to secure other eligible collateral. The PRA considers its proposals would support these firms to continue to meet the margin requirements using existing eligible collateral without incurring additional costs;
• firms would have to immediately comply with the margin requirements when a counterparty or trade comes into scope of the bilateral margining requirements for reasons other than through exceeding the AANA threshold calculation. Firms would otherwise have a grace period to comply if either the firm or their counterparty comes into scope by exceeding the AANA threshold; and
• the rules relating to the application of the bilateral margin requirements to CCPs could be considered ambiguous.

Costs

3.22 PRA considers it is likely that costs would be incurred to both it and firms stemming from the proposals to update the eligibility criteria of funds as collateral. This is relevant where a firm wishes to use third-country funds as collateral for meeting the margin requirements by:

• requiring firms to undertake a risk assessment of third-country funds in order to be treated like a UK UCITS, although the cost would be offset by having a wider range of eligible collateral for meeting the bilateral margining requirements; and
• potentially requiring the PRA to supervise how firms are undertaking the risk assessment of third-country funds.

3.23 The PRA is not able to reasonably provide the quantitative estimate of these costs but considers the costs expected to be incurred to both it and firms not to be material relative to the benefits.

FCA cost benefit analysis

Executive summary

4.1 This Chapter sets out the FCA’s assessment of the costs and benefits of the proposals to amend margin requirements for non-centrally cleared derivatives in BTS 2016/2251. These proposals address uncertainty over the long-term treatment of EEA UCITS as eligible collateral and practical issues where the bilateral margin requirements apply to firms immediately. Unaddressed, these issues could raise costs for firms and potentially disrupt the safe and effective functioning of derivative markets.

4.2 To address these problems, the proposals update the list of instruments eligible as collateral and introduce a fall-back transitional provision in the BTS for firms that would otherwise come into scope of the requirements immediately. Together, the proposed amendments are intended to ensure derivative markets continue to operate safely and effectively.

4.3 The FCA anticipates the proposals will benefit FCA firms currently in scope, or who will enter into scope of the margin requirements. While there will be some compliance costs for firms associated with these proposals, the FCA expects those costs not to be material and that they will be exceeded by the benefits. Updating the list of eligible collateral benefits firms by providing a range of suitable collateral to meet the margin requirements. Introducing a fall-back transitional provision benefits firms by providing a period for firms to establish margin arrangements for the first time. The proposals will also deliver wider benefits by reducing the risk of disruption to derivative markets that could impact wider markets or the UK economy.

Introduction

4.4 Sections 138S and 138I FSMA require the FCA, when it proposes to make technical standards, to publish a cost benefit analysis (CBA) defined as ‘an analysis of the costs, together with an analysis of the benefits that will arise if the proposed rules are made’.

4.5 The FCA’s CBA is set out below. The FCA is conducting a separate CBA to the PRA given the different supervisory remits. The FCA is consulting in relation to all FCA solo-regulated entities and non-financial counterparties in the scope of the margin requirements. As such, this CBA considers the costs and benefits related only to those entities. The FCA has not considered costs and benefits for the proposal on CCPs as the FCA is not the competent authority for CCPs.

4.6 This analysis presents estimates of the quantifiable impacts of our proposals. The FCA provides monetary values for costs and benefits where we believe it is reasonably practicable to do so. For other costs and benefits, the FCA provides qualitative assessments of outcomes. Our proposals are based on carefully weighing up these costs and benefits and reaching a judgement, taking into account all the impacts the FCA foresees.

List of instruments eligible as collateral

Problem and rationale for intervention

Harm and drivers of harm

4.7 As a result of onshoring the margin requirements in BTS 2016/2251, the eligibility of EEA UCITS as collateral was removed from the BTS, and UK UCITS were added to the list of eligible collateral. However, EEA UCITS were given temporary eligibility as collateral until December 2022 as a transitional provision. Without amending the BTS, EEA UCITS will automatically cease to be eligible collateral from December 2022.

4.8 This may raise costs for firms currently in scope of the margin requirements as they may need to find alternative collateral and it may be more difficult and costly to obtain eligible collateral. The UK UCITS market is smaller than the EEA UCITS market and firms will thus have less eligible collateral available to meet margin requirements. In Q4 2021, UK UCITS held c.11% of the total net assets of the European UCITS market.^{footnote [17]}

4.9 Harm to market integrity could occur if firms currently in scope of the margin requirements find that the collateral they hold is no longer eligible to meet margin requirements and are unable to trade compliantly without incurring the cost and disruption of adjusting their collateral holdings. This risk becomes more prevalent with the final stage of the phase-in of margin requirements in September 2022 (Phase 6). The FCA understands firms coming into scope of the requirements in Phase 6 are more likely to use funds as collateral. If no action is taken, these firms might then struggle to meet margin requirements.

4.10 Without regulatory intervention, cross-border trading with EEA firms may also be negatively impacted as EEA firms may prefer to use EEA UCITS as collateral and as a result be less willing to trade with UK firms.

4.11 The driver of this harm is an externality stemming from a technical issue in BTS 2016/2251 and the expiration of transitional provisions.

Summary of proposed intervention

4.12 The FCA proposes to address the identified harm by expanding the list of instruments eligible as collateral in the BTS to include third-country funds provided that certain conditions are met. Specifically, third-country funds will be limited to those investing only in government securities and cash, and where firms accepting the collateral have conducted a risk assessment of the fund’s legal framework.

4.13 The FCA have set out a causal chain below showing how the proposal reduces the risks of market disruption and additional costs for firms.

Baseline and key assumptions

4.14 Baseline: The costs and benefits of this proposal have been assessed against a baseline where, absent intervention, the temporary eligibility of EEA UCITS as collateral expires and only UK UCITS are eligible. As noted above, this would raise costs for firms and could threaten market integrity. Without intervention, the harm would grow once Phase 6 firms enter the scope of margin requirements in September 2022.

4.15 Use of third-country funds: Accepting third-country funds as collateral is not a requirement for firms under this proposal but will be optional. In practice, whether firms incur costs by conducting risk assessments of third-country funds will depend on firms’ judgements as to what collateral they accept. The FCA has accordingly provided an indicative cost estimate per firm for carrying out a risk assessment should firms choose to receive third-country funds as collateral.

4.16 Eligibility of EEA UCITS: Not all EEA UCITS temporarily eligible as collateral will remain eligible under this proposal. Based on engagement with industry, the FCA expects the majority of EEA UCITS currently used as collateral will continue to be eligible, subject to firms conducting a risk assessment.

Affected firms

4.17 The proposal applies to all FCA solo-regulated entities and non-financial counterparties that are, or will be, within the scope of the margin requirements under UK EMIR. The FCA estimates, using UK EMIR reporting data, that this population is up to c.12,000 firms. This figure is not exact as not all firms reporting under UK EMIR are in the scope of the margin requirements, but it provides an indication of the scale of the relevant market. The FCA does not anticipate that all firms in this population will be directly impacted by the proposal, for instance they may not post or receive third-country funds as collateral.

4.18 Based on conversations with industry, the FCA expect firms in Phase 6 to particularly benefit from this proposal as they are more likely to use funds as collateral to meet margin requirements. ISDA have estimated there are over 775 counterparties globally who may enter the scope of margin requirements in Phase 6.^{footnote [18]}

Costs and benefits of amending the list of instruments eligible as collateral

Summary of costs and benefits

4.19 The FCA anticipates there will be some one-off compliance costs associated with this proposal. However, the FCA expect the costs will be significantly outweighed by the benefits of expanding the list of eligible collateral to include certain third-country funds compared with the baseline of a reduced range of eligible collateral.

Benefits

4.20 This section explains the benefits of this proposal. These include reduced risk of market disruption and avoiding higher costs for firms. It is not reasonably practical to quantify these benefits since they are reducing risks that cannot be readily measured.

4.21 Benefits to firms: This intervention ensures there is a wider range of high-quality collateral available to firms compared with the baseline. This reduces costs for firms compared to if the range of eligible collateral is narrowed. The possibility of disruption to the derivatives market due to a lack of eligible collateral negatively impacting firms is also reduced. In addition, the proposal benefits firms by reducing the possibility of disruption to cross-border trading with EEA firms, which could adversely impact firms’ profits.

4.22 Wider benefits: Amending the BTS so firms can use a wider range of high-quality collateral reduces the risk that firms lack appropriate collateral to meet margin requirements, which could generate wider market disruption.

Costs

4.23 Familiarisation and gap analysis: These one-off costs include the time and resources spent by firms familiarising themselves with the proposal and performing a gap analysis to identify any resulting changes. There are 22 pages of text for compliance staff to familiarise themselves with, as well as 3 pages of legal text. Using the Standardised Costs Model, the FCA estimate the one-off costs of familiarisation and gap analysis for an individual firm to be £1850, £544 and £128 for a large, medium and small firm, respectively.

4.24 Conducting risk assessments: Firms receiving third-country funds as collateral will incur one-off compliance costs to carry out a risk assessment of third-country funds’ legal frameworks. The FCA does not expect this to be a substantial cost, but the FCA recognises that costs may vary depending on the nature of a third-country fund’s legal framework and firms’ approaches to conducting a risk assessment. Costs may also be mitigated by firms relying to some degree on assessments conducted by third parties, such as trade bodies.

4.25 To provide an indicative cost range, the FCA has used a risk assessment comparing the EEA UCITS legal framework with UK UCITS. This cost serves as a proxy broadly representative of other jurisdictions. While the FCA is not specifying how firms conduct risk assessments, one method the FCA would consider compliant is obtaining advice from internal counsel. Taking this approach, firms could conduct a legal gap analysis of 150-250 pages of legal text to confirm that the EEA UCITS legal framework provides similar risk safeguards to UK UCITS based on the length of the core documents of each regime. Using the Standardised Costs Model, the FCA estimates that conducting a risk assessment of one jurisdiction in this manner could cost a large firm between £24,274 - £40,457, while costs would likely be lower for smaller firms using this approach.

4.26 Obtaining legal advice is the maximum we would expect of firms conducting a risk assessment, so this approach represents the upper bound of costs firms would likely incur conducting a risk assessment. The estimate provided is indicative of the cost associated with carrying out a risk assessment for a large firm using this approach based on the Standardised Costs Model. Since there are various approaches that would satisfy the FCA’s expectations, in practice firms may not incur costs equivalent to obtaining legal advice.

4.27 Conducting a risk assessment is only required if firms choose to accept third-country funds as collateral. The FCA expects firms will therefore only accept third-country funds if it provides them with a net benefit. Based on industry feedback, the FCA understands firms are mainly interested in using funds from a limited number of jurisdictions so they may only need to conduct a limited number of assessments.

4.28 Indirect costs to firm: Following the expiry of transitional arrangements, indirect costs may arise for firms if the collateral they hold is no longer eligible. The costs are not expected to be material as, based on conversations with industry, the collateral firms are most interested in using will remain eligible, subject to firms conducting a risk assessment where necessary. The FCA does not consider this cost reasonably practical to quantify as it will depend on how these changes impact firms’ future choices of collateral, which is difficult to predict. As the FCA has limited data on this point, we welcome any feedback from respondents.

4.29 Costs to the FCA: The FCA may incur some minor costs to supervise how firms are undertaking risk assessments of third-country funds. The FCA expects these costs to be of minimal significance.

Fall-back transitional provisions

Problem and rationale for intervention

Harm and drivers of harm

4.30 The mechanical application of the BTS means that, in certain circumstances, firms who come into scope of the margin requirements for the first time are required to exchange margin immediately. Absent a transitional provision, firms may be unable to continue trading compliantly since it is operationally challenging to establish margin arrangements immediately. This can disproportionately burden firms and result in legal uncertainty.

4.31 The potential harm is increased where many firms enter the scope of margin requirements at once, since this can cause additional delays to establishing margining arrangements due to onboarding backlogs and resource constraints emerging in the market. In this circumstance, there is potential for market disruption if numerous firms are unable to trade compliantly.

4.32 This could occur when a country that was treated as a non-netting jurisdiction is subsequently treated as a netting jurisdiction and many counterparties based in, or doing business with counterparties in, that jurisdiction are brought into the scope of the margin requirements. Industry has highlighted that this may occur if China is soon treated as a netting jurisdiction without a fall-back provision for counterparties brought into scope to establish margin arrangements. To illustrate the scale of the potential issue, one trade association poll found that members had an average of c.95 Chinese counterparties who may enter the scope of the margin requirements if China is treated as a netting jurisdiction.

4.33 The driver of this harm is a technical issue in the BTS.

Summary of proposed intervention

4.34 The proposed intervention is to create a 6-month fall-back transitional provision for when firms first enter the scope of the margin requirements where they would otherwise apply immediately. This period is for counterparties to establish margin arrangements in line with the BTS’s requirements.

4.35 The FCA has set out a causal chain below showing how the proposal reduces the risks of market disruption and additional costs and complexity for firms.

Baseline

4.36 The costs and benefits of this proposal have been assessed against a baseline where firms are required, in certain circumstances, to start exchanging margin immediately when first entering the scope of margin requirements. The baseline anticipates this issue may become more prevalent if China is treated as a netting jurisdiction.

Affected firms

4.37 This proposal will principally affect FCA firms entering the scope of the margin requirements for the first time. As this population is not stable and as the exact impacted population is unknown, the FCA has estimated costs and benefits for an individual firm, but not given an aggregate total.

4.38 Firms which are particularly likely to benefit are those which might be brought into scope, or have numerous counterparties brought into scope, for example if China is treated as a netting jurisdiction in the future.

Costs and benefits of introducing a fall-back transitional provision in the BTS

Summary of costs and benefits

4.39 While there will be minor costs associated with adjusting to this regulatory change, the FCA expects these will be significantly exceeded by the benefits of creating a transitional provision so firms can trade compliantly while establishing margin arrangements for the first time.

4.40 Since it is not reasonably practicable to establish the pool of affected firms for the intervention, the quantified cost estimates are presented on a per firm basis.

Benefits

4.41 In this section the FCA explains the benefits of this proposal. It is not reasonably practical to quantify these benefits since they are reducing risks that can’t be readily measured.

4.42 Benefits to firms: This intervention benefits firms by providing a period for firms to establish robust margin arrangements while continuing to trade compliantly. This is more proportionate and delivers greater legal certainty for firms first entering the scope of the margin requirements. A transitional provision also benefits firms by reducing the risk of market disruption.

4.43 Wider benefits: Wider benefits from this proposal are reduced risks of market disruption that could impact consumers and firms. Introducing a transitional provision achieves this by reducing the risk of derivative market disruption when many firms enter the scope of margin requirements at once and allowing firms time to establish effective margin arrangements to mitigate the risks associated with non-centrally cleared OTC derivatives.

Costs

4.44 Familiarisation and gap analysis: Firms may incur some familiarisation costs. These costs include the time and resources spent by firms familiarising themselves with the proposal and performing a gap analysis to identify any resulting changes. There are 21 pages of text for compliance staff to familiarise themselves with, as well as 2 pages of legal text. Using the Standardised Costs Model, the FCA estimate the one-off costs of familiarisation and gap analysis for an individual firm to be £1627, £466 and £116 for a large, medium and small firm, respectively.

4.45 Indirect costs to firms: Introducing a transitional provision may cause indirect costs. Counterparties may not enjoy the counterparty risk mitigation benefits of exchanging margin during the fall-back transitional period as exchanging margin may be delayed for up to 6-months. Since these counterparties may not have been margining prior to entering the scope of the margin requirements, this increase in risk will be limited to trading conducted over and above pre-existing trading volumes during the six months’ transitional period. In addition, industry feedback suggests it is not operationally possible to implement margin arrangements any faster to mitigate counterparty risk. As such, the FCA expects this proposal will not substantially change the level of risk. Any costs are not reasonably practical to quantify since they depend on how firms choose to use the fall-back transitional provision provided and how their derivatives trading behaviour changes during that period

FCA Compatibility Statement

Compliance with legal requirements

4.46 This Chapter records the FCA’s compliance with a number of legal requirements applicable to the proposals in this consultation, including an explanation of the FCA’s reasons for concluding that our proposals in this consultation are compatible with certain requirements under the Financial Services and Markets Act 2000 (FSMA).

4.47 When consulting on technical standards, the FCA is required by sections 138S(2)(f) and 138I(2)(d) FSMA to include an explanation of why it believes making the proposed technical standards are (a) compatible with its general duty, under s. 1B(1) FSMA, so far as reasonably possible, to act in a way which is compatible with its strategic objective and advances one or more of its operational objectives, and (b) its general duty under s. 1B(5)(a) FSMA to have regard to the regulatory principles in s. 3B FSMA. The FCA is also required by sections 138S(2)(h) and 138K(2) FSMA to state its opinion on whether the proposed technical standards will have a significantly different impact on mutual societies as opposed to other authorised persons.

4.48 This Chapter also sets out the FCA’s view of how the proposed technical standards are compatible with the duty on the FCA to discharge its general functions (which include technical standards) in a way which promotes effective competition in the interests of consumers (s. 1B(4)). This duty applies in so far as promoting competition is compatible with advancing the FCA’s consumer protection and/or integrity objectives.

4.49 In addition, this Chapter explains how the FCA have considered the recommendations made by HM Treasury under s. 1JA FSMA about aspects of the economic policy of Her Majesty’s Government to which the FCA should have regard in connection with our general duties.

4.50 This Chapter includes our assessment of the equality and diversity implications of these proposals.

4.51 Under the Legislative and Regulatory Reform Act 2006 (LRRA) the FCA is subject to requirements to have regard to a number of high-level ‘Principles’ in the exercise of some of our regulatory functions and to have regard to a ‘Regulators’ Code’ when determining general policies and principles and giving general guidance (but not when exercising other legislative functions like making technical standards). This Chapter sets out how the FCA have complied with requirements under the LRRA.

The FCA’s objectives and regulatory principles: Compatibility statement

4.52 The proposals set out in this consultation are primarily intended to advance the FCA’s operational objective of market integrity. The margin requirements are global standards that look to address the financial stability risk inherent with OTC derivatives transactions that are unable to be centrally cleared. Implementation of the requirements as per the proposals in this consultation will promote a sound, robust and resilient UK derivatives market. For the purposes of the FCA’s strategic objective, “relevant markets” are defined by s. 1F FSMA.

4.53 List of instruments as eligible collateral: The FCA considers this proposal compatible with its strategic objective of ensuring that the relevant markets function well. By expanding eligible collateral to include certain third-country funds, the proposals will ensure firms can use a range of high-quality collateral to meet margin requirements. This will reduce the risk of market disruption and increased costs for firms so derivative markets continue operating safely and effectively.

4.54 Fall-back transitional provisions: The FCA considers this proposal compatible with its strategic objective of ensuring that the relevant markets function well. Providing a fall-back transitional provision for when firms first enter the scope of margin requirements will ensure firms can prepare for margining appropriately and continue trading compliantly while doing so. This will ensure derivative markets continue to operate safely and effectively.

4.55 In preparing the proposals set out in this consultation, the FCA has had regard to the regulatory principles set out in s. 3B FSMA.

The need to use resources in the most efficient and economic way

4.56 List of instruments as eligible collateral: This proposal will support the FCA’s efficient supervision of firms as firms will need to conduct risk assessments of third-country funds’ legal framework if they wish to benefit from using them as eligible collateral, rather than the FCA individually approving third-country funds.

4.57 Fall-back transitional provisions: The proposed transitional provision will allow the FCA to supervise firms in a more efficient and effective way by permitting firms to prepare to comply with margin requirements where they might otherwise struggle to do so if the requirements applied immediately.

The principle that a burden or restriction should be proportionate to the benefits

4.58 List of instruments eligible as collateral: The FCA considers that this proposal is proportionate to the cost for firms in implementing and meeting the margin requirements on a one-off and an ongoing basis, and will be proportionate to firms’ size and complexity. In line with the FCA’s CBA, the FCA have considered the benefits of the proposal against the associated burden and assessed that the benefits should exceed the costs compared to if the FCA took no action and the eligible collateral was reduced.

4.59 Fall-back transitional provisions: The FCA considers that this proposal is proportionate as it supports firms establishing margin arrangements when they first enter the scope of the margin requirements where they would otherwise apply immediately.

The desirability of sustainable growth in the economy of the United Kingdom in the medium and long term

4.60 The FCA considers that these proposals are consistent with this principle because they support a safe and effective derivatives market which can help drive sustainable growth in the UK economy in the medium and long term.

The general principle that consumers should take responsibility for their own decisions

4.61 The proposals are consistent with this principle.

The responsibilities of senior management

4.62 The FCA considers that these proposals do not undermine this principle.

The desirability of recognising differences in the nature of, and objectives of, businesses carried on by different persons including mutual societies and other kinds of business organisation

4.63 The FCA considers that these proposals do not undermine this principle.

The desirability of publishing information relating to persons subject to requirements imposed under FSMA, or requiring them to publish information

4.64 This principle is not relevant to these proposals.

The principle that the FCA should exercise of our functions as transparently as possible

4.65 The proposals are consistent with this principle.

4.66 In formulating these proposals, the FCA has had regard to the importance of taking action intended to minimise the extent to which it is possible for a business carried on (i) by an authorised person or a recognised investment exchange; or (ii) in contravention of the general prohibition, to be used for a purpose connected with financial crime (as required by s. 1B(5)(b) FSMA). The FCA considers that this is not relevant in relation to the proposals in this paper.

Expected effect on mutual societies

4.67 The FCA does not expect the proposals in this paper to have a significantly different impact on mutual societies.

Compatibility with the duty to promote effective competition in the interests of consumers

4.68 In preparing the proposals as set out in this consultation, the FCA has had regard to its duty to promote effective competition in the interests of consumers. The FCA considers that the proposals will create robust but proportional margin requirements to support a safe and effective derivatives market which enables effective competition in the interest of consumers.

HM Treasury recommendations on economic policy

4.69 The FCA has considered that the proposals are consistent with the most recent recommendation from HM Treasury on aspects of the economic policy of the Government, which it should have regard to when acting to advance its objectives and meet its duties (s. 1JA FSMA). In particular, the recommendations on competition, growth, competitiveness, and trade.

4.70 Updating margin requirements to ensure the derivatives market continues to operate safely and effectively without disruption will help to promote sustainable economic growth and facilitate competition in financial services.

4.71 The proposals will support UK competitiveness and encourage trade by providing firms with a range of eligible collateral and ensuring margin requirements are proportional yet robust, so the UK remains an attractive international financial centre.

Equality and diversity

4.72 The FCA is required under the Equality Act 2010 in exercising our functions to ‘have due regard’ to the need to eliminate discrimination, harassment, victimisation and any other conduct prohibited by or under the Act, advance equality of opportunity between persons who share a relevant protected characteristic and those who do not, to and foster good relations between people who share a protected characteristic and those who do not.

4.73 As part of this, the FCA ensures the equality and diversity implication of new policy proposals are considered. The FCA have considered the equality and diversity issues that may arise from the proposals in this CP. Overall, the FCA do not consider that the proposals materially impact any of the groups with protected characteristics under the Equality Act 2010. The FCA will continue to consider the equality and diversity implications of the proposals during the consultation period and will revisit them when making the final technical standards.

PRA statutory obligations

The statutory obligations applicable to the PRA’s policy development process are set out below. This CP explains the policy assessment of relevant considerations.

• Purpose of the policy proposals (FSMA s138J(2)(b)).
• Cost benefit analysis (FSMA s138J(2)(a) and (7)(a)); and
  an estimate of those costs and benefits (if reasonable) (FSMA s138J(8)).
• Analysis of whether the impact on mutuals is significantly different to the impact on other authorised firms (FSMA s138J(2)(c) and 138K).
• Compatibility with the PRA’s primary objectives (FSMA s138J(2)(d)(i), 2B and 2C).
• Compatibility with the PRA’s secondary competition objective (FSMA s138J(2)(d)(ii) and 2H(1)).
• Compatibility with the regulatory principles (FSMA s138J(2)(d)(ii), 2H(2) and 3B).
• Have regard to the HMT recommendation letter (BoE Act s30B).
• Have due regard to the public sector equality duty (Equality Act s149).
• Have regard, subject to any other requirement affecting the exercise of the regulatory function, to the principles of good regulation and when determining general policy or principles to the Regulators Code (Legislative and Regulatory Reform Act 2006 s21 & 22).
• Have regard, so far as consistent with the proper exercise of those functions, to the purpose of conserving biodiversity. Conserving biodiversity includes, in relation to a living organism or type of habitat, restoring or enhancing a population or habitat (Natural Environment and Rural Communities Act 2006, s40).
• Consultation of the FCA (FSMA s138J(1)(a)).
• Where the consultation proposals a PRA rule change or amendment to onshored BTS that affects the processing of personal data - consultation with the Information Commissioner’s Office (article 36(4) General Data Protection Regulation).
• For UK Technical Standards Instruments only: FSMA s138J(1)(a) is replaced with: consultation of the FCA and/or Bank, where that Regulator has an interest in the technical standards (FSMA s138P(4) and (5)).
• For UK Technical Standards Instruments only: notice given to HMT of the consultation on the UKTS (‘best efforts’ basis).
• For CRR rules only: subject to certain exceptions, have regard to:
  • relevant standards recommended by the Basel Committee on Banking Supervision from time to time
  • the likely effect of the rules on the relative standing of the United Kingdom as a place for internationally active credit institutions and investment firms to be based or to carry on activities. For these purposes, the PRA must consider the United Kingdom's standing in relation to the other countries and territories in which, in its opinion, internationally active credit institutions and investment firms are most likely to choose to be based or carry on activities
  • the likely effect of the rules on the ability of CRR firms to continue to provide finance to businesses and consumers in the United Kingdom on a sustainable basis in the medium and long term
  • the target in section 1 of the Climate Change Act 2008 (carbon target for 2050)
  • (s144C (1) & (2) FSMA – exceptions in s144E FSMA).
• For CRR rules only – explanation of the ways in which having regard to the matters specified above has affected the proposed rules (s144D FSMA).
• For CRR rules only – publication of a summary of the proposed CRR rules.
• For CRR rules only – consideration and consultation with HMT about the likely effect of the rules on relevant equivalence decisions (s144C (3) & (4) FSMA).