Including updates on Solvency II, non-centrally-cleared derivatives and credit valuation


Solvency II reporting requirements are taking shape

On 10 July 2012 EIOPA published the Final Report on its consultation on reporting and disclosure requirements under Solvency II. The Report includes an updated package of Quantitative Reporting Templates including additional ‘financial stability’ reporting requirements for large insurers. It also includes updated guidelines on narrative reporting.

The revised reporting package reflects the amendments made to address consultation responses. EIOPA confirmed the updated reporting package is a stable view of the granularity of information that will be required under Solvency II. Although some amendments will be necessary to reflect finalisation of the Solvency II legislation, it is not expected these amendments will be substantial.

Our hot topic, “Getting ready for Solvency II reporting”, outlines the proposed reporting requirements following the release of the final reporting templates, EIOPA’s response to significant comments made on the version consulted on in November 2011 and the areas that are still subject to change. EIOPA is expecting to publish a final reporting package during 2013 to include any amendments resulting from the finalisation of Solvency II legislation.

The biggest challenge for most insurers will be the requirement to report to the regulator on a more frequent basis and in some areas to report information that has not previously been required. Finance functions may need to re-think their target operating model to enable faster reporting and enhanced integration with actuarial, risk and other departments.

EIOPA’s updated reporting package brings us one step closer to certainty on Solvency II reporting requirements. This will be welcome news to European insurers preparing for implementation. The amount of work required should not be underestimated, as Solvency II reporting will be much more detailed and exhaustive compared to current requirements. Insurers should see this updated package, and the additional clarity it provides, as the much-needed trigger to get their reporting workstreams on track.


Setting margin requirements for non-centrally-cleared derivatives

All derivatives traded by financial institutions that are not centrally cleared should be subjected to margining requirements, as Global regulators make a consorted effort to incentivise centralised clearing in derivatives markets.

A joint working group of the Basel Committee on Bank Supervision (Basel Committee) and the International Organization of Securities Commissions (IOSCO) is proposing to set a floor on margin requirements on all non-centrally-cleared derivatives to reduce systemic risk. The proposals and findings from this working group will heavily influence the G20 regulatory agenda, and in particular the EU's EMIR risk management standards for uncleared trades.

The margin should reflect the generally higher risks associated with these derivatives and thus remove the commercial incentive of having lower or no margin requirements on non-standardised products. The consultation paper sets out three options for applying margins:
  • two way margining with zero thresholds
  • two way margining with a single threshold
  • two way margining with three threshold triggers.
The working group does not set out calculations for particular classes of over-the-counter (OTC) transactions, but it notes the possibility of taking hedging into account. It also contemplates that the national regulators' could require additional buffers to top up baseline requirements when there are macro-economic imbalances.

The working group wants to introduce a universal standard for the treatment of collateral. Initial margin should be exchanged on a gross basis, and held under legally secure arrangements to protect the party posting collateral from an insolvency of the other party. It recommends that cash and non-cash collateral collected as initial margin should not be re-hypothecated or re-used.

In principle, the margin requirement would cover all five major asset classes of derivatives (interest rate, credit, equity, foreign exchange and commodity) and all derivative products (both standardised and bespoke) that are not centrally cleared by a central counterparty for any reason. The U.S. and some other countries are keen to exempt foreign exchange swaps and other short dated (less than one year) derivatives from margin rules. The working group couldn’t agree on this matter. However, agreeing regime’s specificities will not stall progress of the overall reforms; the working group will come back to this matter at a future date.

There was broad consensus that the margin requirements should not apply where non-financial entities (that are not systemically significant) enter into non-centrally-cleared derivatives, given that such transactions (i) are viewed as posing little or no systemic risk and (ii) are exempt from central clearing mandates under most national regimes. However, both the US and EU's derivatives rules apply to non-financial firms.

This discrepancy raises the dangers of regulatory arbitrage --- the working group sees this as a real concern. The effectiveness of margin requirements would be undermined if they are not consistent internationally. Activity could easily flow into low-margin regimes as financial institutions benefit from a competitive advantage over their rivals. Given the interconnected nature of markets and the fallacy of decoupling, a failure in one of these markets could reverberate quickly to other markets causing market volatility or a freezing of bilateral transactions, and undermining market confidence.

Mandatory clearing requirements for all standardised products will come into play by the end 2012 in line with G20 commitments to reduce the systemic risk. However, there is no mandatory clearing requirement for non-standardised/bespoke products. These products will continue to be non-centrally cleared and will remain subject to bilateral counterparty risk management, posing ongoing concerns about systemic risk and contagion.

However, the changes are significant and will change the way in which markets operate. Proposed margin requirements could have a great impact on securities firms regulated under net capital rules, because such rules require firms to deduct all assets that cannot be readily converted into cash and adjust the value of liquid assets by haircuts. To assess the impact of the proposed rules on markets, the Basel Committee is conducting a quantitative impact study (QIS) during the consultation period. The QIS will focus on the liquidity impact arising from gross exchange and segregation of initial margin on non-centrally cleared OTC derivatives that are expected to remain in the market over the next several years. The QIS will engage a significant number of international global derivatives dealers and results will be included in the final proposal later this year.

The consultation closes on Friday 28 September 2012. Full details on how to respond are here.


EBA consults on draft RTS on credit valuation adjustment risk

The European Banking Authority (EBA) continues to flesh out aspects of the Capital Requirements Regulation (CRR)/ Directive IV regime, despite the EU Council, Commission and Parliament (‘trialogue’) failing to secure agreement on the final text of the package of reforms before the summer break.

The EBA’s current draft regulatory technical standards (RTS) on CRR elaborates certain specific elements to the calculation of own funds requirements for credit valuation adjustment (CVA) risk. Under CRR, firms are required to adjust to the risk of loss caused by changes in the credit spread of a counterparty when its credit quality changes. The CVA charge is part of the capital treatment for counterparty credit risk on OTC (bilateral) derivative instruments, so it ties into the discussions on margin requirements for non-standardised products presented above.

The RTS provide details on the determination of a proxy spread and the specification of a limited number of smaller portfolios, which are issues relating to the calculation of the CVA capital charge.

While all draft RTS are subject to change given their very nature, we don’t expect the trialogue negotiations to affect these provisions to any great extent.

The consultation closes on 15 September 2012; the EBA must submit the RTS to the Commission by 1 January 2013.