Firms implementing re-use, re-pledge or re-hypothecation of initial margin as an essential component of their business models will have to reconsider strategies. Collateral transformation services may also be affected.
Under EMIR rules, re-hypothecation, re-pledge or otherwise re-use of the collateral collected as initial margin is proposed to be forbidden.
Consultation Paper of 14 April 2014 "Draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012" (JC/CP/2014/03) explains the said restriction is intended to mitigate the risk in the case the counterparty, to which initial margin has been posted, defaults.
The BCBS-IOSCO report has also been cited, which presented the following argumentation:
“The risk would be exacerbated if the counterparty re-hypothecates, re-pledges or re-uses the provided margin, which could result in third parties having legal or beneficial title over the margin, or a merging or pooling of the margin with assets belonging to the others as a result of which the firm’s claim to the margin becomes entangled in legal complications, thus delaying or even denying the return of re-hypothecated / re-used assets in the event that the counterparty defaults."
As the above Consultation Paper further elaborates, the BCBS-IOSCO, in order to achieve a delicate balance between allowing some flexibility and still preserve the efficiency of the initial margin framework has permitted each jurisdiction to allow if they deem it necessary a limited re-use of initial margin under strict conditions.
However, the implementation of those conditions leads to multiple legal and technical difficulties, such as the requested degree of insolvency protection of the initial posting counterparty (i.e. the “customer”) taking into account the diversity of insolvency laws, the return of the collateral from the third counterparty to the initial posting counterparty in case the collecting party defaults, or the one-time re-use of cash collateral.
The European Supervisory Financial Authorities have therefore considered it appropriate to propose a full ban of the re-use of initial margin in the European Union.