Official Position on the Required Level of Segregation of Client Accounts of Clearing System Members Managed by a Central Counterparty

1 The Croatian Agency for Supervision of Financial Services (hereinafter: HANFA) has determined the existence of a public interest in adopting an official position, following open questions that arise in practice regarding the interpretation of relevant legal provisions concerning the required level of segregation of client accounts of clearing system members managed by a central counterparty as defined in Article 2(1) of Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (hereinafter: EMIR), and the required level of segregation of related collateral, particularly in relation to pension funds in accordance with the provisions of the Act on Mandatory Pension Funds (Official Gazette Nos. 19/14, 93/15, 64/18, 115/18, 58/20; hereinafter: ZOMF) and the Act on Voluntary Pension Funds (Official Gazette Nos. 19/14, 29/18, 115/18; hereinafter: ZDMF).

Namely, the question arises whether entities supervised by HANFA that are members of a clearing system providing them with clearing services through a central counterparty are obliged to request that their positions and collateral be segregated from other clients of that clearing system member, and in what manner (either by opening individual accounts for clients under Article 39 of EMIR or by opening an omnibus account for a specific sub-category of entities, which would be segregated from the omnibus account on which other clients of that clearing member are located). The next question is, if such an obligation exists, which HANFA-supervised entities it would apply to, and in what manner it is applied.

With the aim of promoting, organizing, and supervising measures for the effective functioning of the financial market in terms of harmonizing the conduct of entities supervised under Article 2(2) of the Act on the Croatian Agency for Supervision of Financial Services (Official Gazette Nos. 140/05 and 12/12), the following is done.

Based on the provision of Article 15(4) of the Act on the Croatian Agency for Supervision of Financial Services, HANFA adopted on the session of the Board of Directors held on November 17, 2021

OFFICIAL POSITION

I. Article 39 of EMIR defines the concepts of segregation and portability (separation and transferability) in relation to the accounts of clearing system members and the accounts of their clients. Article 39 of EMIR sets the minimum level of segregation that a central counterparty must offer to its members, as well as the minimum level of segregation that members must offer to their clients. Segregation refers to the segregation of client positions and the segregation of related collateral. The possibility of implementing the provisions on the portability of client accounts and related positions and collateral under Article 48(5), (6), and (7) of EMIR, in the event of non-compliance by a clearing system member, will depend on the chosen level of segregation.

The obligations of the central counterparty under Article 39 of EMIR are to:

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• maintain separate records and accounts, thereby enabling it to distinguish at any time and without delay in the accounts held with the central counterparty the assets and positions held for the account of one clearing system member from the assets and positions held for the account of any other clearing system member and from its own assets;
• offer the maintenance of separate records and accounts, thereby enabling each clearing system member to distinguish in the accounts held with the central counterparty the assets and positions of that clearing system member from the assets and positions held for the account of its clients (omnibus accounts for clients);
• offer the maintenance of separate records and accounts, thereby enabling each clearing system member to distinguish in the accounts held with the central counterparty the assets and positions held for the account of a specific client from the assets and positions held for the account of other clients (individual accounts for clients);
• upon request, offer clearing system members the possibility of opening multiple accounts in their own name or for the account of their clients;
• publicly disclose the levels of protection and costs associated with the different levels of segregation offered, which includes a description of the main legal implications of individual levels of segregation as well as information on the applicable insolvency law in the relevant jurisdictions;
• provide these services under acceptable commercial terms.

The obligations of a clearing system member under Article 39 of EMIR are to:

• maintain separate records and accounts that enable it to distinguish, both in accounts held with the central counterparty and in its own accounts, its own assets and positions from the assets and positions held for the account of its clients with the central counterparty.
• offer its clients, at least, a choice between omnibus client account segregation and individual client account segregation, and inform clients about the costs and levels of protection associated with each of these options;
• publicly disclose the levels of protection and costs associated with the different levels of segregation offered, which includes a description of the main legal implications of individual levels of segregation as well as information on the applicable insolvency law in the relevant jurisdictions;
• provide these services under acceptable commercial terms.

In other words, the minimum requirement under EMIR is that at the level of the central counterparty, at least three types of accounts must be mandatorily established and maintained: a) the clearing system member's own account, on which the positions and assets of the member itself are located; b) an omnibus account on which the positions and assets of multiple clients of the clearing system member are located. This type of account enables the distinction between the positions and assets of the clearing system member itself and the positions and assets of its clients, but not between clients located on the same account; c) an individual account on which the positions and assets of an individual client are located. This type of account enables the distinction between the positions and assets of the member itself and those of its clients, as well as between the positions and assets of the clients themselves.

Each account has the following associated sub-accounts:

• a collateral account, which serves for the record of cash funds and financial instruments provided as collateral.

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• a position account, which serves for the calculation of accrued obligations (monetary obligations and quantities of financial instruments) and obligations arising from the payment of required collateral.

A central counterparty may offer other types of accounts or segregation, for example, gross-based omnibus accounts or direct client memberships, but there is no regulatory obligation for this, and it will depend on market needs and demand from clearing system members and their clients.

In any case, in accordance with Article 39(9) and (10) of EMIR, the requirement for distinguishing assets and positions in accounts at the central counterparty is met when:

• assets and positions are booked on separate accounts;
• netting of positions booked on different accounts is prevented;
• assets encompassing positions booked on one account are not exposed to losses associated with positions booked on another account, with the term "assets" referring to collateral held to cover positions and including the right to transfer assets equal to that collateral or proceeds from the realization of any collateral, but not including contributions to the default fund.

II. EMIR in Article 39(5) leaves the choice between these types of segregation to the client, and the client confirms its choice to the clearing system member in writing. As previously stated, the clearing system member is obliged to explain to the client the levels of protection and costs associated with the different levels of segregation offered, which includes a description of the main legal implications of individual levels of segregation as well as information on the applicable insolvency law in the relevant jurisdictions. Based on this explanation, as well as on other information relevant to the individual client, each client makes a decision on the level of segregation required for them.

First of all, it is noted that there are significant differences in the rights and obligations arising for clients of a clearing system member, depending on whether the client uses an omnibus or individual account. The difference in risk levels of a particular type of account can be particularly evident in the case of business transfer under Article 48 of EMIR.

Omnibus accounts always carry a higher level of risk for the client:

• Each client is subject to the risk of other clients on such an omnibus account because the assets of multiple clients are held on this type of account. While the client is protected from losses and risks of the clearing system member managing the account for them, they are not protected from losses and risks of other clients within the omnibus account. Namely, all client positions within the omnibus account (if it is managed on a net basis) are netted against each other, and it is not possible to limit the loss of one client solely to themselves. The same applies in the case of collateral liquidation. Collateral of clients segregated in accordance with Article 39(2) and (3) of EMIR is used exclusively to cover positions held for their account, and in the case of omnibus accounts, the collateral of all clients on that account is used, regardless of which client's position the loss arose from.
• The clearing system member to whom business transfer is carried out under Article 48 of EMIR must, before the start of the business transfer, accept all positions and assets on such an omnibus account, and the omnibus account can be transferred to the member to whom business transfer is carried out only as an omnibus account, not as an individual one. All clients on the omnibus account must agree to such a transfer, which complicates or completely prevents the transfer of the omnibus account, meaning that in the event that the clearing system member on which the account is held enters a state of non-compliance, and the central counterparty initiates a process of settlement and exclusion against that

4 member, the central counterparty will likely then liquidate the client's omnibus account, for which the collateral associated with such an account will be used.

• Since collateral in omnibus accounts is managed on a net basis (gross-based omnibus accounts are currently not offered by the central counterparty in the Republic of Croatia), and since the central counterparty does not have information on which collateral belongs to which client, nor can it distinguish client positions within the omnibus account, the collateral of individual clients within the same omnibus account may be used to cover losses from positions of other clients on the same account.
• The liquidation of an omnibus account may cause other losses to clients located on it related to market conditions at the time of liquidation, as well as increased costs related to the liquidation costs of other clients' positions within the same account.
• If a positive balance remains on the account after the liquidation of the omnibus account, clients can receive such a "surplus" only through their clearing member (which may potentially be in bankruptcy), because the central counterparty, in accordance with Article 48(7) of EMIR, is obliged to fulfill the obligation to the client of the clearing system member for the client's position account only if the client is known to it (this is usually not the case with omnibus accounts) and if all data for the execution of delivery/payment have been provided.
• Business transfer implies the transfer of assets and positions that a non-compliant clearing system member (a member for whom exclusion proceedings are ongoing) holds for the account of its clients to another clearing system member (the member to whom business transfer is carried out). In the case of an omnibus account, this means that all clients of the member for whom exclusion proceedings have been initiated must agree to the transfer to the member to whom business transfer is carried out. Given the short timeframes available for carrying out the business transfer process, in the case of a client with an individual account, the central counterparty will simply identify the client, whereas in the case of an omnibus account, this will be much more difficult, if not impossible.
• Unlike omnibus accounts, in the case of individual accounts, Article 39(6) of EMIR stipulates that any amount of compensation exceeding the requirements of the (individually segregated) client is also booked with the central counterparty and segregated from the compensation amounts of other clients or clearing system members and is not exposed to losses associated with positions booked on another account. In accordance with the ESMA EMIR Q&A document (ESMA EMIR Q&A)1, this imposes an obligation on members to ensure that any amount of collateral collected for individual client accounts that exceeds the required margin value or is returned to the client or booked with the central counterparty, thereby achieving an additional level of protection for individual accounts.

These examples of the higher level of risk associated with omnibus accounts are not exhaustive, and are currently based on the differences between a "classic" omnibus account with full netting of all client positions and an individual client account. Each HANFA-supervised entity as a client of a clearing system member is obliged to independently assess the risks carried by a particular level of segregation, including in the case of account structures and memberships not explicitly described in this official position, but offered by their clearing system members or central counterparties whose services they use.

1 Available at: https://www.esma.europa.eu/file/112409/download?token=3ccaU9P7, we refer to CCP question no. 8, sub-point (n).

5 III. As previously stated, EMIR does not impose an obligation on any category of clients to choose individually segregated accounts, but gives them this option, in accordance with their needs or other regulatory obligations.

However, when it comes to investment firms and credit institutions that, as clients of clearing system members, provide indirect clearing services to their clients, in accordance with the provisions of Articles 4 and 5 of Commission Delegated Regulation (EU) No 149/2013 of 19 December 2012 supplementing EMIR with regard to regulatory technical standards on indirect clearing arrangements, clearing obligations, public registers, access to trading venues, non-financial counterparties, and risk mitigation techniques for OTC derivative contracts not cleared through a central counterparty (hereinafter: Commission Delegated Regulation (EU) No 149/2013), such clients must mandatorily offer their clients a choice (Article 4(2)): a) an omnibus account with assets and positions that, as a client of a clearing system member, they hold for the account of their indirect clients; b) an omnibus account with assets and positions that, as a client of a clearing system member, they hold for the account of their indirect clients, and on which the clearing system member ensures that the positions of the indirect client are not netted against the positions of another indirect client and that the assets of the indirect client cannot be used to cover the positions of another indirect client.

Thus, in cases of indirect clearing, HANFA-supervised entities that are clients of clients of clearing system members do not have a choice between omnibus and individual accounts, but between two categories of omnibus accounts, as previously described. Clients who are HANFA-supervised entities offering such services to their clients and their clearing members are not obliged to offer individual segregation levels to their indirect clients. In accordance with Article 5(3) and (4) of Commission Delegated Regulation (EU) No 149/2013, a client providing indirect clearing services maintains separate records and accounts that enable it to distinguish its own assets and positions from those held for the account of its indirect clients. If the assets and positions of several indirect clients are held by a clearing system member on an account under Article 4(2)(b), the client is obliged to provide the clearing system member daily with all information necessary for the clearing system member to determine the positions held for the account of each individual indirect client.

Apart from this separate regulation for indirect clearing, which provides an exception to the mandatory offer of individual segregation, EMIR does not determine what type of account a client must have.

However, whether there is an obligation to apply a higher level of segregation for certain types of clients or HANFA-supervised entities (either individual for direct clients, or separate omnibus account for indirect clients) will depend primarily on their sectoral basic regulations, and on the level of systemic significance of such supervised entities.

IV. When assessing the levels of segregation under Article 39 of EMIR that would be appropriate for them, and choosing the appropriate level of segregation, HANFA-supervised entities are obliged to take into account at least:

• the previously described level of risk, levels of protection, and costs associated with the different levels of segregation offered by clearing system members and central counterparties;
• regulatory requirements imposed on supervised entities by the legal framework directly governing their establishment and operation;
• whether it is trading for the own account of the supervised entity or trading for the account of the supervised entity's clients, or for the account of funds managed by them or portfolios/products for which services are provided;
• whether the clearing system member is provided with collateral necessary to cover the risks of their positions from their own funds and/or from the funds of their clients, funds managed by them, or portfolios/products for which they provide services, or if the collateral requirement is covered by the clearing system member itself;
• whether the HANFA-supervised entity is a direct or indirect client.

Regarding different HANFA-supervised entities, which are clients of clearing system members or clients of clients of clearing system members, a brief overview of their obligations and options is provided below, as well as non-binding recommendations from HANFA in cases where there is no obligation to apply a higher level of segregation:

a) Investment firms and credit institutions as clients of a clearing system member offering indirect clearing services to their clients must offer them a choice between the two categories of omnibus accounts listed in Article 4(2) of Commission Delegated Regulation (EU) No 149/2013.

b) When trading for their own account, investment firms, investment fund management companies, pension companies, pension insurance companies, insurance companies, reinsurance companies, leasing companies, factoring companies, and other HANFA-supervised entities, as clients of clearing members or as indirect clients, are not obliged to choose an individual level of segregation, provided they are obliged to perform an internal risk assessment of the risks caused by omnibus level segregation, which they are obliged to document internally. If a HANFA-supervised entity, depending on the size of its portfolio, related levels of collateral, and characteristics of instruments in that portfolio, assesses that omnibus level segregation would cause significant risks, it is obliged to internally document how it will manage such risks, and consider the possibility of choosing an individual level of segregation or the level of omnibus segregation under Article 4(2)(b) of Commission Delegated Regulation (EU) No 149/2013, where applicable. HANFA notes that in this case, it will be an assessment of each individual HANFA-supervised entity, which will be carried out as part of their internal risk management system. HANFA's non-binding recommendation is certainly that in the case of supervised entities with larger portfolios, especially in OTC derivatives trading, if possible and cost-effective, the choice of a segregation level with a higher level of protection should be considered (which appropriate higher level depends on the internal assessment of the supervised entity). This particularly applies to (re)insurance companies when investing technical reserve assets.

c) When it comes to transactions concluded and cleared for the account of publicly offered open-ended investment funds (UCITS funds) or alternative investment funds, managed by UCITS fund management companies (DZU) or alternative investment fund management companies (UAIF), DZU and/or UAIF for UCITS funds or AIFs managed by them are not obliged to choose an individual level of segregation, provided they are obliged to perform an internal risk assessment of the risks that omnibus level segregation may cause for the funds they manage, especially for UCITS funds, which they are obliged to document internally. If DZU or UAIF, depending on the size of the portfolios of funds they manage, related levels of collateral, and characteristics of instruments in that portfolio, assesses that omnibus level segregation would cause significant risks for the funds they manage, it is obliged to internally document how it will manage such risks, and consider the possibility of choosing an individual level of segregation or the level of omnibus segregation under Article 4(2)(b) of Commission Delegated Regulation (EU) No 149/2013, where applicable. DZU or UAIF may also, instead of an individual level of segregation for each individual investment fund they manage, request the clearing system member to open one omnibus account for all investment funds with which that DZU or UAIF manages, in such a way that investment funds would not be exposed to the risks of positions of other clients of the clearing system member. HANFA notes that in this case, it will be an assessment of each individual DZU and UAIF, which will be carried out as part of their internal risk management process, and which will depend on the characteristics of the funds they manage, and in the case of AIFs with private offers, potentially also on investor instructions (e.g., supervisory board, where applicable, which depends on the rules and other documentation of each fund). When the required amount of compensation to cover the position accounts of funds is financed from the assets of the funds they manage, the DZU or UAIF is obliged to maintain internal records of how, in what amount, and from the assets of which fund this coverage was secured, and ensure that the assets of one fund do not finance the claim for compensation arising from the positions of another fund, unless such use of the fund's assets is permitted by law and the prospectus or rules of the fund. HANFA's non-binding recommendation is certainly that in the case of funds with more active and larger portfolios, especially in OTC derivatives trading and for UCITS funds, if possible and cost-effective, the choice of a segregation level with a higher level of protection should be considered, for example, by segregating all investment funds managed by the DZU onto one separate omnibus account. Furthermore, DZU or UAIF should not conduct or clear transactions for their own account through such separate accounts on which the positions and collateral of the funds they manage are located. When it comes to indirect clients, the non-binding recommendation is also to choose the one with a higher degree of protection from the two categories of omnibus accounts listed in Article 4(2) of Commission Delegated Regulation (EU) No 149/2013.

In transactions of OTC derivatives concluded for the account of UCITS funds, attention is also drawn to the limitations arising from Article 254(1)(3) of the Act on Open-Ended Investment Funds with Public Offer (Official Gazette No. 4/16, 126/19, and 110/21; hereinafter: ZOIFJP), which limits the exposure of a UCITS fund to one counterparty in OTC derivative transactions to no more than: a) 10% of the net asset value of the fund, if the other counterparty is a credit institution under Article 252(1)(4) of ZOIFJP, or b) 5% of the net

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