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Christopher Bernard | Bloomberg Law EP-Council deal on rules for a safe and transparent derivatives market, European Parliament Press Release, 9 Feb. 2012; New rules will increase transparency and safety in derivatives trading – European Council Press Release, 9 Feb. 2012. The European Parliament and Council announced on 9 February that they had reached agreement on the regulation of over-the-counter (OTC) derivatives in the EU, after a long period of negotiations. The rules will require all trades in OTC derivatives to be cleared through central counterparties (CCPs) in order to reduce counterparty credit risk, and all derivative contracts, not just OTC derivatives, will be reported to trade repositories in order to increase transparency. The legislation will also give the European Securities and Markets Authority (ESMA) responsibility for the registration and oversight of trade repositories and the ability to resolve disputes between Member States regarding the authorisation of CCPs. This agreement brings the EU one step closer to meeting the 2009 commitment of the G-20 nations that all OTC derivatives transactions should be centrally cleared and reported by the end of 2012. However, much remains to be done to achieve that goal.
The European Market Infrastructure RegulationAfter the collapse of Lehman Brothers in 2008, it was widely accepted that the opacity of the OTC derivatives market had contributed to a build-up of systemic risk and exacerbated the global financial crisis. In September 2009, the leaders of the G-20 nations announced a number of initiatives in response to the crisis, including a commitment that all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms and cleared through CCPs by no later than the end of 2012, and that all OTC derivative contracts should be reported to trade repositories.1 In September 2010, following extensive consultation, the European Commission published a proposal to promote safer and more transparent OTC derivatives markets by introducing new requirements for CCP clearing of standardised OTC derivative contracts and the reporting of OTC derivative contracts to trade repositories.2 Similar measures were enacted in the U.S. a few months earlier under the Dodd-Frank Wall Street Reform and Consumer Protection Act. Known as the European Market Infrastructure Regulation, or "EMIR," the Commission's proposal then passed to the European Parliament and Council for their consideration under the co-decision procedure. As a regulation, EMIR will apply directly once it becomes effective without requiring implementation by individual Member States. Since its initial proposal by the Commission, EMIR has been the subject of heated debate. During that time, a number of compromise proposals have been published.3 While the final agreed draft has not yet been released, initial indications are that it has changed from the Commission's original version in several important ways.4
Central Counterparty ClearingUnder EMIR, standardised derivative contracts that meet pre-defined eligibility criteria will need to be cleared through CCPs. Contracts that are not cleared through CCPs, either because the contract is not eligible or because one of the parties is not subject to a clearing obligation, will trigger additional risk mitigation requirements, including being marked-to-market on a daily basis and the exchange of additional collateral. Two approaches will be followed to determine which contracts must be cleared:
Interoperability & Access to Trading VenuesAs originally proposed, CCPs will need regulatory approval before entering into interoperable agreements and must implement satisfactory systems and procedures to manage the additional risks. These provisions will extend only to cash securities. In addition, the agreed text provides that CCPs will have a right of access to transactions traded on a venue of execution. While this new provision could result in a venue being cleared by several CCPs, the Commission notes that it does not mean that interoperability agreements may be implemented between those CCPs.
Authorisation and Supervision of CCPsOne of the most hotly contested elements was the role that ESMA will play in the authorisation of CCPs. Under the original proposal, a CCP would be authorised by the competent authority of the Member State where it is established, provided it meets the requirements of EMIR. Because the authorisation would be effective throughout the EU, the home country regulator would co-operate with ESMA and with a college of competent authorities and central banks from other relevant Member States during the authorisation process. This framework has been retained in the agreed version of the Regulation. In the event that public authorities have legitimate concerns regarding the authorisation of a CCP, a mechanism has been added to the Regulation whereby those authorities can raise their concerns and, to the extent necessary, ask ESMA to take a final decision through a binding mediation procedure. Host authorities will not be able to request binding mediation against the home country authority's opinion unless all host authorities unanimously agree to do so or at least two-thirds of the host authorities are concerned with the proposed authorisation and agree to request mediation. As originally proposed, national regulators will be responsible for supervising the CCPs established in their jurisdictions, supported by ESMA and the college of authorities.
Trade Repository ReportingThe rules will require detailed information regarding OTC derivative contracts to be reported to trade repositories, which will make the data available to national supervisors. Trade repositories will also be required to publish aggregate positions by class of derivatives so that all market participants can access the information. In order to protect commercially sensitive information, trade repositories will not be required to publish trade level data. Whereas the original draft only required reporting of OTC derivative contracts, this obligation will now apply to listed derivatives as well. ESMA will be responsible for the registration and supervision of trade repositories across the EU. In order to be eligible for registration, trade repositories will need to meet a number of criteria, including strict standards intended to ensure the confidentiality, integrity, and protection of the information that they receive.
Covered Classes of OTC DerivativesCurrently, EMIR applies to all classes of OTC derivative contracts, including commodity derivatives and foreign exchange. However, the Commission has indicated that this may change if necessary to achieve global consistency.
Eligible CounterpartiesThe clearing and reporting requirements will apply to financial firms such as banks, insurance companies, and funds, as well as to non-financial firms that have large positions in OTC derivatives, with some limited exemptions:
Operational RiskThe Regulation will require the terms of OTC derivative contracts to be confirmed on a timely basis by electronic means. This will enable counterparties to net the transaction against other transactions and ensure accurate book-keeping, thereby reducing operational risk.
Third Country CCPs & Trade RepositoriesIn order to operate within the EU, a third country CCP will need to be recognised by ESMA. This will require satisfaction of the following conditions:
Next StepsThe European Parliament now needs to vote on the rules, after which the Council will need to formally adopt the Regulation. At that point, the Regulation will appear in the Official Journal and enter into force. ESMA is currently required to submit draft regulatory technical standards to the Commission by 30 June 2012. On 17 January, a group of financial industry associations published a joint letter addressed to the three main EU institutions in which they questioned the authority's ability to meet that deadline. The chair of ESMA expressed similar concerns in a recent speech.5 The rules will also need to be harmonised with those of the U.S. and other countries. EU regulators still have a lot to do. DisclaimerThis document and any discussions set forth herein are for informational purposes only, and should not be construed as legal advice, which has to be addressed to particular facts and circumstances involved in any given situation. Review or use of the document and any discussions does not create an attorney-client relationship with the author or publisher. To the extent that this document may contain suggested provisions, they will require modification to suit a particular transaction, jurisdiction or situation. Please consult with an attorney with the appropriate level of experience if you have any questions. Any tax information contained in the document or discussions is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. Any opinions expressed are those of the author. The Bureau of National Affairs, Inc. and its affiliated entities do not take responsibility for the content in this document or discussions and do not make any representation or warranty as to their completeness or accuracy.©2014 The Bureau of National Affairs, Inc. All rights reserved. Bloomberg Law Reports ® is a registered trademark and service mark of The Bureau of National Affairs, Inc.
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