Draft Regulatory Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a CCP under the Regulation on OTC derivatives, CCPs and Trade Repositories – European Securities and Markets Authority, European Banking Authority, and European Insurance and Occupational Pensions Authority Joint Discussion Paper JC/DP/2012/1 of 6 Mar. 2012; Draft Regulatory Technical Standards on the capital requirements for CCPs under the draft Regulation on OTC derivatives, CCPs and Trade Repositories – European Banking Authority Discussion Paper EBA/DP/2012/1 of 6 Mar. 2012 The process of rewriting the rulebook for the over-the-counter (OTC) derivatives market in Europe continues with the launch of two new consultations by EU regulators. On 6 March, the European Banking Authority (EBA) published a discussion paper on the capital requirements that central counterparties (CCPs) should be required to meet under the recently agreed Regulation on OTC derivatives, central counterparties and trade repositories (Regulation), also known as the European Market Infrastructures Regulation or EMIR.1 On the same day, the EBA, together with the European Securities and Markets Authority (ESMA) and the European Insurance and Occupational Pension Authority (EIOPA), published a joint discussion paper on the risk mitigation techniques required for OTC derivative contracts that are not cleared by a CCP. The supervisory authorities are seeking comments on regulatory technical standards (RTS) that they are required by the Regulation to draft on these topics, which will form the basis of legally binding pan-EU rules.
European Market Infrastructures Regulation
The European Parliament and Council agreed the substance of the Regulation on 9 February, after a long period of negotiations. In 2009, the leaders of the G-20 nations had announced a number of initiatives in response to the financial crisis, including a commitment that all standardised OTC derivative contracts should be cleared through CCPs by no later than the end of 2012.2
Under the new EU regime, among other things, standardised OTC derivative contracts that meet pre-defined eligibility criteria will need to be cleared through CCPs in order to reduce counterparty credit risk. 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. Since an increased amount of counterparty credit risk will be concentrated in CCPs, they will be subject to strict prudential, organisational, and conduct of business standards. The Regulation requires the EBA, ESMA, and the EIOPA (together, European Supervisory Authorities or ESAs) to draft technical standards on a number of issues, including capital requirements for CCPs and risk mitigation techniques for OTC derivative contracts that are not cleared by a CCP. ESMA already published a discussion paper with regard to other technical standards on 16 February.3
Capital Requirements for CCPs
In order to limit a CCP's exposures to counterparty credit risk, the Regulation requires a CCP to collect margins from clearing members, maintain a default fund to which clearing members contribute, and have sufficient dedicated own resources to cover any excess losses in the event of a clearing member's default. Margins posted by a non-defaulting clearing member may not be used to cover losses arising from another clearing member's default, and the dedicated own resources may not be used to meet the CCP's regulatory capital requirements. The Regulation also requires a CCP to maintain additional capital, including retained earnings and reserves, sufficient to mitigate against: (1) credit, counterparty, and market risks arising from its investment and other non-clearing activities; and (2) operational risks arising from all of its activities, including its clearing and non-clearing ones. The preliminary view of the EBA is that a CCP's capital, including retained earnings and reserves, should be maintained at the higher of the following two amounts:
- The CCP's operational expenses during an appropriate time span for winding down or restructuring its activities; and
- The capital requirements for its overall operational risk and for the credit, counterparty, and market risks arising from its non-clearing activities.
The EBA has derived its conclusions from two main sources: (1) the Principles for Financial Market Infrastructures (CPSS-IOSCO Principles),4
which were published for consultation in March 2011 by the Committee on Payment and Settlement Systems (CPSS)5
and the Technical Committee of the International Organization of Securities Commissions (IOSCO); and (2) the Capital Requirements Directive (CRD).6
Principle 15 of the CPSS-IOSCO Principles recommends that a CCP hold sufficiently liquid net assets funded by equity to cover general business losses. The amount should be large enough to ensure an orderly wind-down or reorganisation of critical operations and services over an appropriate time period. These resources are in addition to resources held to cover participant defaults or other risks. In order to avoid double regulation, capital held under international risk-based capital standards should be included as appropriate. The Regulation goes beyond the CPSS-IOSCO Principles in that its minimum capital requirements also take into consideration a CCP's exposure to risk not covered by specific financial resources. The EBA's approach is therefore intended to result in capital requirements that are at least equal to those resulting from the CPSS-IOSCO Principles. The discussion paper also provides recommendations on how CCPs should calculate operational expenses for winding down or restructuring, which would entail an estimate of the time required and take into consideration recent operational expenses and projected or expected events. In the EBA's preliminary view, risk exposures and capital requirements should be calculated using the CRD's approaches for banks. The CRD contemplates three alternative approaches to measure operational risk: the Basic Indicator Approach, the Standardised Approach, and the Advanced Measurement Approach. According to the EBA, CCPs could potentially use any one of these approaches, though some adaptation may be required. The EBA also recommends that CCPs use the Standardised Approach for credit risk and market risk and considers that CCPs could, with the approval of competent authorities, use internal models to calculate capital requirements for credit, counterparty credit, and market risks arising from non-clearing activities. The EBA suggests that CCPs have procedures in place to identify other risks, including business risks, monitor compliance with the clearing requirements on an ongoing basis, and provide quarterly reports to competent authorities. Notification could be required if a CCP's capital falls below a given threshold, in which case the competent authority could impose restrictive measures until capital is restored. Authorities could also require CCPs to hold additional capital if they do not manage their risks.
Risk Mitigation Techniques for OTC Derivatives
In order to address the additional risks that arise from OTC derivative transactions in the absence of central clearing, the Regulation requires:
- Financial counterparties (including banks, insurance companies, UCITS,7 and hedge funds) and non-financial counterparties (NFCs) that exceed a clearing threshold to have procedures in place for the timely, accurate, and appropriately segregated exchange of collateral for non-centrally cleared OTC derivative contracts; and
- Financial counterparties to hold capital that is appropriate and proportionate to the remaining risks that are not covered by the exchange of collateral.
The ESAs are mandated to determine the levels of collateral and capital, the eligible collateral, and the frequency of exchange of collateral required for these transactions. — Collateral Requirements The ESAs recommend that the collateral requirements include at least an exchange of variation margin (VM) collateral by both parties. VM reflects current exposures resulting from actual changes in the value of the relevant transactions, therefore limiting exposures due to market movements between margin calls. The ESAs are considering whether to require counterparties to provide initial margin (IM) collateral as well. IM covers potential future exposures arising from the relevant transaction during the period between the final exchange of margins and the liquidation of the relevant positions. Although the ESAs view IM as the most effective buffer against counterparty risk, the use of IM can constrain liquidity and increase trading costs. The ESAs set forth three potential options for the provision of IM:
- Posting of IM by all counterparties;
- Collection of IM only by prudentially regulated financial counterparties (PRFCs) such as investment firms, banks, and insurance companies; or
- Collection of IM by PRFCs unless exposure is to certain counterparties and below a certain threshold.
IM could be calculated using a standardised approach or, where appropriate, internal models. Where collateral is exchanged, IM would need to be segregated and could not be re-used. In determining what types of collateral would be eligible for VM or IM, the ESAs seek to provide a sufficiently narrow definition that does not unduly constrain liquidity. Two options are proposed:
- Criteria-based collateral requirements as proposed by ESMA for central clearing eligibility;8 or
- A prescribed list of eligible collateral.
In the ESAs' view, collateral should be re-valued daily. To protect against changes in valuation, the ESAs suggest that all parties use standardised haircuts. Alternatively, counterparties meeting minimum requirements could use their own estimates for haircuts. According to the ESAs, counterparties should have appropriate documentation and systems and controls in place for the exchange of collateral. The ESAs are also considering capping the minimum transfer amount below which no collateral is required to be transferred. Although the ESAs are not mandated to outline a third country regime for the exchange of collateral, they note that transactions with non-EU counterparties must be subject to adequate margin requirements and that collateral posted outside the EU must be adequately protected. The ESAs propose that this be achieved through monitoring by the Commission or RTS drafted by ESMA. — Capital Requirements Capital requirements are intended to absorb unexpected losses and to protect firms from becoming insolvent. The ESAs believe that existing capital regimes should be sufficient in the case of PRFCs. They therefore do not propose to introduce new capital requirements for PRFCs in the RTS. Because non-prudentially regulated financial counterparties (NPRFCs) such as UCITS, fund managers, and hedge funds are not subject to capital requirements under their respective regulatory regimes, the ESAs do not consider it appropriate to introduce new capital requirements in the RTS. Instead, NPRFCs and NFCs should cover risks arising from positions in OTC derivatives through adequate exchange of collateral. — International Consistency Many commentators have stressed the importance of aligning international standards on margin requirements for non-centrally cleared derivative transactions in order to avoid regulatory arbitrage.9
The ESAs acknowledge this risk and indicate that they will consider the proposals of international standard setting bodies in this regard. A working group established by IOSCO, CPSS, the Basel Committee for Banking Supervision, and the Committee on the Global Financial System is expected to produce a report on margining standards by mid-2012.
The comment period for both discussion papers ends on 2 April, after which the relevant authorities will publish draft RTS for further consultation. In addition to seeking feedback on the substantive issues, the authorities are requesting input for their required analysis of the costs and benefits of the new provisions. Final RTS must be submitted to the Commission by 30 September, after which they will be endorsed in the form of Commission Regulations and legally binding in all Member States without further implementation.
The final text of the Regulation has not yet been published. For the European Commission's original proposal, see Proposal for a Regulation on OTC derivatives, central counterparties and trade repositories, COM(2010) 484 final
of 15 Sept. 2010. For a summary of the final agreed Regulation, including an overview of changes from the original proposal, see New European rules on Over-the-Counter Derivatives and Market infrastructures – Frequently Asked Questions – Commission Press Release, MEMO/12/91
of 9 Feb. 2012. See also European Parliament and Council Reach Agreement on OTC Derivatives Rules, Bloomberg Law Reports® – UK Financial Services Law, Vol. 4, No. 3
(Mar. 2012). 2
G-20 Leaders' Statement
: The Pittsburgh Summit, 24-25 Sept. 2009 at 9. 3
Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories – ESMA Discussion Paper ESMA/2012/95
of 16 Feb. 2012 (ESMA Discussion Paper). For an overview, see ESMA Commences Rulemaking Process for OTC Derivatives, Bloomberg Law Reports® – UK Financial Services Law, Vol. 4, No. 3
(Mar. 2012). 4
Principles for financial market infrastructures, CPSS & IOSCO Consultative Report
, Mar. 2011. For an overview, see New International Principles for Financial Market Infrastructures, Bloomberg Law Reports® – UK Financial Services Law, Vol. 3, No. 5
(May 2011). The consultation on the proposed principles closed on 29 July 2011, with the expectation that CPSS and IOSCO would publish a final report in early 2012. 5
The CPSS is a committee of the Bank for International Settlements, comprised of representatives of leading central banks, which sets standards for payment and securities settlement systems internationally. 6
The Capital Requirements Directive comprises Directive 2006/48/EC
and Directive 2006/49/EC
, as amended by Directive 2010/76/EU
. On 20 July 2011, the Commission proposed to replace these Directives with a new Directive and Regulation. See Proposal for a Directive on the access to the activity of credit institutions and the prudential supervision of credit institutions and investment firms and amending Directive 2002/87/EC on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate, COM/2011/0453
final of 20 July 2011; Proposal for a Regulation on prudential requirements for credit institutions and investment firms, COM/2011/0452
final of 20 July 2011. 7
Undertakings for collective investments in transferable securities (UCITS) regulated by Directive 85/611/EEC
See ESMA Discussion Paper, supra note 3. 9
For example, in a recent speech, Steven Maijoor, the chair of ESMA, said that differences between U.S. and EU margin requirements for non-centrally cleared foreign exchange (FX) derivative transactions could compromise the G-20's global objectives. See Keynote address of Steven Maijoor, Chair of ESMA, at the AFME Market and Liquidity Conference – Speech ESMA/2012/76
of 8 Feb. 2012. For an overview, see ESMA Chair Provides Insights into Authority's Approach to OTC Derivatives & Other Issues, Bloomberg Law Reports® – UK Financial Services Law, Vol. 4, No. 3