By Ron Feldman and Neil Robson, Schulte Roth & Zabel International LLP
The recent financial crisis and the failures of Bear Stearns in March 2008 and AIG and Lehman Brothers in September 2008 have focused regulators’ interest on over-the-counter (OTC) derivatives. Particular attention has been given to the deficiencies in OTC derivatives markets regarding the way in which counterparty credit risk is managed1 and the lack of transparency which the European Commission believes may lead to a lack of liquidity and, potentially, limit regulators’ ability to monitor risks in those markets.2
During the G20 summit in Pittsburgh in September 2009, it was agreed by the G20 nations3 that OTC derivatives transactions should be cleared through central counterparties (CCPs) by the end of 2012 and that such transactions should be reported to trade repositories. Following this commitment, the Commission proposed in September 20104 a Regulation on Derivatives Transactions, Central Counterparties and Trade Repositories (also known as the European Market Infrastructure Directive (EMIR or the Regulation)), together with parallel legislative proposals to revise MiFID5 (the revisions are known as MiFID II) which followed in December 2010.6 Together, EMIR and MiFID II form a core part of the overall strategy of the Commission to harmonise financial regulation and is set substantially to change EU market practices within the backdrop of other global initiatives such as the Dodd-Frank Wall Street Reform and Consumer Protection Act in the U.S.
The proposed Regulation sets out the framework for a qualifying CCP with the relevant regulator in each Member State to be responsible for authorising CCPs established and operating in their jurisdiction.12 However, it is also proposed that a CCP established outside the EU (a third country CCP) may provide clearing services to EU clients if: 1) it meets certain conditions and is recognised by ESMA;13 and, 2) ESMA has entered into a co-operation agreement or recognition arrangement with the third country CCP’s regulator.
However, the concentration of risk in a CCP does raise a question as to whether EMIR will create new entities that might themselves become "too big to fail." The proposed Regulation mentions that where a CCP risks insolvency, the ultimate fiscal responsibility may lie with the Member State in which it is established.14 This could potentially lead to Member States with a large number of CCPs established within their territory (such as the UK) taking greater CCP counterparty risk and responsibility than other Member States.
However, under current bilateral arrangements between OTC derivative counterparties, collateral is called based on negotiated collateral terms which are typically documented under a Credit Support Annex (CSA) to the International Swaps and Derivatives Association's Master Agreement governing OTC derivatives transactions. The proposals in EMIR would therefore change the way that counterparties operate and the terms in place between them in relation to transactions which are cleared by a CCP. For example, under a CSA a better capitalised and larger counterparty might be able to negotiate a "one-way" arrangement under which it receives, but does not post, collateral to its counterparty. However, for cleared trades, under the proposed Regulation, both sides of the transaction would have to meet more stringent and more frequent collateral requirements which would be exposure-based rather than dependent on bilateral negotiations, as is currently the case.
Some market counterparties might face the operational complexity of managing both cleared and uncleared collateral arrangements. This could potentially mean an expense to such institutions which will either need to dedicate resources to build their own systems or source a third party generic system to do the same. Alternative Investment Funds (AIFs) which are required by the AIFM Directive to maintain a depositary may potentially find that they are being required to make frequent movements of margin between the depositary and the CCP. This could add a layer of operational concerns such as system connectivity or ensuring that a margin call is met on time, which AIFs might need to consider in relation to cleared transactions.
In preparing the technical standards, ESMA will also be required to take into consideration whether more than one CCP already clears the same class of derivatives and the ability of the relevant CCP to handle the expected volume of trading.
Derivative types which might be captured could include rates and credit derivatives. The potential positive commercial impact on the market in relation to transactions subject to the clearing requirement could be an increase of volume. However, it remains to be seen whether or not the posting of margin to a CCP (and therefore the inability of counterparties to rehypothecate such margin in relation to cleared transactions) would have an adverse effect on the liquidity of certain collateral types.
— "On Market Trading" of OTC derivatives
— Commodity Derivatives
However, the proposed changes in the MiFID Review Consultation23 suggest that there should be:
Ron Feldman is a senior associate in the Structured Products & Derivatives Group in the London office of Schulte Roth & Zabel LLP. The main areas of his practice area are the negotiation of prime brokerage and custody documentation and advising and negotiating derivatives and structured products transactions. With global prime brokers, Ron has experience negotiating all forms of derivative, trading and prime brokerage agreements. He also has experience structuring and negotiating structured products transactions and derivatives agreements on behalf of private investment funds and other financial institutions. Telephone: +44 (0) 20 7081 8027; E-mail: email@example.com.
Neil Robson is a senior associate in the London office of Schulte Roth & Zabel LLP. He has extensive experience providing regulatory advice to funds and managers regarding: FSA authorisation and compliance; cross-border issues in the financial services sector; market abuse; anti-money laundering and regulatory capital requirements; formations and buyouts of financial services groups and structuring and marketing of investment funds; agreements with customers; custodians and services providers; and, outsourcing arrangements. Telephone: +44 (0) 20 7081 8037; E-mail: firstname.lastname@example.org.
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