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.
Both EMIR and MiFID II are currently only legislative proposals; they are not yet binding law. The original proposals put forward by the Commission have been developed and amended by different Presidencies of the European Council (which changes every six months), with the latest proposal having been published by the Polish Presidency in July 20117 (Presidency Compromise). MiFID II has also been the subject of extensive consultation by the Committee of European Securities Regulators (CESR) (which on 1 January 2011 was reformed into the European Securities and Markets Authority (ESMA)). Both EMIR and MiFID II were due to be debated by the European Parliament at its plenary sitting in July 2011 but these debates were postponed until September 2011. If the proposals are adopted in September, they will then be returned to ESMA which will have responsibility for drafting technical standards and detailed rules to submit to the Commission by 30 June 2012. The final rules are scheduled to come into force at the end of 2012.
A "financial counterparty" is broadly defined under EMIR and includes:
A "non-financial counterparty" is an EU undertaking other than a financial counterparty.
Under the proposed draft of EMIR:
From a practical perspective, market counterparties entering into transactions on or around the date that EMIR comes into force will need to have already become established as clearing members of a CCP or otherwise have obtained access to a CCP as a client of a clearing member in relation to clearable trades. The Presidency Compromise proposes that there should be a "frontloading"10 requirement, such that transactions entered into on or after the date EMIR comes into force (but prior to the date on which the clearing obligation takes effect) may still be required to be cleared.
EMIR imposes reporting obligations on financial and non-financial counterparties in relation to cleared and uncleared derivatives contracts. The information to be reported would include, at a minimum, the parties to the contract, the beneficiary of the rights and obligations arising from the contract and the main characteristics of the contract (including the type, underlying investment, maturity date and notional value). It is proposed that the information would be published on an aggregate positions basis by derivatives type and made available to ESMA, national regulators and central banks. Reports would be submitted as follows:
The Commission has recognised that the requirement to clear OTC derivatives through a CCP replaces the risk of default by a counterparty with the risk of a default by a CCP. As a result, it is proposed that CCPs would be required to maintain adequate liquidity and meet minimum capital requirements. It is proposed that liquidity may come from central bank liquidity and/or from reliable commercial bank finance. A base capital requirement of €5 million has been proposed for CCPs, although it is anticipated that (based on their risk and exposure profiles) most CCPs will have a capital requirement substantially in excess of this amount – which at all times must be sufficient to ensure an orderly winding-down or restructuring of their activities over an appropriate time span (and which is sufficient to allow the CCP to be adequately protected against operational and residual risks).
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.
Margin is seen by the Commission as the primary line of defence for a CCP providing for credit risk mitigation to a bilateral relationship under a trade. It is intended that the margin collected by a CCP should be sufficient to cover losses that result from at least 99 percent of exposure movements over a specific time.15 It is proposed that margin should be called and collected by a CCP on an intra-day basis and at minimum when pre-defined thresholds are breached.16 Notably, the current draft of the proposed Regulation suggests that "highly liquid" collateral types such as covered bonds, guarantees callable on first demand which are granted by a member of the European System of Central Banks and commercial bank guarantees could be acceptable collateral to a CCP.17
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.
Under the Presidency Compromise, the clearing obligation applies to OTC derivatives only, although this has been the subject of debate.18 The reporting requirement under EMIR would be applicable to cleared and non-cleared derivatives. The overall criteria for determining whether or not a derivative transaction is clearable (and therefore subject to the clearing requirement) includes classes of derivatives which have a degree of standardisation in their contractual terms and operational processes, volume and liquidity and the availability of pricing information in relation to such trades.19
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.
During 2010, CESR provided the Commission with technical advice and information on various MiFID-related issues20 in response to the Commission's formal request for advice and information.21 Although the Commission is not legally obliged to follow this advice, it has nonetheless taken CESR's recommendations into account when undertaking its review of MiFID. Two of the key areas covered in CESR's technical advice are "on market trading" of OTC derivatives and commodity derivatives.
— "On Market Trading" of OTC derivatives
While at present there are no MiFID rules relating to "on market trading" of OTC derivatives, the MiFID Review Consultation, in line with G20 commitments, proposed to require trading of standardised OTC derivatives on exchanges or electronic trading platforms (where appropriate) with all trading in derivatives22 to be required to move to either regulated markets (RMs), multilateral trading facilities (MTFs) or a proposed new sub-regime for organised trading facilities. All these trading venues would have to fulfil the following criteria:
ESMA would also be required to:
— Commodity Derivatives
At present, most commodity firms will be exempt from MiFID requirements where they deal on their own account in financial instruments or provide investment services in commodity derivatives on an ancillary basis (but only where they are not subsidiaries of financial groups). In addition, physically settled forward contracts fall outside MiFID where the delivery is to be made within two trading days (e.g., spot contracts) or the contract (not on a RM or MTF) is entered into with an administrator/operator of an energy transmission grid, energy balancing mechanism or pipeline network.
However, the proposed changes in the MiFID Review Consultation23 suggest that there should be:
As to the last point, the Commission has put forward the following options for position reporting systems:
All parties to a derivatives contract will find that by the end of December 2012 the way that derivatives markets work, both within the EU and globally, will have changed markedly. All standardised OTC derivatives contracts will have to be traded on exchanges or electronic trading platforms; eligible OTC derivatives contracts will have to be cleared through CCPs; OTC derivatives contracts will have to be reported to trade repositories; and, there will be wide-ranging changes to the way that commodity derivatives are regulated. These changes could potentially raise practical and operational issues for market participants as well as incurring substantial set-up costs in preparation for the new requirements. However, before the new EU rules are finalised, there still remains a huge amount of detail to be drafted by ESMA and debated by European legislative bodies, including the Commission and the Parliament.
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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