The financial crisis has brought derivatives to the forefront of regulatory attention. In 2009, the G-20 leaders agreed that all standardized over-the-counter (OTC) derivative contracts should be traded on exchanges and cleared through central counterparties by the end of 2012. In CapLaw-2010-47, we gave an overview of the pending initiatives to regulate OTC derivatives in the EU. Since then, some significant developments have occurred. This article provides an update on the pending initiatives to regulate OTC derivatives in the EU.
By Thomas Werlen / Stefan Sulzer (Reference: CapLaw-2012-16)
In the wake of the financial crises, the G-20 leaders agreed in Pittsburgh in September 2009 that all standardized over-the counter (OTC) derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by the end of 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non centrally cleared contracts should be subject to higher capital requirements. In fall 2009, the European Commission announced that it would come forward with comprehensive proposals to regulate the OTC derivative markets. On 11 February 2010, European Parliament member Werner Langen published a draft report on the OTC derivative reforms. The Langen Report supported the European Commission’s aims to reduce default risk, to reduce operational risk, to increase transparency and to enhance market integrity and oversight. On 15 September 2010, the European Commission published its proposal for a regulation on OTC derivatives, central counterparties and trade repositories, commonly referred to as the European Market Infrastructure Regulation or EMIR. In the US, the Dodd- Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) of July 2010 has a similar scope of application. Title VII of the Dodd-Frank Act contains parallel provisions requiring the reporting of OTC derivative contracts and the central clearing and exchange trading of eligible contracts. It also puts in place strict capital and collateral requirements for OTC derivatives that remain bilaterally cleared.
On 24 May 2011, the European Parliament’s Economic and Monetary Affairs (ECON) Committee passed a number of amendments to the European Commission’s proposal and the European Parliament approved the ECON Committee text on 5 July 2011. On 4 October 2011, the Finance Ministers of the 27 Member States, sitting as the Council Committee on Economic and Financial Affairs (ECOFIN), approved a final version of their amended text. Under the ordinary legislative procedure, representatives of the European Commission, the European Parliament and the European Council engaged in tri-party negotiations (known as trilogues) to seek agreement on a common text of EMIR. On 9 February 2012, agreement was reached on the EMIR text (the final text was published on 19 March 2012 and is available under http://register.consilium.europa.eu/pdf/en/12/st07/st07509-re01.en12.pdf. The European Parliament approved the agreed text of the EMIR on 29 March 2012 and it will now pass to the European Council for its consideration and approval.
The objectives of the EMIR are to increase transparency in the OTC derivatives market and to make it safer by reducing counterparty credit risk and operational risk. To increase transparency, the EMIR requires that (i) detailed information on OTC derivative contracts entered into by EU financial and non-financial firms are reported to trade repositories and made accessible to supervisory authorities (if no trade repository is available, details must be reported to the European Securities and Markets Authority—ESMA), and that (ii) trade repositories publish aggregate positions by class of derivatives accessible to all market participants. Details of a reportable derivative contract include the parties to the contract, the rights and obligations of the contract, the type of contract, the underlying maturity, the notional value, the price and the settlement date. In the course of the negotiations the scope of the proposal has been widened to cover the reporting of both listed (i.e. non-OTC) and OTC derivatives. Along with the reporting obligation, all counterparties must keep records of the details that would be required to be reported for at least five years following termination of the contract.
To reduce counterparty credit risk, the EMIR introduces (i) stringent rules on prudential, organizational and conduct of business standards for central counterparties (CCPs), (ii) mandatory CCP-clearing for contracts that have been standardized, and (iii) risk mitigation standards for contracts not cleared by a CCP. The procedure for granting CCP authorization has been a particularly contentious issue among the Member States in the European Council. The agreed procedure is that a CCP will submit applications for authorization to the competent authority of the jurisdiction in which they are established. The competent authority then forwards the application to a college of regulators, comprising of the competent authorities for the CCP, the largest clearing members, venues of currencies of the financial instruments cleared and ESMA. The college conducts a risk assessment of the CCP, prepares a report on that assessment and then issues a simple majority opinion on whether the CCP meets the requirements of the EMIR and should, thus, receive authorization. The CCP’s competent authority is required to consider the opinion of the college and, where it disagrees with the opinion, must give a fully reasoned written account of its decisions and why it disagrees with the college’s opinion. What has been particularly contentious during trilogue negotiations is the ability for the college, on a unanimous vote, to block the authorization. It is feared that such powers could be used for political motives and many of the Member States have feared that existing, nationally important CCPs could be prevented from gaining necessary authorization. Where this power is exercised, the college must provide a fully reasoned opinion on why the CCP does not meet the requirements of the EMIR and the CCP’s home competent authority may seek ESMA intervention to help settle any dispute. Where two thirds of the college members disagree with granting the CCP authorization, they may also seek ESMA’s help in reaching a settlement. A CCP authorization is effective throughout the EU. As a condition of authorization, CCPs must have permanent and available capital of at least EUR 7.5 million and otherwise have capital proportionate to the risks stemming from their activities. CCPs will be required to impose, call and collect margin from clearing members to cover potential exposures between the date of default of a clearing member up until the liquidation of the positions, covering at least 99% of exposure movements over an appropriate time horizon. Positions will be collateralized at least on a daily basis and be regularly monitored. Counterparties within the scope of the EMIR will be subject to the clearing obligation for OTC derivative contracts. Counterparties must clear those eligible contracts with either an authorized EU-regulated CCP or a third-country recognized CCP that is granted permission to clear derivatives. The clearing obligation applies not only to trades between EU counterparties, between an EU counterparty and a third country counterparty, but also to trades between two non-EU counterparties where the contract has a direct, substantial and foreseeable effect within the EU or it is necessary or appropriate to prevent the evasion of any provisions of EMIR.
Finally, to reduce operational risk, the EMIR requires that counterparties ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk, including the use of electronic means for the timely confirmation of the terms of OTC derivatives contracts. This allows counterparties to net the confirmed transaction against other transactions and ensure accurate book keeping. Counterparties are also required to have risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral.
The EMIR provides for some limited exemptions from clearing and reporting requirements, including exemptions for (i) contracts by non-financial firms below a clearing threshold (commercial and treasury hedging activities will not count towards the threshold), (ii) financial institutions involved in the management of public debt, (iii) pension funds, and (iv) intra-group transactions because requiring clearing of intra-group transactions could substantially increase the capital and liquidity required by firms that centralize risk management in certain entities as well as increase operational complexity.
It is expected that the EMIR will be published in the Journal of the European Union and enter into force some time in the second quarter of 2012. However, this does not mean that the entirety of the regulation starts applying as there is a need to finalize binding technical standards first. On 6 March 2012, ESMA invited stakeholders to provide comments on proposed technical standards to implement the EMIR. The deadline for comments was 2 April 2012 (the proposed technical standards are available under http://www.eba.europa.eu/ cebs/media/ aboutus/News%20and%20Communications/JC-DP-2012-01-ver1–Draftdiscussion- paper-on-RTS-on-Article-6-3-EMIR-.pdf). It is expected that the final technical standards will be adopted some time in the fourth quarter of 2012 and will start applying six months following their adoption by the European Commission presumably in the second or third quarter of 2013.
We will continue to monitor and report on this initiative as the legislation evolves.