By Martin Hess (Reference: CapLaw-2013-29)

1) European Law

EU-Regulation 648/2012 of 4 July 2012 on OTC derivatives, central counterparties and trade repositories usually called EMIR (European Market Infrastructure Regulation) implements the Group of Twenty (G 20) commitment to have standardized OTC derivatives cleared through a central counterparty (CCP) in the European Union. In order to increase market transparency, EMIR requests that derivative transactions are to be reported to a trade repository. Finally, EMIR defines the conditions for authorization and the supervision of CCPs. This contribution deals with two of these requirements for CCPs.

a) The parties involved in clearing

b) Segregation

Under EMIR, CCPs have to offer clearing members (direct participants, i.e. general clearing member or GCM, and individual clearing member or ICM) the ability to legally and operationally segregate the claims and obligations resulting from cleared transactions (called Positions) and assets (i.e. collateral held to cover Positions – except default fund contributions – hereinafter Collateral) in the event that a clearing member or the CCP become insolvent or loses the respective authorization.

Article 39 (2) EMIR requires that the CCP keeps separate records and accounts enabling the distinction between

• the Collateral and Positions held for the account of clients of the clearing member, and

• the Collateral and Positions of the clearing member itself.

This is called omnibus client segregation. The client account is fully segregated from the house account of the clearing member. The Positions and Collateral of the clients are commingled and not known to the CCP. In general, clearing members have to provide Collateral to the CCP for the net exposure recorded on the client account. Netting of client exposures is possible.

Article 39 (3) EMIR requires alternatively the CCP to keep separate records and accounts enabling the distinction between

• the Collateral and Positions held for the account of each client, and

• the Collateral and Positions held for the account of each other client.

This is called individual client segregation. The clients choosing individual client segregation are known to the CCP. Their Collateral and Positions must be recorded on separate accounts also by the CCP. Netting of Positions recorded on different accounts is prevented. The Collateral covering the Positions in an account are not exposed to losses connected to losses recorded in a different account.

In addition, article 39 (4) EMIR requests that clearing members keep separate records and accounts that enable them to distinguish between – both in accounts held with the CCP and in its own accounts – the Collateral and Positions held for the account of its clients at the CCP from its own assets and Positions.

c) Portability or Porting

In case of default of a clearing member, article 48 (5) and (6) EMIR request that a CCP be committed to trigger the procedures for the transfer of Positions and Collateral held by the defaulting direct participant (GCM) for the account of its clients e.g. indirect participants (usually called non-clearing member or NCMs) to a transferee direct participant (Transferee GCM). This is known as Portability or Porting (Übertragbarkeit).

In order for Positions and Collateral to be ported in the event of default of a direct participant (GCM), an indirect participant (NCM) needs to have appointed a Transferee GCM who is prepared to act as replacement direct participant (GCM). If no such Transferee GCM is appointed, or if the Transferee GCM that has been so appointed declines to become party to replacement contracts, the CCP will have to liquidate the Positions, which will affect also the NCM’s collateral and positions and therefore the market itself.

2) Current Swiss Legal basis

a) Supervisory Regime in Switzerland

In order to protect the stability of the financial system, the Swiss central bank, the Swiss National Bank, oversees systems for the clearing and settlement of payments and of transactions with financial instruments. Such oversight also extends to payment and securities settlement systems including CCPs whose operators are domiciled abroad, provided that substantial parts of the operation or leading participants are located in Switzerland. The Swiss regulator for banks and securities traders FINMA might also grant tailor made banking licenses to such systems.

The Swiss National Bank has issued rules on portability and segregation in the National Bank Ordinance (NBO) which have entered into force on 1 July 2013 and are more or less similar to article 39 EMIR:

i. Segregation

Article 24b (1) NBO stipulates that a CCP shall keep separate records and accounts, enabling it to distinguish

• its own assets and Positions from the Collateral and Positions of its clearing members;

• Collateral and Positions of a clearing member from those of other clearing members; and

• Collateral and Positions held for the account of indirect participants (NCMs) from those of a clearing member participating directly, unless the direct participant itself undertakes or is required to perform such segregation. Article 24b (2) NBO requires that the CCP must offer a clearing member the choice between keeping and recording the Collateral and Positions of the indirect clients connected via the direct participant either jointly (omnibus client segregation) or separately (individual client segregation).

ii. Porting

Article 24b (3) NBO stipulates that a central counterparty shall have procedures for the transfer of Collateral and Positions held by the defaulting GCM for an NCM to a Transferee GCM indicated by the NCM, provided

• the transfer is enforceable in the relevant jurisdictions; and

• the Transferee GCM has contractually agreed with the NCM to assume the latter’s Collateral and Positions.

If such a transfer is not possible, the CCP must provide procedures offering comparable protection for the Collateral and Positions of the indirect participants (NCM) (article 24b (4) NBO).

b) Segregation according to article 12 Intermediated Securities Act

Except the provisions in the amended NBO for CCPs, Swiss law so far does not impose segregation as mandatory. Segregation is mentioned in article 12 Intermediated Securities Act. Article 12 defines certain consequences in case a custodian applies segregation in respect of its holdings with sub-custodians.

c) Restructuring procedures according to the Banking Act

The restructuring procedures defined in the Banking Act authorize FINMA to order the continuation of certain services of financial institutions in distress. FINMA has the power to transfer the agreements or parts of a financial institution (including assets and liabilities) to a third party or a bridge bank (article 30 Banking Act). Based on such an intervention of FINMA, Porting is currently already possible under Swiss law. In case of transfer of certain services from a financial institution licensed in Switzerland as bank or securities trader in distress to a third party (including a bridge bank) FINMA is entitled to prohibit the use of contractual provisions which lead to the termination of a contract in case of default for a certain period of time, the longest for 48 hours (article 57 Bank Insolvency Ordinance).

d) Porting based on private law rules

i. Relevant principles of Swiss Bankruptcy Law

According to the Debt Enforcement and Bankruptcy Act (DEBA) currently in force, a bankrupt debtor loses the right of disposition of its assets (article 204 (1) DEBA). Based on this provision, a Swiss direct participant (GCM) who becomes insolvent will lose the power of disposal, of amending, cancelling or transferring any Position or Collateral.

Any acts of the debtor performed after the adjudication of bankruptcy are not effective against its creditors (Void Disposition Rule).

Swiss law allows the advance disposal of claims as long as the limits imposed by article 27 Civil Code (protection of the individual against excessive commitments) and article 20 Code of Obligations (nullity of contracts of impossible, unlawful or immoral content) are respected. The sole requirements for such an advance disposal are that the pertinent claims can be designated with sufficient certainty and that the power of disposal is effective at the time it is executed.

Contractual arrangements in which the debtor, i.e. the defaulting direct participant, renounces in advance any rights in case of bankruptcy are likely to qualify as a preferential treatment of certain creditors and as an infringement of the principle of equal treatment of creditors. In case of insolvency of a Swiss direct participant any liquidation measures such as the transfer of Positions and Collateral of the defaulter by the CCP to another direct participant (GCM) or the creation of new contracts to which the defaulter is a party would therefore be in contradiction to the principle of equal treatment of creditors and might be challenged by the liquidator or other creditors because of preferential treatment of certain creditors (articles 285 et seq. DEBA).

ii. Portability after close out netting

Subject to regulatory measures as outlined above the Void Disposition Rule does not prevent termination of the contract by the CCP and the replacement of such contract by a new contract to which the defaulting direct participant (GCM) is not a party. The cleared transactions will be terminated either mandatorily by Swiss Law in case of insolvency (article 211 (2bis) Bankruptcy Law) or as contractually agreed. The arrangement for replacing of cleared transactions by terminating the contract and concluding a replacement contract with a third party is a matter outside of the bankruptcy of the direct participant (GCM) and therefore possible.

3) Forthcoming Swiss regulation

Except certain NBO-provisions there are no tailor made rules for CCPs in the currently applicable Swiss regulations. Switzerland is in the process of implementing regulations in the area of financial market infrastructure which are equivalent to that of the EU in order to allow Swiss CCPs to be recognized under article 25 EMIR (recognition of third country CCP).

The federal administration is preparing a Financial Infrastructure Law which should enter into force in 2015. Part of this new law will deal with Porting. It is expected that the Financial Infrastructure Law will introduce an obligation for CCPs to provide rules for the transfer of Positions and Collateral from an indirect participant (NCM) in case of default of a direct participant (GCM) to a direct participant (Transferee GCM) in good standing. The transfer of Position and Collateral will be declared mandatory by the forthcoming law.

4) Implications of Segregation and Portability

a) For the Swiss legislator

The new Financial Infrastructure Law must create an unambiguous basis for Porting which supersedes the current obstacles as outlined above 2 d) i. A simple copying of the wording of article 39 and 48 EMIR does not create legal certainty as the ongoing discussions about the scope of EMIR demonstrate:

– There is need for a statement in the new law that the provisions of the DEBA are not applicable in the situation where Porting should work.

– The new law must clearly define whether it applies to both, i.e. the relationship CCP-GCM and the relationship GCM-NCM (or even the relationship NCM – client in case of indirect clearing arrangements), or only to the relationship CCP-GCM.

– The territorial scope of application of the new law must be defined, since clearing relationships cross national boundaries.

b) For the contractual arrangements between CCP, GCM and NCM

Porting is only possible if a tri-party agreement between CCP, direct participant (GCM) and indirect participant (NCM) is concluded. Furthermore, alternative clearing arrangement between indirect participant (NCM) and the Transferee GCM need to be in place.

Finally, the Transferee GCM must accept in advance (without knowing the details) all Positions (and the related Collateral) entered into by the defaulting GCM.

Porting depends on the level of segregation implemented. Porting of Collateral is likely to be more feasible for indirect participants (NCM) using individual client segregation. For omnibus client segregation, Porting of the entire client omnibus account to a Transferee GCM – subject to consent of all indirect participants (NCM) – is possible but does not seem likely given that all NCMs need to agree.

The choice of the type of security agreement for providing Collateral (full title transfer, e.g. irregular pledge, or security interest other than full ownership, e.g. pledge) need to be analyzed with great care. Furthermore, providing of Collateral to the Transferee GCM under the condition precedent of default of a GCM has to be agreed in advance. The account structure for holding collateral will become more complex than for simple omnibus accounts. Collateral Management Services by neutral service providers such as custodians will be used more often for establishing the respective accounts, managing the Collateral, for the enforcement of the Collateral in case of default or for the transfer of the Collateral if Segregation and Porting apply.