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. This article provides an update on the pending initiatives to regulate OTC derivatives in the US, in Switzerland and in the EU and gives a more detailed overview of the recently adopted European Regulation on OTC derivatives, central counterparties and trade repositories (EMIR).
By Thomas Werlen / Stefan Sulzer (Reference: CapLaw-2013-13)
1) United States
In the US, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) was passed in July 2010 (see already CapLaw-2010-34, CapLaw-2010-47, CapLaw-2011-24 and CapLaw-2012-54). Since then, the Commodity Futures Trading Commission (CFTC) and the Securities and Exchange Commission (SEC) have finalized the majority of implementing rules to be developed under the Dodd-Frank Act. The US are now entering the implementation phase. On 13 August 2012, final rules on the definitions of the terms “swap” and “security-based swap” were published, triggering the effective date for many key rules under the Dodd-Frank Act. The final definitions and a number of final rules became effective on 12 October 2012.
The reporting obligations are phased-in by products and types of market participants: Swap Dealers and Major Market Participants must report interest rate and credit swaps since 12 October 2012 and equity swaps, foreign exchange swaps and other commodity swaps since January 2013. The rules also established a compliance date of 10 April 2013 for Non-swap Dealers and Non-major Swap Participants. However, on 9 April 2013, the CFTC issued a no-action letter providing non-financial Non-swap Dealers and non-financial Non-major Swap Participants with reporting relief with respect to (i) interest rate and credit swaps until 1 July 2013, (ii) equity, foreign exchange and other commodity swaps until 19 August 2013, and (iii) all other swap classes until 31 October 2013. Non-swap Dealers and Non-major Swap Participants that are financial entities must be in compliance with their reporting obligations with respect to interest rate and credit swaps since 10 April 2013. CFTC’s no-action letter provides financial Non-swap Dealers and financial Non-major Swap Participants with reporting relief with respect to (i) equity, foreign exchange and other commodity swaps until 29 May 2013, and (iii) all other swap asset classes until 30 September 2013.
The clearing obligations will also be phased-in by products and type of market participants. On 28 September 2012, the CFTC has issued rules mandating clearing of four classes of interest rate swaps and two classes of index credit default swaps. Mandatory clearing for Swap Dealers and Major Swap Participants for these swaps began on 11 March 2013. Other parties will be required to clear these swaps beginning on 10 June 2013 and 9 September 2013. In addition, the application of the US securities laws to security-based swaps will become effective on 11 February 2014.
2. Switzerland
In Switzerland, there is no mandatory clearing or trade reporting regime in place for OTC derivatives transactions. However, Switzerland is committed to the implementation of the G-20 reforms on OTC derivatives. The Swiss Federal Council decided on 27 August 2012 that the existing Swiss regulation of financial market infrastructure needed to be amended to comply with the Financial Stability Board (FSB) recommendations and with the new standards developed by international standard setters for financial market infrastructure. The Federal Department of Finance has been instructed to prepare a draft consultation paper by spring 2013 and aims at coordinating its approach with legislative initiatives in the EU.
3. European Union
In the EU, OTC derivatives regulation is implemented through four legislative initiatives: (i) the European Market Infrastructure Regulation (EMIR); (ii) the Markets in Financial Instruments Directive Revision (MiFID II) (this legislative initiative has not yet been finalized); (iii) the Short Selling and Credit Default Swap (CDS) Regulation (the new Regulation (EU) No 236/2012 came into force on 1 November 2012); and (iv) the Capital Requirements Directive IV (CRD IV—Basel III requirements) (this legislative initiative has not yet been finalized).
EMIR, which constitutes the main part of the EU OTC derivatives market reform, was adopted on 4 July 2012 and entered into force on 16 August 2012 (Regulation (EU) No. 648/2012) (see already CapLaw-2010-47 and CapLaw-2012-16). The main obligations under EMIR are: (i) central clearing for certain classes of OTC derivatives; (ii) application of risk mitigation techniques for non-centrally cleared OTC derivatives; (iii) reporting to trade repositories; (iv) application of organizational, conduct of business and prudential requirements for Central Counter Parties (CCPs); and (v) application of requirements for trade repositories, including the duty to make certain data available to the public and relevant authorities. The types of derivatives covered by EMIR are set out in Annex I of MiFID. EMIR applies to any entity established in the EU that has entered into a derivatives contract, and applies indirectly to non-EU counterparties trading with EU parties as well as to non-EU counterparties trading with each other, if a sufficient connection to the EU is established. EMIR identifies two main categories of counterparties to derivative transactions: (i) financial counterparties, which includes banks, insurers, investment firms, fund managers and pension schemes; and (ii) non-financial counterparties, which covers any counterparty that is not classified as a financial counterparty, including entities not involved in financial services.
As with any other EU Regulation, EMIR provisions are directly applicable, i.e., are legally binding in all Member States without transposition into national law. However, many of the obligations under EMIR needed to be specified further via regulatory technical standards and became effective following the entry into force of these technical standards. On 19 December 2012, the European Commission adopted nine key Regulatory Technical Standards and Implementing Technical Standards, proposed by the European Securities and Markets Authority (ESMA), specifying obligations under EMIR. These Technical Standards have been published in the Official Journal on 21 December 2012 and 23 February 2013, respectively, and entered into force on 15 March 2013, which triggered the effective date for many key obligations under EMIR.
a) Clearing Obligations (derivatives cleared by CCPs)
Financial counterparties and non-financial counterparties must clear OTC derivative contracts that ESMA has determined are subject to a mandatory clearing obligation by an authorized or recognized CCP when they trade with each other or with third country (non-EU) entities that would be subject to the clearing obligation if established in the EU. The clearing obligation also applies to derivative transactions between entities incorporated outside of the EU that would be subject to the clearing obligation if they were incorporated in the EU, provided that the relevant transaction has a direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent the evasion of any provisions of EMIR. ESMA has not yet published any details on what transactions have “direct, substantial and foreseeable effect within the EU”.
Central Counter Parties (CCPs). CCPs established in the EU and third country CCPs have six months, i.e., until 15 September 2013, to submit their application for authorization or recognition under EMIR and the national competent authorities then have six months, i.e., until 15 March 2014, to determine whether or not to authorize or recognize the CCP (Article 14 and 17 EMIR). To ensure that CCPs already active in the EU can continue to provide services during this transitional period, they may continue to operate, subject to any applicable national regimes, until they have been authorized or recognized under EMIR.
Clearing Threshold. From 15 March 2013, non-financial counterparties have to calculate the clearing threshold and must notify the relevant national competent authority and ESMA if on any day, without taking into account any hedging transaction, the gross notional amount with respect to all OTC derivate transactions of the same asset class exceeds the following threshold with respect to such class: (i) EUR 1 billion for credit derivatives and equity derivatives; and (ii) EUR 3 billion for interest rate derivatives, foreign exchange derivatives, commodity derivatives and other OTC derivatives (Article 10 EMIR).
If a company reaches or exceeds the clearing threshold for one of the asset classes mentioned above, it is subject to the clearing obligation for all classes of OTC derivative transactions, and not just the class for which the clearing threshold has been reached or exceeded.
Clearing Obligations. Clearing obligations will only apply, once CCPs have been authorized or recognized under EMIR. This step is necessary to ensure that CCPs are safe and sound. Where a national competent authority authorizes or recognizes a CCP to clear a class of OTC derivatives, it must immediately notify ESMA of that authorization or recognition. Within six months of receiving such notification, ESMA must submit draft regulatory technical standards on clearing obligations, specifying, among other things, the class of OTC derivatives that should be subject to the clearing obligation, and the date or dates from which the clearing obligation takes effect (Article 5 EMIR). In order to expedite the assessment of OTC derivatives to be cleared, national competent authorities had to notify ESMA of any existing classes of OTC derivatives cleared by CCPs in their jurisdiction by 15 April 2013.
Given the above, the first clearing obligations are not expected to arise until the first quarter of 2014.
b) Risk Mitigation Techniques (derivatives not cleared by CCPs)
Counterparties that enter into an OTC derivative transaction not cleared by a CCP must ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk and counterparty credit risk. Some of these risk mitigation techniques came into effect on 15 March 2013.
Timely Confirmation Obligation. From 15 March 2013, financial counterparties and non-financial counterparties that enter into an OTC derivative transaction not cleared by a CCP must timely confirm the terms of the relevant OTC derivative transaction within deadlines specified in the applicable Technical Standard (Article 11(1)(a) EMIR). Confirmation means the documentation of the agreement of the counterparties to all the terms of an OTC derivative transaction. To comply with the confirmation requirement, the counterparties must, therefore, reach a legally binding agreement on all the terms of an OTC derivative transaction.
On 8 March 2013, the International Swaps and Derivatives Association, Inc. (ISDA) published the ISDA 2013 EMIR NFC Representation Protocol to enable parties to Covered Master Agreements to amend the terms of each such Covered Master Agreement to reflect the confirmation obligation under EMIR. The ISDA protocol and standard form wording is available under www2.isda.org/functional-areas/protocol-management/protocol/11.
Daily Valuation. From 15 March 2013, financial counterparties and non-financial counterparties have to mark-to-market the value of outstanding derivative transactions on a daily basis (article 11(2) EMIR). Where market conditions prevent marking-to-market, reliable and prudent marking-to-model must be applied.
Portfolio Reconciliation. EMIR requires portfolio reconciliation for financial counterparties. The frequency of portfolio reconciliation depends on how many OTC derivative transactions are outstanding between the counterparties. Daily reconciliations will be required when the number of outstanding OTC derivative transactions between counterparties is greater than 500. Weekly reconciliations will be required when the number of outstanding OTC derivative transactions is greater than 50 and less than 500. Quarterly reconciliations will be required when the number of OTC derivative transactions is less than 50.
Portfolio Compression. Counterparties with 500 or more OTC derivative transactions outstanding (facing each other) which are not centrally cleared must have procedures in place to regularly, and at least twice a year, analyze the possibility to conduct a portfolio compression exercise in order to reduce their counterparty credit risk.
Dispute Resolution. Counterparties must agree to detailed processes and procedures for the identification, recording and monitoring of disputes and their timely resolution. In addition, counterparties must notify the relevant competent authority where a dispute lasts longer than 15 business days and is for an amount or value higher than EUR 15 million.
The risk mitigation requirements regarding portfolio reconciliation, portfolio compression and dispute resolution (Article 11 (1) (b) EMIR) will apply from six months after the Technical Standards came into force, i.e., from 15 September 2013.
Margin Requirements. Financial counterparties and non-financial counterparties are required to have procedures for the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative transactions. On 15 February 2013, the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) published a consultative paper which represents a near-final proposal on margin requirements for non-centrally cleared derivatives for comment by 15 March 2013. Several features of this near-final proposal are intended to manage the liquidity impact of the margin requirements on financial market participants. It is proposed that variation margin will apply from 1 January 2015 and that initial margin requirements will be phased-in and would apply to the largest, most active and most systemically risky derivative market participants first with the threshold lowering gradually over a period of 4 years from 1 January 2015 up to 2019. The proposed requirements would allow for the introduction of a universal initial margin threshold of EUR 50 million.
The expected regulatory technical standards on margin requirements for uncleared OTC derivatives will follow the delivery of BCBS/IOSCO’s final report.
Capital Requirement. EMIR also requires financial counterparties to hold an appropriate and proportionate amount of capital to cover uncollateralized risks.
The precise level and exact type of collateral to be exchanged (margin requirements) and the level of capital required to manage the risk not covered by the appropriate exchange of collateral (capital requirement) will be specified by further regulatory technical standards. There is no timetable yet set to specify these requirements. It is unlikely that these requirements will enter into force before 2014.
c) Reporting Obligations
Counterparties to all derivative transactions are required to report to a registered trade repository post-trade details of any derivative transaction they have concluded and of any modification or termination of the transaction. The details must be reported no later than the working day following the conclusion, modification or termination of the transaction. EMIR encourages counterparties to cooperate in the reporting process to avoid inconsistencies. EMIR specifically states that reports should be made without duplication and permits one counterparty, or a CCP, to report on behalf of both counterparties to the trade repository, or for the reporting duty to be delegated to a third party (e.g., trading platform).
Trade repositories established in the EU and third-country trade repositories have six months, i.e., until 15 September 2013, to apply to ESMA for registration or recognition under EMIR. To ensure that trade repositories already active in the EU can continue to provide services during this transitional period, they may continue to operate, subject to any applicable national regimes, until they have been registered or recognized under EMIR.
Reporting obligations for credit and interest rate derivatives will come into effect on 1 July 2013. For all other asset classes underlying derivatives, reporting will start on 1 January 2014, if the relevant trade repository has been registered before 1 October 2013, otherwise ninety days after registration or recognition of any such trade repository.
We will continue to monitor and report on these initiatives as the legislation evolves.