On 13 December 2013, the Federal Council launched the consultation on the Financial Market Infrastructure Act (FMIA). In line with market developments and international requirements, FMIA adjusts the regulation of financial market infrastructure and introduces new rules on derivatives trading. This article, which continues a series of articles on FMIA, focuses on the new rules for over-the-counter (OTC) derivatives.
By Stefan Sulzer/Petra Ginter (Reference: CapLaw-2014-6)
1) Introduction
The financial crisis has brought derivatives to the forefront of regulatory attention. In 2009, the G-20 leaders agreed in Pittsburgh that all standardized over-the-counter (OTC) derivative contracts should be traded on exchanges, cleared through central counter-parties, and registered with trade repositories by the end of 2012. In the EU (European Market Infrastructure Regulation – EMIR) and in the US (Dodd-Frank Act), legislation has been passed in 2010 and 2012, respectively, to regulate OTC derivatives (see CapLaw-2013-13, CapLaw-2012-54, CapLaw-2011-24, CapLaw-2010-47, and CapLaw-2010-34).
The existing Swiss regulation of financial market infrastructure has not kept up with the developments in the global financial markets and does not satisfy the new international standards and commitments. On 29 August 2012, the Federal Council announced that new legislation is required to ensure competitiveness of the Swiss financial market and to strengthen financial stability. Thereby, the G-20 commitments and the Financial Stability Board recommendations on OTC derivatives trading should be implemented as fully as possible. On 13 December 2013, the Federal Council launched the consultation on the FMIA and invited interested parties to provide comments on the draft bill (the draft bill is available under http://www.news.admin.ch/NSBSubscriber/message/ attachments/33179.pdf). The consultation will run until 31 March 2014.
2) Overview of the New Rules
The new rules on OTC derivatives are contained in articles 87 et seq. FMIA. The rules are modeled after the analogous regulation in the EU (EMIR) as derivatives trading in Switzerland is mainly cross-border trading and predominantly with EU-counterparties. The new rules are applicable to all OTC derivatives, irrespective of the documentation used (e.g., ISDA Master Agreement or Swiss Master Agreement published by the Swiss Bankers’ Association). Repo transactions and securities lending are, however, not considered derivatives in the meaning of FMIA.
The new rules introduce the following four basic pillars: (i) obligation to clear standardized derivatives trades through central counterparties, (ii) obligation to report derivatives trades to trade repositories, (iii) risk mitigation obligations, and (iv) obligation to trade standardized derivatives on trading platforms. According to the draft bill, the duty to trade derivatives on trading platforms will not yet be mandatory with the entry into force of FMIA. Rather, such duty shall only become mandatory once international developments indicate the requirement of such duty.
3) Specifi c Rules on Derivatives
a) Scope of Application (Articles 87 and 88 FMIA)
The new rules on derivatives apply to “Financial” as well as “Non-Financial Counterparties” (as defi ned in the FMIA) that are incorporated in Switzerland. Financial Counterparties are banks, securities dealers, primary insurers, reinsurers, holding companies of a financial or insurance group or conglomerate, fund management companies, SICAVs, limited liability companies for collective investments schemes, SICAFs and asset managers for collective investment schemes. A Non-Financial Counterparty is a legal entity that is not a Financial Counterparty. The Federal Council may declare that the new rules also apply to Swiss branches of foreign financial market participants in case they are not subject to equivalent foreign regulations.
The new rules do not apply to the Swiss Federation, Cantons and political communities, the Swiss National Bank (SNB) or the Bank for International Settlement (BIS).
b) Clearing Through a Central Counterparty (Articles 89 et seq. FMIA)
Article 89 FMIA introduces for Financial as well as Non-Financial Counterparties the obligation to clear all standardized derivatives trades through FINMA approved or recognized central counterparties (CCPs). The clearing obligation also applies in case a foreign counterparty of a Swiss counterparty that is required to clear through a CCP would be obliged to clear through a CCP if it had its domicile in Switzerland. It is up to FINMA to defi ne which derivatives trades are standardized in the sense of FMIA, and up to the Federal Council to determine the applicable thresholds as well as the calculation method for each category of derivative. Exceptions to the clearing obligation apply to certain intra group trades, to “Small Non-Financial Counterparties” (article 90 FMIA) as well as to “Small Financial Counterparties” (article 91 FMIA).
c) Reporting to Trade Repositories (Articles 96 et seq. FMIA)
Financial and Non-Financial Counterparties as well as CCPs must report certain information regarding derivatives trades to a FINMA approved or recognized trade repository (TR). The reporting obligation applies to all OTC derivatives trades (not only to standardized derivatives transactions). It may be delegated to a third party, such as a CCP. For each trade, at least the following must be reported: (i) identity of the parties, (ii) type of derivative, (iii) maturity, (iv) nominal value, (v) price, (vi) settlement date, and (vii) currency.
d) Duty to Mitigate Risk (Articles 99 et seq. FMIA)
Derivative transactions that are not cleared through a FINMA approved or recognized CCP are subject to certain risk mitigation obligations. Financial and Non-Financial Counterparties (except for Small Financial and Small Non-Financial Counterparties) must assess, monitor and mitigate operational risks and counterparty risks arising from their derivatives transactions. In particular, they must, among other things, timely exchange confi rmations, establish appropriate portfolio reconciliation and agree on dispute resolution procedures.
Also, Financial and Non-Financial Counterparties (except for Small Non-Financial Counterparties) must provide suffi cient collateral to cover the outstanding exposure. Such collateral must be appropriately segregated from own assets. No collateral needs to be exchanged in case (i) both parties are subject to the same consolidation, (ii) both counter-parties are subject to suitable centralized risk assessment, measure and control procedures, (iii) no legal or factual hurdles for the immediate transfer of assets or the repayment of debt exist, and (iv) the trades are not entered into in order to circumvent margin duties.
e) Trading Platforms (Articles 104 et seq. FMIA)
Financial Counterparties (except for Small Financial Counterparties) and Non-Financial Counterparties (except for Small Non-Financial Counterparties) are required to trade standardized derivatives on FINMA approved or recognized trading platforms. FINMA will determine which derivatives need to be traded on trading platforms. The trading obligation also applies if a foreign counterparty of a Swiss counterparty that is subject to the trading obligation would be obliged to trade a derivative on an approved or recognized platform if it had its domicile in Switzerland. Certain exceptions from the trading obligations apply to intra-group transactions.
4) Initial Thoughts on the New Derivatives Rules
The derivatives market is an international and fast developing market. Switzerland cannot afford to stand isolated and aside of current legislative initiatives. Rather, Switzerland is well advised to close the legislative gaps to other leading jurisdictions, such as the EU and the US, as soon as possible. With FMIA, the Swiss legislature has made a step in the right direction. Equivalent legislation ensures that Swiss market participants will continue to have access to international derivatives markets and that foreign market participants may continue to enter the Swiss derivatives market.
The derivatives legislations in the EU and the US are not fully implemented yet. As the Swiss legislative initiative evolves, Switzerland should closely follow international legislation implementations and ensure that the Swiss legislation is not more restrictive than such other legislations. In other words, to safeguard the competitiveness of the
Swiss derivatives market, the Swiss legislator should abstain from introducing a “Swiss
Finish” on the new derivatives legislation. We will continue to monitor and report on FMIA as the legislation evolves.