European Parliament and Council Reach Agreement on OTC Derivatives Rules
Christopher Bernard | Bloomberg Law
EP-Council deal on rules for a safe and transparent derivatives market, European Parliament Press Release, 9 Feb. 2012; New rules will increase transparency and safety in derivatives trading – European Council Press Release, 9 Feb. 2012.
The European Parliament and Council announced on 9 February that they had reached agreement on the regulation of over-the-counter (OTC) derivatives in the EU, after a long period of negotiations. The rules will require all trades in OTC derivatives to be cleared through central counterparties (CCPs) in order to reduce counterparty credit risk, and all derivative contracts, not just OTC derivatives, will be reported to trade repositories in order to increase transparency. The legislation will also give the European Securities and Markets Authority (ESMA) responsibility for the registration and oversight of trade repositories and the ability to resolve disputes between Member States regarding the authorisation of CCPs.
This agreement brings the EU one step closer to meeting the 2009 commitment of the G-20 nations that all OTC derivatives transactions should be centrally cleared and reported by the end of 2012. However, much remains to be done to achieve that goal.
The European Market Infrastructure Regulation
After the collapse of Lehman Brothers in 2008, it was widely accepted that the opacity of the OTC derivatives market had contributed to a build-up of systemic risk and exacerbated the global financial crisis. In September 2009, the leaders of the G-20 nations announced a number of initiatives in response to the crisis, including a commitment that all standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms and cleared through CCPs by no later than the end of 2012, and that all OTC derivative contracts should be reported to trade repositories.1
In September 2010, following extensive consultation, the European Commission published a proposal to promote safer and more transparent OTC derivatives markets by introducing new requirements for CCP clearing of standardised OTC derivative contracts and the reporting of OTC derivative contracts to trade repositories.2 Similar measures were enacted in the U.S. a few months earlier under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Known as the European Market Infrastructure Regulation, or “EMIR,” the Commission’s proposal then passed to the European Parliament and Council for their consideration under the co-decision procedure. As a regulation, EMIR will apply directly once it becomes effective without requiring implementation by individual Member States.
Since its initial proposal by the Commission, EMIR has been the subject of heated debate. During that time, a number of compromise proposals have been published.3 While the final agreed draft has not yet been released, initial indications are that it has changed from the Commission’s original version in several important ways.4
Central Counterparty Clearing
Under EMIR, standardised derivative contracts that meet pre-defined eligibility criteria will need to be cleared through CCPs. Contracts that are not cleared through CCPs, either because the contract is not eligible or because one of the parties is not subject to a clearing obligation, will trigger additional risk mitigation requirements, including being marked-to-market on a daily basis and the exchange of additional collateral.
Two approaches will be followed to determine which contracts must be cleared:
- Under the “bottom-up” approach, when a regulatory authority in a Member State authorises a CCP to clear a class of derivatives, it will inform ESMA, which will decide whether a clearing obligation should apply to that class of derivatives across the EU. ESMA will then draft regulatory technical standards, which must be adopted by the Commission. The original proposal gave ESMA the ability to make this determination without the Commission’s involvement, but this power was subsequently deemed to be inconsistent with EU jurisprudence.
- Under the “top-down” approach, ESMA, together with the European Systemic Risk Board (ESRB), will identify contracts that should be subject to the clearing obligation but for which no CCP has been authorised.
In making these determinations, ESMA will consider the:
- Degree to which the contract and operational processes are standardised;
- Liquidity and volume of contracts; and
- Availability of fair, reliable, and generally accepted pricing information.
In order to reduce systemic risk, CCPs will be subject to strict prudential, organisational, and conduct of business standards. The revised proposal also subjects CCPs to strict liquidity risk management requirements, which will be specified in technical standards.
Interoperability & Access to Trading Venues
As originally proposed, CCPs will need regulatory approval before entering into interoperable agreements and must implement satisfactory systems and procedures to manage the additional risks. These provisions will extend only to cash securities.
In addition, the agreed text provides that CCPs will have a right of access to transactions traded on a venue of execution. While this new provision could result in a venue being cleared by several CCPs, the Commission notes that it does not mean that interoperability agreements may be implemented between those CCPs.
Authorisation and Supervision of CCPs
One of the most hotly contested elements was the role that ESMA will play in the authorisation of CCPs. Under the original proposal, a CCP would be authorised by the competent authority of the Member State where it is established, provided it meets the requirements of EMIR. Because the authorisation would be effective throughout the EU, the home country regulator would co-operate with ESMA and with a college of competent authorities and central banks from other relevant Member States during the authorisation process. This framework has been retained in the agreed version of the Regulation.
In the event that public authorities have legitimate concerns regarding the authorisation of a CCP, a mechanism has been added to the Regulation whereby those authorities can raise their concerns and, to the extent necessary, ask ESMA to take a final decision through a binding mediation procedure. Host authorities will not be able to request binding mediation against the home country authority’s opinion unless all host authorities unanimously agree to do so or at least two-thirds of the host authorities are concerned with the proposed authorisation and agree to request mediation.
As originally proposed, national regulators will be responsible for supervising the CCPs established in their jurisdictions, supported by ESMA and the college of authorities.
Trade Repository Reporting
The rules will require detailed information regarding OTC derivative contracts to be reported to trade repositories, which will make the data available to national supervisors. Trade repositories will also be required to publish aggregate positions by class of derivatives so that all market participants can access the information. In order to protect commercially sensitive information, trade repositories will not be required to publish trade level data. Whereas the original draft only required reporting of OTC derivative contracts, this obligation will now apply to listed derivatives as well.
ESMA will be responsible for the registration and supervision of trade repositories across the EU. In order to be eligible for registration, trade repositories will need to meet a number of criteria, including strict standards intended to ensure the confidentiality, integrity, and protection of the information that they receive.
Covered Classes of OTC Derivatives
Currently, EMIR applies to all classes of OTC derivative contracts, including commodity derivatives and foreign exchange. However, the Commission has indicated that this may change if necessary to achieve global consistency.
The clearing and reporting requirements will apply to financial firms such as banks, insurance companies, and funds, as well as to non-financial firms that have large positions in OTC derivatives, with some limited exemptions:
- OTC derivative contracts of non-financial firms below a “clearing threshold” will not need to be cleared through a CCP, and derivatives used to hedge risks related to the activities of those firms will not be counted towards those thresholds or need to be cleared. ESMA, in consultation with the ESRB and other authorities, will draft technical standards establishing those thresholds, taking into account the systemic relevance of the sum of net positions and exposures by counterparty per class of derivatives.
- European central banks, public bodies involved in the management of public debt, and the Bank for International Settlements will not be subject to clearing, reporting, or bilateral risk mitigation obligations.
- As agreed during the negotiations, pension funds will benefit from a temporary exemption from the clearing obligations, while technical solutions are developed for the provision of non-cash collateral as variation margins by such funds. In the meantime, pension funds will need to exchange collateral for OTC derivatives.
- The Regulation now also includes an exemption from the clearing obligation for transactions entered into within a group of financial and/or non-financial firms. Such intra-group transactions will require bilateral collateralisation unless two conditions are met: (1) there is no current or foreseen practical or legal impediment to the prompt transfer of own funds and the repayment of liabilities between the counterparties; and (2) the counterparties’ risk management procedures are sufficiently sound, robust, and appropriate for the complexity of the derivative transactions.
The Regulation will require the terms of OTC derivative contracts to be confirmed on a timely basis by electronic means. This will enable counterparties to net the transaction against other transactions and ensure accurate book-keeping, thereby reducing operational risk.
Third Country CCPs & Trade Repositories
In order to operate within the EU, a third country CCP will need to be recognised by ESMA. This will require satisfaction of the following conditions:
- The Commission must determine that the third country’s regulatory framework is equivalent to the EU’s;
- The CCP must be authorised and subject to effective supervision in the third country; and
- ESMA must have established co-operation arrangements with the third country regulators.
Third country trade repositories will be subject to similar requirements. In addition, the Commission must have entered into an agreement with the third country regarding mutual access to data and exchange of information on OTC derivative contracts held in trade repositories.
Many commentators have expressed concerns that market participants operating across borders could be subject to conflicting rules regarding their OTC derivative activities in the EU and other jurisdictions. According to the Commission, the final text will introduce “important tools” to manage these risks. The Regulation will also contain an anti-avoidance clause, pursuant to which EMIR will apply to contracts that are deliberately structured outside the EU in order to avoid the Regulation.
The European Parliament now needs to vote on the rules, after which the Council will need to formally adopt the Regulation. At that point, the Regulation will appear in the Official Journal and enter into force.
ESMA is currently required to submit draft regulatory technical standards to the Commission by 30 June 2012. On 17 January, a group of financial industry associations published a joint letter addressed to the three main EU institutions in which they questioned the authority’s ability to meet that deadline. The chair of ESMA expressed similar concerns in a recent speech.5 The rules will also need to be harmonised with those of the U.S. and other countries. EU regulators still have a lot to do.
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