International Requirements for Mandatory Clearing: IOSCO's Recommendations
Christopher Bernard | Bloomberg Law
On 29 February, the Technical Committee of the International Organization of Securities Commissions (IOSCO) published a report (Report) setting out recommendations that regulatory authorities should follow when establishing mandatory clearing regimes for over-the-counter (OTC) derivatives contracts in their jurisdictions. The Report addresses a number of key areas, including:
- Which products should be subject to a mandatory clearing obligation;
- Potential exemptions from the clearing obligation;
- Communications among authorities and with the public;
- Cross-border issues; and
- Ongoing monitoring and reviewing.
The Report is the latest step in an ongoing effort to co-ordinate global reforms to the OTC derivatives markets.
Mandatory Clearing of OTC Derivatives
In September 2009, the G-20 leaders announced a set of initiatives in response to the financial crisis, including a commitment that all standardised OTC derivatives contracts should be cleared through central counterparties (CCPs) by the end of 2012.1 The Financial Stability Board (FSB) published a report in October 2010 in which it made a number of recommendations regarding the implementation of mandatory central clearing. Among other things, the FSB recommended that IOSCO, working with other authorities as appropriate, co-ordinate the application of central clearing requirements for products and participants, and any exemptions from them, in order to minimise the potential for regulatory arbitrage.2
Since then, lawmakers around the world have been busily redrafting rulebooks in an effort to comply with the G-20′s commitments, but as the deadline for centralised clearing looms, concerns have been increasingly voiced regarding the timing, quality, and cross-border operability of the various proposals.3 In October 2011, the FSB released a second progress report assessing the implementation process, in which it recognised the work being undertaken but noted that few legislative and regulatory frameworks for mandatory clearing were in place and that different approaches seemed to be emerging.4 Section 723(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act 2010, Pub. L. No. 111-203, § 124 Stat. 1376 (Dodd-Frank), which was adopted in July 2010, established the legislative framework for mandatory clearing in the U.S., but the Commodity Futures Trading Commission (CFTC) is still in the process of finalising rules to implement these requirements.5 In February 2012, after months of negotiations, the European Parliament and Council finally agreed the text of the European Market Infrastructure Regulation, or “EMIR,” establishing the legislative framework for mandatory clearing in the EU;6 the European Securities and Markets Authority (ESMA) is now tasked with drafting implementing rules and is months behind schedule.7
The Report was prepared by the IOSCO Task Force on OTC Derivatives Regulation in response to the FSB’s 2010 recommendations. It is intended to provide guidance to national authorities in order to promote co-ordination and reduce the potential for regulatory arbitrage.
Determination of Products Subject to Mandatory Clearing
The Report recommends that authorities have an ongoing ability to determine mandatory clearing obligations so that they can respond to market developments as OTC derivative products emerge and evolve. Distinction is made between “determining authorities,” which have the power to mandate central clearing, and “supervising authorities,” which can authorise a CCP to clear a particular product, though in many jurisdictions one authority performs both functions.
As the Report acknowledges, a number of jurisdictions are employing a combination of bottom-up and top-down approaches in making these determinations.8Under the bottom-up approach, products cleared by CCPs are made subject to mandatory clearing by the relevant authority, whereas under the top-down approach, the authority makes products subject to mandatory clearing regardless of whether they are already cleared by CCPs.
— Bottom-up Approach
The Report recommends that relevant authorities use the bottom-up approach, if allowed by their legislative framework, and outlines a process whereby:
- The CCP or its supervising authority notifies the determining authority of the existence of products eligible for the clearing obligation; and
- The determining authority: (1) gathers information; (2) consults with stakeholders (including other authorities, market participants, and the general public) on a transparent basis; and (3) publicly communicates its decision.
The determining authority’s assessment should consider the following factors:
- The degree of standardisation of a product’s contractual terms and operational processes;
- The nature, depth, and liquidity of the market for the product;
- The availability of fair, reliable, and generally accepted pricing sources; and
- Additional analysis, including international consistency.
The Report emphasises that a determining authority should work closely with its foreign counterparts to ensure that mandatory clearing is assessed and implemented appropriately for third country CCPs operating within its jurisdiction.
The timeframe for implementation of a new clearing obligation should strike a balance between speed and safety. The Report recommends that determining authorities take the follow factors into consideration when making this decision:
- Readiness of CCPs to clear increased volumes;
- Readiness of different types of market participants to clear products; and
- Feasibility of multiple CCPs clearing the same product.
Depending on the results of this assessment, the determining authority may wish to delay or stagger implementation of the clearing obligation. The authority will also need to consider whether and in what timeframe the clearing obligation should apply to historical contracts.
— Top-down Approach
The top-down approach described in the Report would result in a list of products that the determining authority deems suitable for mandatory clearing, even if they are not currently cleared by a CCP. The authority would then need to do additional work to consider what steps should be taken to promote clearing of those products.
In deciding which products may be suitable for mandatory clearing, the determining authority should access relevant data from a variety of sources. The authority should then assess those products that may be eligible for mandatory clearing, applying similar criteria to those used in the bottom-up approach. In addition, the authority will need to consider whether any CCPs are able to clear the products. As with the bottom-up approach, the determining authority should consult with all relevant stakeholders before making a final decision. In some cases, it may be appropriate to expedite the timeline for implementation, for example where a product has been developed for the purpose of avoiding a mandatory clearing obligation.
If the determining authority concludes that a product is suitable for mandatory clearing, but the product is not currently cleared, the authority should clearly identify and disclose what actions are needed to facilitate the development of clearing by a CCP and the imposition of a mandatory clearing obligation. Among other things, the authority should understand why the product is not currently cleared and how to develop a clearing solution (which may include the authorisation of third country CCPs).
In some cases, it may be appropriate for regulators to tailor exemptions from the mandatory clearing obligation, provided the exemption does not create systemic risk and is regularly monitored and reviewed.
The Report identifies three types of exemptions:
- Product: some classes of derivative products may be exempted if they are not appropriate for clearing or would not benefit from the risk mitigation that clearing provides. For example, some jurisdictions are considering exempting certain foreign exchange derivatives from the mandatory clearing obligation.9
- Participant: certain types of market participants may be exempted, typically because the burden of compliance outweighs the limited risk posed by those participants. Examples include participants with low derivatives exposures or who use derivatives to hedge their commercial activities.10
- Fixed period: products and participants can also be exempted on a temporary basis, to give regulators more time to develop appropriate clearing regimes. The Report recommends that these temporary periods have fixed end dates that are clearly communicated. Pension funds have received temporary exemptions in some jurisdictions.11
In order to avoid regulatory arbitrage, the Report urges regulators to co-ordinate their activities when developing exemptions. Two specific participant exemptions are provided as examples that warrant further consideration:
- Intragroup/interaffiliate transactions: in some jurisdictions, transactions between counterparties within the same corporate group may be exempted.12 There is a risk that counterparties could exploit this exemption by transferring positions to affiliates in jurisdictions where clearing obligations do not apply.
- Small financial firms and non-financial firms: small financial firms and non-financial firms have been exempted in some jurisdictions because they do not pose a systemic risk and because non-financial firms generally use derivatives for business rather than speculative purposes. The Task Force suggests that regulators may wish to limit the clearing exemption for non-financial firms to transactions entered into for such purposes.13 The Report also recommends that regulators impose thresholds to ensure that uncleared trading activity does not rise to a level that could pose systemic risk.
Communication among authorities
The Task Force encourages authorities to communicate with each other regarding the implementation of mandatory clearing regimes in their own jurisdictions, both during initial assessment and on an ongoing basis, in order to promote consistency while reducing the risk of regulatory arbitrage. The Report identifies several key areas for transparency:
- Products subject to the mandatory clearing obligation;
- CCPs authorised to clear those products;
- Timeframes in which mandatory clearing obligations become applicable; and
The Task Force recommends that IOSCO evaluate whether this information can be consolidated in a central information repository on a global basis.
Given the global nature of the OTC derivatives markets, gaps, overlaps, or inconsistencies between mandatory clearing regimes could have a significant impact on market participants engaged in cross-border transactions. The Report suggests that authorities co-operate on a bilateral and multilateral basis to address these risks.
In some cases, it may be necessary or desirable for an authority to permit third country CCPs to clear transactions in its jurisdiction. Some regimes already allow for this through a distinct form of authorisation or by mutual recognition of the third country regulatory framework. However, the authority may have limited oversight or power to intervene in respect of third country CCPs, which could cause concern if, for example, those CCPs clear products that are systemically important in the authority’s jurisdiction. One way to address this risk is for the third country regulators to confirm that risk management of those products is carried out in line with appropriate regulatory standards and for co-operative oversight arrangements to be put in place. Alternatively, contractual or operational links could be established between CCPs. While these are currently being considered, they are unlikely to be in place by the end of the year.
In January, the FSB announced the establishment of the OTC Derivatives Co-ordination Group, which is intended to co-ordinate implementation of international reforms.14
Monitoring of Mandatory Clearing
The Report recommends that, once mandatory clearing regimes are established, authorities have effective mechanisms in place to monitor compliance with clearing obligations and exemption requirements and ensure that the regulatory framework remains fit for purpose as markets evolve. Information will be required from a variety of sources, and reporting obligations and regime changes should be clearly communicated to the market.
The recommendations of the Task Force represent a sensible approach to the need for global co-operation in the implementation of mandatory clearing regimes. U.S. and EU regulators have already recognised this imperative and have been actively involved in the efforts of the Task Force and other multilateral initiatives.15 Achieving these objectives, however, is no easy task. Even with the best intentions, there may be unintended consequences. The devil is in the detail.
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