Over-the-counter ("OTC") derivatives contracts have long been viewed as the domain of sophisticated professional investors such as large corporate entities, institutional investors and financial institutions. As such, historically the OTC market has been only lightly regulated, the assumption being that professional investors are sufficiently aware of the risks associated with their various transactions and that such investors have a vested interest in effectively hedging their exposures.
Events since the near-collapse of Bear Stearns and the bankruptcy of Lehman Brothers have raised questions as to whether the OTC derivatives market should be allowed to continue to self-regulate and there is currently a global move towards improving regulatory and supervisory knowledge of, and transparency in relation to, the OTC derivatives market.
The G20 Summit
The main drive for reform has developed at an international level. In April this year, the G20 agreed upon a commitment to "promote the standardisation and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision" and subsequently at their meeting in Pittsburgh on 25 September 2009 adopted the following Declaration:
"All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the [Financial Stability Board] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse."
Taking its cue from the international consensus, the Commission has been developing more specific proposals. On 3 July 2009, the Commission published its Communication "Ensuring efficient, safe and sound derivatives markets" (COM (2009) 332) which was issued with an accompanying consultation document upon which stakeholders were invited to comment. The consultation process concluded on 31 August 2009 and a further Communication, "Ensuring efficient, safe and sound derivatives markets: Future policy actions" (COM (2009) 563) (the "October Communication") was published by the Commission on 20 October 2009.
In these Communications, the Commission opted to develop comprehensive policies for the OTC derivatives market as a whole rather than using a market segment-specific (eg. credit default swap only) regulatory approach. The aim in doing this was to prevent (so far as possible) market participants structuring transactions so as to exploit differences in the rules (so-called "regulatory arbitrage"). In recognition that the OTC derivatives market is also a global market, there was an express desire that any regulation or legislation be consistent with non-EU markets and, in particular, that the EU model be consistent with the approach adopted in the U.S., thereby again avoiding regulatory arbitrage.
The Commission recognises that there will be a need to incentivise market-wide adoption of these changes due to the costs for market participants adapting to the proposed new systems. As a result, although the Commission has undertaken to provide proposals for legislative reforms in 2010, it is also committed to carrying out impact assessments before finalising such proposals, taking into account stakeholder evidence with regard to the costs and benefits of implementing each proposal.
Standardised and non-standard derivatives contracts
The October Communication acknowledged that not all derivatives contracts would be suitable for central clearing either because they are highly specific to the trade concerned or due to the product not being liquid enough for central clearing. Nonetheless the Commission stated that such bespoke derivatives should be "appropriately priced in relation to the systemic risk they entail, in order to avoid those risks being passed on to taxpayers" and noted that "current collateral levels are too low and do not reflect the risk that bilaterally-cleared derivatives trades pose to the financial system when they reach a certain critical mass".
As a result, the Commission proposes that financial firms entering into non-standardised contracts will be required to post "initial margin" in proportion to the risk profile of the counterparty and "variation margin" in relation to the change in value of the contract over time. In addition to mitigating the risk of default, these measures are also intended to dissuade participants from entering into non-standardised contracts which could have been standardised and cleared centrally.
Bilateral non-cleared OTC contracts will also be subject to higher capital charges. The gap between the relative capital charges for cleared and non-cleared derivatives provided for within the Capital Requirements Directive ("CRD") will be widened and the Commission will work with the Basel Committee on Banking Supervision to amend the CRD appropriately (see "Further Commission Proposals for Minimising Operational Risk in OTC Derivatives Markets" below). As with margin, this increased relative cost for bilateral non-cleared OTC contracts is viewed to be consistent with the increased risk associated therewith.
The Commission intends that central clearing for all standardised contracts should be mandatory and will work with other non-EU G20 nations in order to develop a consistent approach to defining which contracts are in fact standardised. The key question as to what will constitute "standardised" and "non-standardised" contracts has not yet been agreed.
Many non-standardised, bespoke contracts are industry or sector specific and often involve counterparties who are corporate non-financial entities and who need to hedge specific exposure. There is a concern that such corporate entities might be disadvantaged through having to post additional collateral in relation to their non-standardised contracts. While the Commission undertakes to take account of the relative difficulty that might be faced by non-financial corporate counterparties in posting collateral, it is cautious of creating loopholes that might be exploited. As a result, it is currently intended that regulation will be proposed permitting non-financial corporate entities to continue transferring risk using derivatives (especially when under a certain threshold) without posting additional collateral. Currently there is no definition for what constitutes a "non-financial corporate counterparty" however and there is an awareness that such definition, when finalised, should not allow institutions that compete with banks in the OTC derivatives market to have a regulatory and financial advantage.
Clearing is the name given to the post-trade processes other than the final payment and discharge of obligations (i.e. settlement) and includes trade matching and confirmation. Both the G20 and the Commission view the use of central clearing counterparties ("CCPs") as the main tool to mitigate counterparty risk. CCPs have operated in Europe for some time but until recently were regulated by individual EU member states. Given the importance ascribed by the Commission to CCPs, the need for consistent Europe-wide regulation and supervision is something that the Commission has prioritised. The Commission therefore intends proposing legislation in 2010 to establish common safety, regulatory and operational standards for all CCPs.
What is a CCP and how could their use benefit the derivatives market?
In order to explain what CCPs are and how entering into derivatives transactions through them could benefit the derivatives markets (and thereby wider financial markets) it is necessary to explain the different effect on counterparty exposure that arises when transactions are carried out through a CCP as against when they are not.
Typically, where there is a bilateral derivatives master agreement under which Party A defaults, Party B is able to net any amount owed to Party A against any amount due to it from Party A, taking into account all the trades covered by the master agreement. This results in a single net figure representing a sum owing from or to Party A and thereby reduces potentially massive gross exposures.
Party A however is not likely to have entered into only one bilateral transaction but potentially hundreds of transactions with different counterparties and if Party A becomes bankrupt it is not usually possible for all these firms to combine their claims so that only one single amount is claimed against the bankrupt Party A. As a result, each firm will potentially have outstanding gross exposures for which it will need to account and, as a result, this potentially increases the risk of knock-on insolvencies.
Where parties deal through a CCP, the single master agreement is replaced by two back-to-back master agreements: one between Party A and the CCP and the other between Party B and the CCP. Under the terms of this arrangement, each trade between Party A and Party B is deemed to form two discrete contracts each of which mirrors the other. This arrangement also applies to each of the other numerous entities with whom Party A would otherwise have had a bilateral master agreement. The result of this is that, in the event of Party A’s default, a global netting can take place whereby Party A’s various net obligations to the CCP are set-off against the various debts owed by the CCP to Party A. In this way, the use of a CCP reduces the entire market’s exposure to counterparty risk.
In addition to the mutualisation of claims, the use of CCPs also allows for the effective monitoring of market behaviour and provides regulators with accurate information on the trades taking place through it. The principal problem that could arise when using CCPs lies in the risk of insolvency of the relevant CCP itself. In order to mitigate this risk, CCPs will impose strict requirements as to initial margin and variation risk.
Key Concepts for CCPs
Two main areas need to be considered in order for CCPs to effectively work from the perspective of clearing members and their customers.
It is not envisaged that market participants will trade directly with CCPs. Instead, trading would be carried out through broker dealers, each of which has a direct contractual relationship with the CCPs. These broker-dealers are known as clearing members ("CMs"). Where customers post margin through a CM, it is important that this margin is protected from the possibility that in the event of the default of the CM, the posted collateral is viewed by insolvency practitioners as an asset of the CM. Customer margin must be segregated from the relevant CM margin through the use of customer omnibus accounts that are held at the CCP or through other arrangements with the CM, such as the use of a custodian bank.
CCPs will only enter into transactions with a relatively small number of broker-dealers who have satisfied the CCP’s strict criteria for entry onto the trading platform as a CM. Other non-clearing member market participants ("Customers") will trade through one or more CMs of their choice using mandatory standardised contracts, as required by the CM’s agreement with the CCP. It is intended that the standardised contract will include the CM undertaking, in the event of its being in default, to "port" any open positions to an alternative (and non-defaulting) CM. The concept of open positions being transferred away from the defaulting CM, is known as "portability". Portability of positions (i.e. the ability to novate open positions to a financial institution or other CM along with the transfer of related margin) reduces the need for position close-outs and the resulting costs associated.
Where portability is possible, a Customer may transfer all, but not part, of its positions with the defaulting CM to an alternative CM. With this scenario in mind, Customers will be required to have, for example, ISDA Master Agreements ("ISDAs") in place with an alternative CM before they clear trades through their chosen alternative CM. Problems, however, may arise where there is no ISDA already in place with a alternative CM (especially if the terms of the defaulting CM’s contract seem unfavourable to the transferee).
At present, the porting of customer positions can only be done with the consent of all parties, including the defaulting CM. This impediment would be exacerbated where Automatic Early Termination was applied by the parties. In such a scenario, the parties’ obligations having been closed-out and netted, and the close-out amount calculated by the CCP, any porting could only be effected if all parties (including the defaulting CM’s insolvency representative) agreed to reinstate their position prior to the Automatic Early Termination.
One way of addressing these problems is by developing rules to enhance position portability for Customers. As an example of this, the intention of one proposed CCP (ICE Clear Europe) is that a standard form of ISDA (the "Standard Annex") should be entered into between Customers and CMs. The terms of the Standard Annex would provide certain rights for ICE Clear Europe, including remedies in the case of the relevant CM’s default. The Standard Annex will also include an agreement and consent on the part of the Customer for ICE Clear Europe to transfer CM-Customer positions to a new CM.
Further Commission Proposals for Minimising Operational Risk in OTC Derivatives Markets
Operational risk relates to the failure of internal processes or the impact of external events. In addition to central clearing and the standardisation of contracts and legal terms, the use of trade repositories, the enhancement of transparency and the maintenance of market integrity are all key to the Commission’s proposals for reducing operational risk.
(i) Trade Repositories
Trade repositories provide for the collection and collation of information on trades in one or more segments of the OTC derivatives markets. The type of information provided includes the number of outstanding contracts, size of outstanding positions in a particular contract and exposures of a specific entity. In the interests of allowing regulators to have an overview of the derivatives market, the Commission proposes that all trades be reported to trade repositories. It is proposed that legislation be put in place to "provide a common legal framework" to address authorisation, registration requirements, access and participation to a repository, disclosure of data, data quality and timeliness, access to data, safeguarding of data, legal certainty of registered contracts, governance and operational reliability.
(ii) Transparency and Market Integrity
Markets in Financial Derivatives Directive ("MiFID")
The October Communication considers that the trading of all standardised OTC derivative contracts will eventually be traded on "exchanges or electronic platforms". These are organised trading venues where trades are executed in an automated manner according to pre-defined rules and where prices and other trade-related information are publicly displayed. MiFID defines these as "regulated markets, multilateral trading facilities, or systematic internalisers."
This measure is intended to improve pre and post-trade transparency as well as facilitating more effective regulation of the OTC derivatives market however, as they are aware of the potentially negative side-effects on liquidity, the Commission does intend to take a measured approach to introducing transparency obligations. The October Communication indicates that the use of various organised venues will be addressed within the review of MiFID in 2010 (see "Time Line" below).
Market Abuse Directive ("MAD")
Market integrity and oversight will be addressed in the review of MAD in 2010 (see "Time Line" below). The Commission proposes clarifying and extending the scope of MAD to derivatives and giving regulators the power to set position limits. This proposition should assist regulators in prohibiting excessive risk-taking and moderating the concentration of risk within certain areas of the market. Importantly, with regard to commodity derivatives, it can also be used to curb excessive price volatility.
Capital Requirements Directive ("CRD")
As mentioned previously, it now appears that an international consensus is forming that non-centrally cleared contracts (i.e. non-standardised contracts) should be subject to higher capital requirements to reflect the increased risk that such contracts pose to the financial system. The primary method being considered to achieve this is the widening of the difference of the capital charges between centrally-cleared and non-centrally cleared contracts. The Commission undertakes to make proposals to amend the CRD which are in line with the approach taken by the Basel Committee on Banking Supervision. As the concerns are global, the proposals will also take into consideration the work currently being done by G20 partners, notably the U.S., to arrive at practicable proposals.
The following time-line is taken from the October Communication and sets out the action the Commission wants to take, and by when:
Reduce counterparty credit risk – strengthen clearing
(1) Propose legislation on CCP requirements governing:
(a) safety requirements (e.g. conduct of business, governance, risk, management, legal protection of collateral and positions);
(b) authorisation/withdrawal of authorisation and supervision of CCP;
(c) mandating of CCP clearing of standardised derivatives;
(2) Amend CRD in order to:
(a) mandate financial firms supplying initial and variation margin;
(b) Substantially differentiate capital charges between CCP-cleared and non-CCP cleared contracts in CRD;
Reduce operational risks - standardisation
(3) Assess whether to re-shape the operational risk approach in the CRD to prompt standardisation of contracts and electronic processing.
(4) Work with industry to increase standardisation of legal regimes and processes.
Increase transparency – trade repositories
(5) Propose legislation on trade repositories:
(a) Regulate trade repositories.
(b) Mandate reporting by OTC derivatives transactions to trade repositories.
Increase transparency - trading
(6) Amend MiFID to require transaction and position reporting to be developed in conjunction with CCPs and trade repositories;
(7) Ensure trading of standardised contracts on organised trading venues under MiFID;
(8) Enhanced trade and price transparency across venues and OTC markets, as appropriate, in MiFID;
(9) Conclude review of exemptions from MiFID for commodity firms;
Improve market integrity
(10) Extend MAD to OTC derivatives;
(11) Give regulators the power to set position time limits in MiFID.