The main purpose of the Proposal is to implement the mandatory clearing of certain standardised OTC (i.e. over-the-counter) derivatives transactions, that meet predefined eligibility criteria, through central counterparties (“CCPs”) and the reporting of OTC derivatives transactions to trade repositories.
The Proposal is similar in scope to the OTC derivatives legislation that has recently been adopted in the United States (i.e. the Frank-Dodd Act) and has been drafted in line with the initiative agreed by the G-20 in September 2009 that:
“All standardised OTC derivatives 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.”
The Proposal covers all categories of OTC derivatives contracts and sets out requirements for both financial counterparties and, in certain circumstances, non-financial counterparties, with respect to the clearing and reporting of OTC derivatives contracts as well as setting out requirements for CCPs and trade repositories. Certain entities, such as central banks, national bodies performing similar functions and multilateral development banks, are specifically excluded from the scope of the Proposal.
The Proposal also sets out the obligations in relation to the clearing of OTC derivatives transactions of a new European Supervisory Authority, the European Securities and Markets Authority (“ESMA”), that will have responsibility for, amongst other things, determining which types of OTC derivatives transactions are to be cleared, the supervision of trade respositories and liaising with the relevant national competent authorities with respect to the authorisation of CCPs.
Clearing and Reporting Requirements
Financial counterparties and non-financial counterparties
All financial counterparties will be subject to the clearing and reporting requirements set out in the Proposal. The definition of ‘financial counterparty’ in the Proposal covers investment firms, insurance undertakings, assurance undertakings, reinsurance undertakings, undertakings for collective investments in transferable securities (UCITS), institutions for occupational retirement provision and alternative investment fund managers.
Non-financial counterparties, which are defined as undertakings established in the EU that do not fall within any classification of financial counterparties, will only be subject to the clearing requirement if they exceed a clearing threshold and will only be subject to the reporting requirement if they exceed an information threshold. The level of these thresholds is not set out in the Proposal. Instead, the Proposal delegates powers to the EU Commission to specify these thresholds, which will be based on draft regulatory standards to be drawn up by ESMA, after consultation with relevant authorities.
The rationale for these thresholds is that certain non-financial counterparties are active market participants and enter into a large number of OTC derivatives transactions and, therefore, excluding them entirely from the clearing and reporting obligations could well undermine the effectiveness of these obligations.
The Proposal sets out the following two approaches that will be used to determine which type of OTC derivatives transactions must be cleared:
1. The “bottom-up” approach – Under this approach, a CCP starts clearing a certain type of OTC derivatives transaction after being authorised to do so by its national competent authority. Once this authorisation has been given, such national competent authority is obliged to inform ESMA who will then decide whether a clearing obligation should apply with respect to all such OTC derivatives transactions across the EU. Under the Proposal, ESMA has six months to make a decision and will base such a decision on certain criteria such as the reduction of systemic risk in the financial system and the liquidity of contracts.
2. The “top down” approach – Here ESMA takes the initiative and decides which type of OTC derivatives transactions should be cleared that are not being cleared by a CCP. ESMA will notify the EU Commission of any such OTC derivatives transactions.
ESMA shall keep an up to date register of all eligible types of OTC derivatives transactions that are required to be cleared and the CCPs that are authorised to clear them.
Financial counterparties will be required to report every OTC derivatives transaction that they enter into, modify or terminate to a trade repository by the working day following the execution, clearing or modification of each such OTC derivatives transaction. Non-financial counterparties that exceed the information threshold described above will be subject to the same reporting requirement.
National competent authorities will continue to authorise (and withdraw the authorisation) for CCPs to clear particular types of OTC derivatives transactions. In order to facilitate, amongst other things, such authorisation process the relevant national competent authority for a CCP will establish and chair a college consisting of relevant competent authorities and ESMA. The college will have a number of responsibilities such as the exchange of information, the determination of supervisory examination programmes based on a risk assessment of the CCP and the determination of procedures and contingency plans to address emergency situations. ESMA will, therefore, be able to play a central role in the authorisation of CCPs by ensuring that the provisions in the Proposal for the authorisation of CCPs are consistency applied.
Organisational and Prudential Requirements
The Proposal sets out a number of organisational and prudential requirements for CCPs. Although such requirements exist at a national level they differ between different Member States and so the Proposal seeks to harmonise such requirements across Member States.
The Proposal requires that CCPs have robust corporate governance arrangements in place and that these are publicly disclosed. In addition, the Proposal sets out others requirements for a CCP to cover matters such as a CCP’s record keeping and the senior management and board of a CCP. Furthermore, a CCP is required to establish a risk committee that will be composed of representatives of its clearing members and independent members of the board. The risk committee shall, amongst other things, advise the board of the CCP on matters that could affect the risk management of the CCP.
As the clearing process will entail a CCP becoming a counterparty to each OTC derivatives transaction that it clears, it is important that a CCP does not fail. A failure of a CCP would likely lead to widespread market turmoil. The various organisational and prudential requirements for CCPs have been included in the Proposal so as to help ensure that no CCP fails.
Portability and Segregation
CCPs will only deal directly with clearing members, who will likely be major broker dealers. Other market participants will, therefore, be required to clear OTC derivatives transactions through chosen clearing members who will, in turn, arrange for such OTC derivatives transactions to be cleared through the relevant CCP.
The Proposal requires that CCPs segregate the assets and positions of each clearing member from both the assets and positions of other clearing members and the assets and positions of the CCP. Following a pre-defined trigger event, such as the insolvency of a clearing member, a CCP will, at the request of a client, transfer the assets and positions of such clearing member to another clearing member that has previously agreed to accept such assets and positions pursuant to a contractual relationship for that purpose.
Therefore, clients of a clearing member that is subject to such a pre-defined trigger event will be able to move or “port” their assets and positions to another clearing member. It is anticipated that this will provide a certain degree of market stability following the collapse of a major broker dealer.
Trade Repositories will be responsible for holding information on OTC derivatives that is provided by financial counterparties and, if subject to the reporting requirement, non-financial counterparties. In contrast to the authorisation of CCPs, the Proposal gives ESMA powers to register (and remove the registration) of trade repositories. Given the central role played by trade repositories and their lack of fiscal responsibility the Commission is of the view that ESMA will be in a better position to carry out these functions than a relevant national authority.
ESMA will also be responsible for ensuring that each trade repository is meeting the various requirements for trade repositories set out in the Proposal. Trade repositories, like CCPs, will be required to ensure that they have robust corporate governance arrangements in place. In addition, trade repositories will be required to, amongst other things, ensure that the regulatory information that they hold on OTC derivatives transactions is reliable and secure.
Consideration and Implementation
The Proposal will now be considered by the European Parliament and the Member States with the intention that it is implemented as a Regulation by the end of 2012 in line with the G-20 initiative noted in the Overview section above.