The main purpose of the Proposal was to implement the mandatory clearing of certain standardised OTC (i.e. over-thecounter) derivatives transactions, that meet predefined eligibility criteria, through central counterparties (“CCPs”) and the reporting of those transactions to trade repositories, for use by relevant authorities. However, subsequent drafts of the Regulation use a wider definition of ‘derivatives’, bringing transactions executed on regulated markets into scope. This means the reporting requirements of the Regulation may apply to all types of derivatives, not just OTC transactions, and ESMA could potentially require any type of derivatives contract to be centrally cleared.
The Proposal is similar in scope to the OTC derivatives legislation that has recently been adopted in the United States (i.e. the Dodd-Frank 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 sets out requirements for both financial counterparties and, in certain circumstances, non-financial counterparties, with respect to the clearing and reporting of 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 these matters of the new European Supervisory Authority, the European Securities and Markets Authority (“ESMA”). ESMA will have responsibility for, amongst other things, determining which types of derivatives transactions should be cleared, the supervision of trade repositories 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 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. 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 by 30 June 2012, after consultation with relevant authorities.
According to the Proposal, the threshold recommended by ESMA will take into account “systemic relevance of…net positions and exposures” and will be reviewed periodically. Importantly, under the latest draft, hedging transactions will not count toward the calculation of a non-financial counterparty’s positions for the purpose of the threshold, but they will need to be cleared if the threshold is reached.
The rationale for these thresholds is that certain non-financial counterparties are active market participants and enter into a large number of 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 derivatives transactions must be cleared:
- The “bottom-up” approach – Under this approach, a CCP will start clearing a certain type of 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 aclearing obligation should apply with respect to all such 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.
- The “top down” approach – In addition, ESMA may take the initiative and decide whether a particular class of derivatives transactions should be subject to a mandatory clearing obligation. ESMA will notify the EU Commission of any such derivatives transactions.
ESMA shall keep an up to date register of all eligible types of derivatives transactions that are required to be cleared and the CCPs that are authorised to clear them.
Whether or not they are subject to the clearing obligation, all counterparties, whether financial or non-financial, and CCPs will be required to report the conclusion, modification and termination of every transaction of a certain type to a trade repository by the working day following the execution, clearing or modification of each such transaction. It is not yet clear whether this requirement will relate only to OTC derivatives transactions or all derivatives, as defined in the Proposal.
The competent authorities of Member States will continue to authorise (and withdraw the authorisation) for CCPs to clear particular types of derivatives transactions. In order to facilitate, amongst other things, the CCP authorisation process, the relevant competent authority will establish and chair a college consisting of other relevant competent authorities, relevant central banks and ESMA. The college will have a number of responsibilities such as providing a joint opinion about the CCP, the coordination 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, Conduct of Business and Prudential Requirements
The Proposal sets out a number of organisational, conduct of business 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 sets out various requirements for CCPs, such as having robust corporate governance arrangements and that these are publicly disclosed, along with its prices and fees. In addition, the Proposal sets out requirements relating to business continuity, segregation of assets and positions, default funds, default procedures and transaction portability between clearing members.
The clearing process will entail a CCP becoming a counterparty to each derivatives transaction that it clears. Given that the main aim of the Proposal is the reduction of counterparty risk, it is important that CCPs do not fail. To that end, the various organisational, conduct of business and prudential requirements for CCPs have been included in the Proposal in order to try and avoid any such failure.
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 derivatives transactions through chosen clearing members who will, in turn, arrange for such 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. The alternative clearing member will only be obliged to accept such assets and positions where it has previously agreed to do so 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 and isolate market participants from counterparty risk as much as possible.
Trade Repositories will be responsible for holding information on derivatives that is provided by counterparties and CCPs pursuant to the reporting obligation described above. 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 derivatives transactions is reliable and secure.
Consideration and Implementation
The Proposal is still being considered by the Council of the EU, with political agreement expected by mid-May 2011. It is anticipated that the European Parliament will adopt the Proposal shortly afterwards, with ESMA to provide the technical standards that are to apply by 30 June 2012 and for the Regulation to apply by the end of 2012.
It is important to note that the legislation will be a Regulation, not a Directive. This means that its provisions will have direct effect and will not be subject to legislative interpretation at the national level. The Commission chose a Regulation because it achieves a greater level of harmonisation than a Directive.