Regulation of OTC Derivatives and an Introduction to Client Clearing. clearing. central counterparties. trade repositories

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1 slaughter and may Regulation of OTC Derivatives and an Introduction to Client Clearing financing BRIEFING november 2010 In September 2009, the G-20 leaders agreed 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 G-20 statement is being implemented In the United States through Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act, signed into law by President Obama on 21 July Most of Title VII will become effective in July 2011 or, where a provision requires rulemaking, at least 60 days after the rules are written (if later). Rule-writing resides with the Commodity Futures Trading Commission and the SEC. In the EU, the G-20 statement is being implemented as follows: Legislation Subject matter Status European Market Infrastructure Regulation MiFID review clearing central counterparties trade repositories additional capital requirements trading venues standardisation transaction reporting (trade price transparency) 15 September 2010: proposed Regulation was published by the European Commission Text of the Regulation now passes to the European Parliament and Member States for consideration The Regulation should apply by the end of 2012 EC is expected to publish its public consultation in Q4 2010

2 In addition, the proposed EU Regulation on short selling was published on 15 September 2010, while the ongoing review of the Market Abuse Directive (MAD) is expected to address position limits in OTC Derivatives. Thus the European regulatory landscape for OTC derivatives is still emerging, with the most developed piece being the European Market Infrastructure Regulation, the key elements of which are summarised in this Briefing. The European Market Infrastructure Regulation (EMIR) The key elements of EMIR are: Clearing: eligible OTC derivatives must be cleared through a central counterparty (CCP) if transacted between financial counterparties. Certain non-financial counterparties will also have to clear eligible OTC derivatives. Reporting: financial counterparties and certain non-financial counterparties must report OTC derivatives trades (and any modification or termination) to trade repositories within one working day. This applies to both cleared and non-cleared trades. Non-cleared transactions: financial counterparties and certain non-financial counterparties must have processes which ensure timely confirmation of transactions (where possible, by electronic means) and monitor risk, the latter to include the exchange of collateral or the holding of appropriate capital (rules and standards to follow). CCPs and trade repositories: the authorisation, supervision and regulation of CCPs and trade repositories is provided for. The clearing obligation The clearing obligation will apply to all eligible OTC transactions, unless one of the parties is a non-financial counterparty. However, a non-financial counterparty will also become subject to the clearing obligation if it takes positions in OTC derivatives contracts exceeding a clearing threshold. The clearing threshold will be set by the EU Securities and Markets Authority (ESMA) in consultation with the European Systemic Risk Board (ESRB), taking into account the systemic relevance of the net positions and exposures by counterparty per class of derivatives. The clearing threshold will be set by class of derivatives and it is envisaged that thresholds will be different for different classes of derivatives and even within classes. For example, for commodity derivatives, the clearing threshold may be different for oil and wheat. In calculating a non-financial counterparty s positions, OTC contracts that are objectively measurable as directly linked to the commercial activity of that counterparty shall not be taken into account. 02 SLAUGHTER AND MAY

3 The reporting obligation The reporting obligation will apply to all financial counterparties and to non-financial counterparties which take positions in OTC derivatives contracts exceeding an information threshold. The information threshold, like the clearing threshold, will be set by ESMA in consultation with the ESRB, taking the same factors into account, and there will be different thresholds for and within different classes of derivatives. A non-financial counterparty which exceeds the information threshold must notify the competent authority (in the UK, the FSA or its successor) and provide justification for taking these positions. In contrast to the clearing obligation, in calculating a non-financial counterparty s positions for purposes of the information threshold, transactions linked to a counterparty s commercial activity must be taken into account. The trade repositories will have to make trading data available to national regulators and will also have to publish aggregated (i.e. non-trade specific) position data for separate classes of derivatives. Non-cleared transactions The additional requirements for non-cleared transactions (which will include requirements regarding the exchange of collateral or the holding of appropriate capital ) will apply to all financial counterparties and to non-financial counterparties which take positions in OTC derivatives contracts exceeding the clearing threshold. Non-financial counterparties not subject to these requirements may nevertheless find their counterparties imposing more onerous collateral requirements and more expensive pricing. The known unknowns These include: eligible OTC derivative contracts (the clearing obligation will apply only to eligible OTC derivative contracts) clearing thresholds for non-financial counterparties information thresholds for non-financial counterparties information to be provided to trade repositories additional requirements for non-cleared transactions. It is expected that interest rate, FX 1, CDS, equity and commodities will all be represented among the categories of eligible OTC derivative contracts. Within each category, derivatives will be eligible only if they have been accepted for clearing by a CCP and determined by ESMA to be eligible. 1 There is continuing debate as to whether FX should be included. 03 SLAUGHTER AND MAY

4 Financial and non-financial counterparties A financial counterparty is an investment firm, credit institution, insurer, UCITS, pension fund 2 or alternative investment fund manager. A non financial counterparty is any other entity established in the EU. A wide range of institutions and entities will therefore become subject to the clearing and reporting obligations as financial counterparties. An introduction to clearing and client clearing Non-cleared transaction An OTC derivatives transaction which is not cleared will be entered into directly between two counterparties. Counterparty A Counterparty B Cleared transaction If the same transaction were executed on a cleared basis, then each counterparty would instead enter into a transaction with the CCP. The CCP s role on each transaction would be equal and opposite, so that the CCP is in a matched position. Counterparty A CCP Counterparty B Client clearing The CCP will enter into cleared transactions only with its members. Membership is restricted to large banks, because any losses of the CCP arising from the default of a member, in circumstances where the CCP is holding insufficient collateral, will be mutualised among the other members. Each member therefore has a common interest in the financial strength of all the other members. 2 A pension fund, for these purposes, is defined as an institution for occupational retirement provision as defined in Directive 2003/41/EC on the Activities and Supervision of Institutions for Occupational Retirement Provision. In the UK context this will, for practical purposes, mean all UK tax approved funded pension schemes. 04 SLAUGHTER AND MAY

5 Anyone who falls within the financial counterparty definition or exceeds the clearing threshold will become subject to the clearing obligation in respect of eligible OTC derivatives contracts. If it is not a member of the relevant CCP, it will need to become a client of a member, who will act as its clearing broker. Clearing broker CCP Counterparty B Counterparty A (client of clearing broker) Client clearing: some points to consider Points for clients of clearing brokers to consider include: Choice of brokers: A cleared trade may initially be executed by the client with another bank (an execution broker), before it is moved to the clearing broker. The client will face (and be exposed to) its execution broker before it faces (and is exposed to) its clearing broker. Once a trade is cleared, exposure to the clearing broker will reduce, but might not be eliminated. If a trade is not accepted for clearing, the client may have to pay compensation for the resulting failed trade. Choice of CCPs: It is the wild west for CCPs, with new offerings appearing on a monthly basis. Eventually, winners should emerge, with the rest retiring from the field. There is a risk that competition will result in a race to the bottom, undermining the financial integrity of the CCPs. Clients should choose their CCPs carefully, in conjunction with their clearing brokers, and may be well advised to use conservative CCPs, even if this results in higher initial margin requirements. Clients will be exposed to the CCPs they use. Cost of collateral: For each cleared trade, a client will have to post initial margin with its clearing broker (whose requirements may exceed the CCP s), which should be held by the CCP under arrangements aimed at protecting the CCP and the client from the clearing broker s insolvency. Clearing will significantly increase the total amount of collateral being held for OTC derivatives. A CCP will provide little or no return on collateral. Sourcing collateral: A clearing broker might allow a client to exchange ineligible securities, such as corporate bonds, for collateral acceptable to the CCP (i.e. cash and eligible government securities). Such an exchange is likely to result in the client taking risk on the clearing broker, at least in respect of the haircut. 05 SLAUGHTER AND MAY

6 Portability: If a clearing broker fails, the CCP will impose a short timetable within which that broker s trades will be terminated and closed out, unless transferred to another member of the CCP. The short timetable is required to protect the CCP s integrity, but gives clients a small window to avoid an unhedged position by transferring trades to another clearing broker. In practice, it is unlikely a client will meet this timetable unless it has an existing, functioning relationship with the transferee. Clients concerned about portability might wish to allocate their cleared trades across at least two clearing brokers, to improve the prospects of a successful transfer were one of them to fail. Documentation: A separate master agreement will be required between a client and its clearing broker for each CCP it uses. If three CCPs are used, there could be four master agreements per clearing broker (one for each CCP and one for non-cleared trades). While the additional documents requiring signature might not seem extensive, they will incorporate complex standard terms for the relevant CCP. Standardisation will reduce the scope for negotiation, but some points are negotiable. Complexity: Each CCP is adopting a different legal structure for providing client clearing. The structures and resulting legal analysis are complex and can raise cross-border questions. There is no practicable way for clients individually to do legal due diligence on the CCPs to test the robustness of their offerings. Jurisdiction: The jurisdiction of the CCP may impact on the law governing any dispute. It also remains to be seen how potential conflict between US and EU regulation will be resolved. If you would like to discuss the issues raised in this briefing paper, please contact one of the following or your usual Slaughter and May contact: Richard Levitt: richard.levitt@slaughterandmay.com Jan Putnis: jan.putnis@slaughterandmay.com Ben Kingsley: ben.kingsley@slaughterandmay.com Slaughter and May One Bunhill Row London EC1Y 8YY United Kingdom T +44 (0) Slaughter and May 2010 This material is for general information only and is not intended to provide legal advice. ksm16.indd 1110