OTC derivatives reforming EU market structures Ash Saluja, Partner CMS Cameron McKenna LLP
The OTC derivatives market - a brief reminder. Scope $605 trillion notional amount / $25 trillion gross market value Interest rate (72%), FX (8%), CDS (6%), equity-linked (1%), commodities (1%), other (12%) 10 times larger than exchange traded market London has a significant market share FX (39%) and interest rate (44%) Users/market participants Financials (banks, insurers, fund managers etc) all types Non-financials to manage risk FX, interest rate and commodities in particular Retail FX, CFDs and financial spreadbets
What rules are in place now? Applicable rules. No requirement to trade on exchange or trading platform Limited transaction reporting (equity CFDs, single name CDS) Little or no transparency on pricing and terms (although in theory MiFID best execution will apply in some cases) No compulsory standardisation counterparties are generally free to negotiate terms, although many use standard documentation No mandatory central counterparty clearing - although possible for some products
Why change? Impact of the financial crisis Bear Sterns, Lehmans, AIG etc. Too big/too interconnected to fail - the domino effect Potential impact on financial and non-financial sectors Other reasons Transparency Investor protection Increased regulatory supervision and intervention
Political will The G20 commitment: All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at latest. OTC derivatives contracts should be reported to trade repositories. Noncentrally cleared contracts should be subject to higher capital requirements.
The EU legislative response All standardised OTC derivative contracts. traded on exchanges or electronic trading platforms, where appropriate - Markets in Financial instruments Directive and Regulation (MiFID II/MiFIR) cleared through central counterparties - European Market Infrastructure Regulation (EMIR) by end-2012 at latest MiFID - Level 1 to be agreed by Q1 2013, with Levels 2/3 2014, and implementation by 2015? EMIR - Level 1 about to be agreed?, Level 2 split over 2012 and 2013 The European Securities and Markets Authority (ESMA) will play a key role in providing its technical standards (i.e. the detail for most areas)
The EU market landscape under MiFID Current execution/trading venues Multilateral (multiple buying/selling interests) Regulated Markets (RMs) Multilateral Trading Facilities (MTFs) Bilateral Systematic internalisers (SIs) (equities only) OTC Post MiFID II/MiFIR Multilateral Regulated Markets (RMs) Multilateral Trading Facilities (MTFs) Organised Trading Facilities (OTFs) Bilateral Systematic internalisers (Sis) (all financial instruments including derivatives) OTC
What is an OTF? A system or facility which is not a regulated market or an MTF, operated by an investment firm or a market operator, in which multiple third party buying and selling interests in financial instruments are able to interact in the system in a way that results in a contract Scope not entirely clear - includes broker crossing systems (internal matching systems that execute client orders against each other) and some derivatives trading systems not caught as RMs/MTFs, but not pure order routing systems The operator of the OTF may not execute client orders against its proprietary capital Difference between an OTF and an MTF/RM may be the discretion that OTF operator maintains on execution OTFs get brought into rules (on access, transparent rules and pricing, monitoring and reporting etc) applicable to other trading venues such as RMs and MTFs
Systematic internalisers Currently, SIs are investment firms that deal on own account by executing client orders in shares outside an RM or MTF, and perform that activity on an organised, frequent and systematic basis MiFID II/MiFIR extends definition to cover all financial instruments SIs subject to: certain unique requirements (e.g. to provide firm quotes on the request of a client) some requirements applicable to other trading venues (e.g. pre and posttrade transparency requirements)
Platform/exchange trading MiFID II/MiFIR introduces a requirement to trade eligible derivatives on qualifying exchanges/platforms (i.e. RMs, MTFs and OTFs and some non EU venues) but not SIs Scope of eligible derivatives - derivatives that are admitted to trading or traded on at least one RM, MTF or OTF and that are sufficiently liquid may be declared by ESMA as subject to the mandatory trading obligation Links to EMIR mandatory trading obligation = mandatory clearing obligation Is this necessary? Central counterparty clearing/trade reporting should reduce systemic risk But on platform/exchange trading could Facilitate standardisation and hence central clearing Increase transparency/regulatory oversight Reduce operational risk through automated procedures
Extended transparency requirements Scope currently pre trade transparency requirements covering equities and post trade transparency requirements covering all instruments admitted to trading on RM post MiFID II/MiFIR, transparency requirements will cover also derivatives eligible for clearing or traded on RM/MTF/OTF or reported to trade repositories Pre-trade transparency requirements all RMs/MTFs/OTFs must publish pre-trade information SIs must make firm quotes (below certain size) Post-trade transparency requirements RMs/MTFs/OTFs/SIs all subject to reporting requirements subject to certain thresholds and delays
Extended transaction reporting requirements Scope Current position - all instruments admitted to trading on a regulated market plus instruments whose price/value depends on such instruments Post MiFID II/MiFIR: all financial instruments admitted on a RM, a MTF or an OTF financial instruments whose value depends on the value of a financial instrument traded on a RM, a MTF or an OTF financial instruments which have or are likely to have an effect on a financial instrument admitted to trading or traded on an MTF or OTF. any other OTC derivative covered by EMIR reporting/clearing obligation Buy side should continue to be able to rely on EU sell side to report, but possible obligations when trading with third country firms
Data consolidation Licensing regime covering Approved Publication Arrangements (APAs) Consolidated Tape Providers (CTPs) Approved Reporting Mechanisms (ARPs) Improving access to data from trading venues Unbundling of pre and post trade data Data free after 15 minutes
Non-discriminatory access rules Trading venue access to CCPs CCPs to accept clearing of financial instruments on non-discriminatory and transparent basis, irrespective of trading venue where executed CCP access to venues Trading venues must provide data feeds to CCPs (EU/and recognised non-eu CCPs) Access to benchmarks used in calculating price of financial instrument Benchmark owners must allow CCPs and trading venues access to price/data feeds and methodology (compulsory non-exclusive licensing)
Dealing with systemic risk Position limits RMs, MTFs and OTFs that facilitate the trading of commodity derivatives, emissions allowances or related derivatives are required to apply position limits ESMA to define scope in technical standards Trading venues to publish weekly report containing aggregate positions held by different categories of trader Supervisory powers for national regulators to ban or restrict the trading of a product if threat to financial stability to have position management powers in respect of certain derivative contracts to require the cessation of any conduct or activity which gives risk to investor protection or financial stability concerns
Other relevant EU legislation Market Abuse Directive and Regulation (MAD II and MAR) extended to cover all financial instruments traded on RM, MTF and OTF Regulation for Energy Market Integrity and Transparency (REMIT) covers insider dealing and market manipulation in wholesale energy market products Capital Requirements Directive IV possible capital implications for banks/investment firms trading non-ccp cleared/exchange traded derivatives
Potential buy side impacts Transparency requirements should have a positive impact - much more data available Less flexibility to customise standardised derivatives Higher charges/fewer potential counterparties? Trillion dollar question still to be answered what derivative instruments will be in scope for mandatory exchange/platform trading?
European Market Infrastructure Regulation (EMIR) Jason Harding, Partner CMS Cameron McKenna LLP 1
EMIR 15 September 2010 European Commission publishes Proposal for a Regulation of the European Parliament and of the Council on OTC derivatives central counterparties and trade repositories Also known as the European Market Infrastructure Regulation (EMIR) Covers similar areas to Dodd-Frank Act but NOT exchange trading Exchange trading covered under MiFID/MiFIR No scope for individual member state interpretation 2
EMIR - Key points Mandatory clearing of all eligible OTC derivatives contracts by financial counterparties and the reporting of OTC derivatives contracts to trade repositories Mandatory clearing of all eligible OTC derivative contracts where positions exceed a clearing threshold by non-financial counterparties For non-financial counterparties, OTC derivative contracts objectively measureable as directly linked to the commercial activity of that counterparty not taken into account 3
Parties affected Financial counterparties Investment firms (MiFID) Credit institutions (Capital Requirements Directive) Insurance undertakings (First Non-Life Directive) Assurance undertakings (Life Directive) Reinsurance undertakings (Reinsurance Directive) UCITS Funds (UCITS IV) Institutions for Occupational Retirement Provision (Occupational Pension Funds Directive) Alternative Investment Funds (Alternative Investment Fund Managers (AIFM) Directive) 4
Parties affected (continued) Non-financial counterparties undertaking established in EU not falling within above Pension schemes to be exempt for three years after entry into force of EMIR Certain exemptions for intra-group contracts Possible exemptions for corporates being discussed Central banks, certain public bodies charged with management of debt and multilateral development banks excluded 5
Instruments affected Derivatives Options, futures, swaps, forwards and contracts for differences relating to securities, currencies, interest rates, yield, certain commodities and CDSs (Annex 1, Section C, numbers (4) to (10) of MiFID) Eligible OTC derivatives contracts Bottom-up CCP makes a decision to clear an OTC derivatives contract and informs regulator European Securities and Markets Authority (ESMA) has six months to decide whether a clearing obligation applies to those contracts in EU Top-down ESMA identifies OTC derivatives contracts to be standardised Assumed to be interest rate, FX and CDS 6
Non-cleared derivatives contracts Risk mitigation techniques for operational and credit risk including: electric confirms where possible; daily mark-to-market; and timely, accurate and appropriately segregated exchange of collateral, or face a higher capital charge 7
Central Counterparties (CCPs) Authorised by relevant competent authority Access to adequate liquidity and minimum capital requirements ( 5 million) Segregate assets of Clearing Members and allow for Clearing Member s assets and positions to be transferred to other Clearing Members Restricted on what collateral they can accept Required to make extensive information with regards to governance rules, risks and levels of segregation available to the public 8
Trade repositories Role of trade repositories Registered with ESMA (not local regulators) Trade repositories will need to publish aggregate positions by class of derivatives on reported OTC derivatives contracts Reporting obligations Applies to financial counterparties and certain non-financial counterparties with positions above an information threshold Details on derivative types, underlying assets, maturity, and notional value must be reported to registered trade repository 9
Segregation and portability Segregation of assets and positions between clearing members Segregation of assets and positions of clearing member and its clients Allow for detailed segregation of assets Disclosure of risks and costs Allows for transfer on pre-defined event of assets and positions to another clearing member Only if previously had contractual arrangement with other clearing member To prevail over conflicting laws (eg, insolvency laws) 10
Margin Mandatory Initial margin and Variation margin Intra-day basis at a minimum when pre-defined thresholds breached 11
Current status Economic and Monetary Affairs Committee (ECON) of the European Parliament approved draft Regulation with amendments on 24 May 2011 European Council has since released a number of proposals - the latest dated 26 January 2012 Last meeting of European Council, European Commission and European Parliament held on 31 January 2012 ended after only two hours to allow Danish Presidency more time to work on a compromise European Parliament to consider draft Regulation in session on 13-16 February 2012 Committee envisages central role for ESMA to draw up technical standards by 30 June 2012 This could be delayed until September 2012 12
Current issues Clearing and information thresholds for non-financial counterparties Types of OTC derivatives contracts covered Margin Segregation Intra-group transactions Territorial scope Concentration of risk in CCPs Confidential Information Automatic early termination No consistency of clearing member documentation 13
Costs of clearing Liquidity management Variation margin must be paid for in cash usually same day (but some clearing members may offer no intra-day liquidity calls) Buffer to manage this liquidity risk or collateral exchange programmes (repo finance) Capital Capital requirements on cleared OTC derivatives contracts will decrease Capital requirements on non-cleared OTC derivatives contracts will increase 14
Costs of clearing (continued) Clearing member costs A fee for ticket processing will be applied Further costs for collateral upgrade and single currency margin Implementation costs Requirements to pick a CCP Requirements to pick a clearing member Changes in operational processes and integration 15
Benefits of clearing Reduction in counterparty risk Counterparty risk removed due to CCP default management process and managing requirements Increased trading liquidity ISDA and CSA with clearing members and simplified documents with other liquidity providers Ability to trade electronically Operational efficiency Electronic affirmation and confirmation at point of trade Single movement of cash in a day covering fees, margin and interest No collateral disputes 16
What to do next? Choosing a clearing member Process/operations Collateral management Legal issues 17
Proposed principal-to-principal model in Europe CCP Rules and Procedures Security Interest Clearing Member Individual or Omnibus Account Clearing ISDA Master Agreement and CSA Give-Up Agreement Executing Broker Customer ISDA Master Agreement and CSA 18
cf Proposed agency model in US CCP Rules and procedures Clearing Member Individual or Omnibus Account Give-Up Agreement Executing Broker Third Party Custodian Statutory segregation rules Customer Futures Commission Merchant Agreement ISDA Master Agreement and Credit Support Annex 19