EU Derivatives Reform: Regulators Dash for the Finish Line

On 15 September 2010, the European Commission unveiled its proposal for a Regulation on OTC derivatives, central counterparties, and trade repositories, the so-called “EMIR” regulation. EMIR (which stands for European Market Infrastructure Regulation) is the European Commission’s response to the G20 mandate to regulate OTC derivatives markets by the end of 2012, covering the obligation to centrally clear OTC derivatives, the structure and operations of central counterparties (CCPs), the organization of trade repositories (TRs), and the obligation to report trades to TRs. After a long and highly politicized discussion, the European Council adopted EMIR in June 2012, and it finally entered into force in July.

The Level 1 Regulation foresees many technical standards to be proposed by the European Securities and Markets Authority (ESMA) to complete and clarify the Level 1 framework. ESMA has recently published a consultation on these Draft Technical Standards, which must be submitted to the European Commission by 30 September.

Without attempting to summarize the entire content of the Regulation, here are some of the issues crucial for the buy-side that emerged during the legislative process:

Exemptions: Corporates (defined as non-financial counterparties in EMIR) already obtained an exemption from EMIR in the Commission’s initial proposal for all their derivatives used for hedging purposes (more specifically, for all contracts “objectively measurable as reducing risks relating to the commercial activity or treasury financing activity”). A better definition of such contracts is provided in ESMA’s Technical Standards. Derivatives contracts for non-hedging purposes are subject to central clearing when they exceed specific thresholds (also defined by ESMA).

Corporates were granted the exemption to avoid the requirement to post collateral (in particular, cash collateral) as margin to CCPs. They successfully argued that companies do not have the necessary cash and that using it for this purpose would have put a strain on their commercial activities or reduced their hedging, thus increasing risk.

Institutional investors (investment managers, insurance companies, and pension funds) also argued against the initial provisions in EMIR limiting the types of assets which could be used as collateral to “highly liquid collateral with minimal credit and market risk.” They sought a broadening of allowable collateral from just cash and government bonds to at least corporate bonds and perhaps also equities. Buy-side investors (especially pension funds and their managers using liability-driven investment strategies) argued that the cost of converting higher-yielding assets into cash or government bonds would be substantial and fall on European savers and pensioners. Alternatively, hedging was going to be reduced, thus increasing risks. Legislators and regulators were above all worried about injecting more risk into CCPs, and were not very receptive to such arguments, except in the case of pension funds.

Consequently, pension funds were granted a transitional period of three years, which could be extended after a review by the Commission to establish whether CCPs’ policies on collateral margining have sufficiently evolved (in terms of eligible assets). Other institutional investors must comply immediately with the central clearing obligation unless ESMA grants a phase-in of the obligation when it makes its final proposals regarding the clearing of each individual class of OTC derivatives. The decision will be preceded by public consultation, and the proposals must be adopted by the European Commission.

The final choice of the assets eligible as margin is left to the CCPs, and it remains to be seen how many of them will decide to accept more types of assets, and thus balancing the needs of clients against the need to protect themselves.

Segregation: After a long battle to ensure adequate protection for client assets, the initial and vague EMIR provisions on client asset segregation were strengthened. They now foresee the segregation at the CCP level of client assets and positions in a client omnibus account, and, upon request, segregation at the individual client level.

These provisions only apply to the clearing members’ direct clients, but in the Technical Standards ESMA has presented, proposals to ensure “equivalent protection” for indirect clients (that is, for the clients of a client of a clearing member), albeit through segregation at the clearing member level. Due to the complicated structure of banking groups in Europe, such “client chains” with multiple links are likely to be frequent, as many smaller firms will continue to deal with their non-clearing banks at the local level. As CFA Institute stressed in its reply to ESMA’s consultation, it is very important that the final investor at the end of the chain is still considered as an indirect client and can enjoy the legal protection of its assets and positions. Otherwise the main benefit of central clearing will be lost for parts of the investment community.

Open Access and Interoperability: Frustrated by the lack of regulation at the EU level and the slow pace of implementation of the voluntary code of conduct agreed to by established European CCPs (linked to stock exchanges in integrated groups), the European Commission incorporated provisions on non-discriminatory access and interoperability into EMIR. Non-discriminatory (or “open”) access refers to the possibility of access to a trading venue (by a CCP), as well as access to a CCP by a trading venue; it is supposed to foster competition and bring about a long-awaited reduction in clearing and settlement costs (which are much higher in Europe than in the United States). Commercial interests of established infrastructure groups are colliding on this issue with the interests of new entrants seeking to gain market share.

In the final text, the provisions were maintained, but with a more restrictive language. Regarding access by a CCP to a trading venue, it was granted only where it would not “threaten the smooth and orderly functioning of markets in particular due to liquidity fragmentation.” ESMA is tasked with defining “liquidity fragmentation” in its Technical Standards, and CFA Institute in its reply supported regulatory measures facilitating access by CCPs, enhancing competition and lowering costs.

In the final text of EMIR, interoperability is limited only to transferable securities and money-market instruments, and the tenor of the text changed from encouraging interoperability to allowing it only if certain conditions are met. During the legislative discussion, the focus turned to the possible risks created by interoperability, and the concern for systemic risk won over competition. A decision on the extension of interoperability to other financial instruments has been delayed to September 2014, when ESMA must submit a report to the Commission on its appropriateness.

CCP Governance: Improvements were made to the initial Commission proposal, which did not foresee any client representation at all. Unfortunately clients are not entitled to have permanent representatives on the CCP Board, although they “shall be invited to board meetings” for matters related to transparency, segregation, and portability. Clients have been granted, however, representation on the risk committee.

FX Derivative Contracts: Most FX contracts fall under EMIR’s scope and could therefore be subject to central clearing. The final decision is up to ESMA, but it is unclear which approach they will take (the proposed draft Technical Standards only include some general criteria), or whether it will be the same as the partial exemption permitted in the United States. In any case, an obligation to centrally clear FX contracts would presuppose the existence and notification of a CCP for certain classes of FX derivatives, and a public consultation by ESMA would be required.

In spite of all the technically challenging and important issues covered by EMIR, the most hotly debated issues during the discussion of the Level 1 text were political ones. Hottest of all were access to central bank funding for CCPs and CCP supervision (structure of the college of supervisors, supervisors’ decision-making powers).

Still unsolved are crucial issues such as the extraterritorial application of EMIR (the same applies to Dodd-Frank, of course), and rules for bilateral contract margins (ESMA is awaiting the recommendations by global regulators such as the Basel Committee on Banking Supervision and IOSCO).

Central clearing is key to mitigating systemic risk, but to achieve that goal CCPs must be properly structured, the “rules of the game” must be fair for all stakeholders, and risk management (not commercial interests) must be the highest priority. Only time will tell whether regulators worldwide have the right answers to these challenges.