May 3, 2012
Over-the-counter (OTC) derivatives are an important means to hedge risks in financial markets and are therefore key tools for companies, authorities and financial institutions in managing their exposure to risks linked with interest rates, exchange rates, commodity prices etc. Prior to the financial crisis, OTC derivatives markets were largely unregulated. In 2009, the G20 leaders agreed that all standardised OTC derivative contracts should be cleared through CCPs, that all derivative contracts should be reported to trade repositories and that non-centrally cleared contracts should be subject to higher capital requirements. In the EU, the G20 commitment is implemented by the EMIR which was finalised in February 2012 and approved by the European Parliament in March 2012.
Globally, the gross value of the OTC derivatives market totals USD 18.104 trillion (see chart). Prior to the financial crisis, OTC derivatives markets were largely unregulated. However, as the financial crisis has brought to light many weaknesses in OTC derivatives markets, such as their intransparency, inherent counterparty risks and the danger of contagion, there has been an international effort to increase stability in (OTC) derivatives markets and to reduce risks associated with them. In 2009, the G20 leaders agreed that all standardised OTC derivative contracts should be cleared through central counterparties (CCPs) from the end of 2012 at the latest, that all derivative contracts (not only OTC derivatives) should be reported to central data centres, i.e. trade repositories which would have to publish aggregate positions by class of derivative, and that non-centrally cleared contracts should be subject to higher capital requirements.
In the EU, the G20 commitment to centrally clear and report OTC derivatives is implemented by the European Market Infrastructure Regulation (EMIR) which was finalised in February 2012 and approved by the European Parliament in March 2012. It will take effect at the end of 2012. Commensurate with the G20 commitment, the regulation requires all derivatives to be centrally reported and standard OTC derivative contracts to be cleared through CCPs. Furthermore, it requires and establishes stringent organisational, business-conduct and capital requirements for the CCPs. Derivatives that are not centrally cleared will be subject to higher margin and capital requirements. Information on all European derivative transactions will thus be reported to trade repositories and will be accessible to supervisory authorities, including the European Securities and Markets Authority (ESMA), so that policy makers and supervisors may obtain an overview of the distribution of risk in the markets.
During the legislative process, the biggest debates centred on the issue of who is responsible for authorising CCPs. A matter of particularly fervent debate was whether to give a binding mediation role to ESMA in disputes between national regulators over the authorisation of CCPs. In the end, the European Parliament secured a mediation role for ESMA in cases in which a supervisory college blocks authorisation of a CCP. Other issues of dispute, such as the period during which pension schemes are exempt from the central clearing obligation and the way in which third-country CCPs are to be treated, have also been resolved: a relatively loose regime has been established for pension schemes with regard to the clearing obligation. This will apply for three years, extendable by another two years plus one, subject to proper justification, and CCPs from third countries will be recognised in the EU only if the legal regime of the third country in question provides an effective equivalent system for recognition. This does not, however, set a standard for other legislation on the oversight and supervision of financial market infrastructure.
Detailed rulemaking has been delegated
EMIR delegates a number of areas of detailed rulemaking to the European Commission and these technical standards will be developed by the European Supervisory Authorities (ESAs). ESMA, in particular, is now tasked with drafting the implementing measures. These measures shall specify: i) which classes of derivative must be cleared centrally, ii) what the capital requirements for non-cleared trades will be, iii) how intra-group transactions will be treated and iv) what exemptions will be made for pension funds and non-financial companies. In the rulemaking process, numerous consultation papers were published by the ESAs in March 2012 to seek industry views. Input from stakeholders will now be used to shape the draft technical standards for which ESMA faces a deadline of September 30, 2012. Once finalised, the standards will be endorsed by the European Commission and are expected to enter into force by end-2012 or early 2013.
In formulating the implementing measures and finalising the rules, regulators should seek to align US and EU reforms for OTC derivatives markets. An eye should thus be cast on cross-border trades and cross-border coordination, since cross-border coordination in implementing clearing requirements is crucial. If different jurisdictions have different clearing requirements, it may be impossible for cross-border transactions to comply with both sets of applicable requirements.
So far, ESMA has aimed for convergence with the US rules on minimal margin requirements. In parallel, a group of international bodies including the Basel Committee for Banking Supervision and the International Organization of Securities Commissions (IOSCO) have established a working group to examine whether to set global minimum margin requirements to avoid regulatory arbitrage. Also, IOSCO recently joined forces with the Committee on Payment and Settlement Systems (CPSS) to publish new international standards for payment, clearing and settlement systems, including CCPs, which should be adopted by the end of 2012. This new set of global standards toughens requirements for how CCPs manage risk. As such, it imposes thorough stress testing and margin requirements as well as segregation and portability standards. Furthermore, it addresses concerns that arise when derivatives are cleared on a global basis, such as the access by regulators and firms to CCPs based in other jurisdictions. Generally, it is sensible to seek (international) coordination on risk management standards since competition on standards, such as the size of the margin a CCP may demand, carries the risk that clearing houses will water down those standards to win deals. However, it would be preferable for CCPs to compete on the quality of services offered.
Furthermore, regarding the definitions of which instruments must be cleared, regulators should be vigilant: the more complex and illiquid a derivative is, the less suited it is to clearing as i) market volume will be too small and ii) it will be difficult for the CCP to find adequate collateral or margin requirements. To clear such trades centrally would thus not be viable.
On an operational level, one important aspect is that the rules which need to be coded into IT systems (e.g. which derivatives are to be cleared) are explicit and sufficiently detailed to allow consistency of implementation across the single market.
Concerning trade reporting, attention should be paid to the potential for non-financial firms to be overloaded by burdensome requirements and the interaction of reporting rules under EMIR and the MiFID. Thus far, ESMA has announced that it is aiming for a broad and flexible definition of hedging but a low clearing threshold. Generally, exemptions for non-financials that typically use derivatives to manage business risk and smooth out cash flows over time can be welcomed as long as the institution in question does not pose any systemic risk.
The future of the OTC derivatives industry critically hinges on whether the regulation strikes an appropriate balance between greater stability and preserving the benefits of vibrant derivatives markets. EMIR seems to have found that balance – as long the ESAs keep an eye on the critical points when finalising the implementing measures.
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