Background
Over-the-counter ("OTC") derivatives contracts have long been viewed as the domain of sophisticated professional investors such as large corporate entities, institutional investors and financial institutions. As such, historically the OTC market has been only lightly regulated, the assumption being that professional investors are sufficiently aware of the risks associated with their various transactions and that such investors have a vested interest in effectively hedging their exposures.
Events since the near-collapse of Bear Stearns and the bankruptcy of Lehman Brothers have raised questions as to whether the OTC derivatives market should be allowed to continue to self-regulate and there is currently a global move towards improving regulatory and supervisory knowledge of, and transparency in relation to, the OTC derivatives market.
The G20 Summit
The main drive for reform has developed at an international level. In April this year, the G20 agreed upon a commitment to "promote the standardisation and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision" and subsequently at their meeting in Pittsburgh on 25 September 2009 adopted the following Declaration:
"All standardized OTC derivative 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. We ask the [Financial Stability Board] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse."
European Commission
Taking its cue from the international consensus, the Commission has been developing more specific proposals. On 3 July 2009, the Commission published its Communication "Ensuring efficient, safe and sound derivatives markets" (COM (2009) 332) which was issued with an accompanying consultation document upon which stakeholders were invited to comment. The consultation process concluded on 31 August 2009 and a further Communication, "Ensuring efficient, safe and sound derivatives markets: Future policy actions" (COM (2009) 563) (the "October Communication") was published by the Commission on 20 October 2009.
In these Communications, the Commission opted to develop comprehensive policies for the OTC derivatives market as a whole rather than using a market segment-specific (eg. credit default swap only) regulatory approach. The aim in doing this was to prevent (so far as possible) market participants structuring transactions so as to exploit differences in the rules (so-called "regulatory arbitrage"). In recognition that the OTC derivatives market is also a global market, there was an express desire that any regulation or legislation be consistent with non-EU markets and, in particular, that the EU model be consistent with the approach adopted in the U.S., thereby again avoiding regulatory arbitrage.
The Commission recognises that there will be a need to incentivise market-wide adoption of these changes due to the costs for market participants adapting to the proposed new systems. As a result, although the Commission has undertaken to provide proposals for legislative reforms in 2010, it is also committed to carrying out impact assessments before finalising such proposals, taking into account stakeholder evidence with regard to the costs and benefits of implementing each proposal.
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Background
Over-the-counter ("OTC") derivatives contracts have long been viewed as the domain of sophisticated professional investors such as large corporate entities, institutional investors and financial institutions. As such, historically the OTC market has been only lightly regulated, the assumption being that professional investors are sufficiently aware of the risks associated with their various transactions and that such investors have a vested interest in effectively hedging their exposures.
Events since the near-collapse of Bear Stearns and the bankruptcy of Lehman Brothers have raised questions as to whether the OTC derivatives market should be allowed to continue to self-regulate and there is currently a global move towards improving regulatory and supervisory knowledge of, and transparency in relation to, the OTC derivatives market.
The G20 Summit
The main drive for reform has developed at an international level. In April this year, the G20 agreed upon a commitment to "promote the standardisation and resilience of credit derivatives markets, in particular through the establishment of central clearing counterparties subject to effective regulation and supervision" and subsequently at their meeting in Pittsburgh on 25 September 2009 adopted the following Declaration:
"All standardized OTC derivative 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. We ask the [Financial Stability Board] and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse."
European Commission
Taking its cue from the international consensus, the Commission has been developing more specific proposals. On 3 July 2009, the Commission published its Communication "Ensuring efficient, safe and sound derivatives markets" (COM (2009) 332) which was issued with an accompanying consultation document upon which stakeholders were invited to comment. The consultation process concluded on 31 August 2009 and a further Communication, "Ensuring efficient, safe and sound derivatives markets: Future policy actions" (COM (2009) 563) (the "October Communication") was published by the Commission on 20 October 2009.
In these Communications, the Commission opted to develop comprehensive policies for the OTC derivatives market as a whole rather than using a market segment-specific (eg. credit default swap only) regulatory approach. The aim in doing this was to prevent (so far as possible) market participants structuring transactions so as to exploit differences in the rules (so-called "regulatory arbitrage"). In recognition that the OTC derivatives market is also a global market, there was an express desire that any regulation or legislation be consistent with non-EU markets and, in particular, that the EU model be consistent with the approach adopted in the U.S., thereby again avoiding regulatory arbitrage.
The Commission recognises that there will be a need to incentivise market-wide adoption of these changes due to the costs for market participants adapting to the proposed new systems. As a result, although the Commission has undertaken to provide proposals for legislative reforms in 2010, it is also committed to carrying out impact assessments before finalising such proposals, taking into account stakeholder evidence with regard to the costs and benefits of implementing each proposal.
Standardised and non-standard derivatives contracts
The October Communication acknowledged that not all derivatives contracts would be suitable for central clearing either because they are highly specific to the trade concerned or due to the product not being liquid enough for central clearing. Nonetheless the Commission stated that such bespoke derivatives should be "appropriately priced in relation to the systemic risk they entail, in order to avoid those risks being passed on to taxpayers" and noted that "current collateral levels are too low and do not reflect the risk that bilaterally-cleared derivatives trades pose to the financial system when they reach a certain critical mass".
As a result, the Commission proposes that financial firms entering into non-standardised contracts will be required to post "initial margin" in proportion to the risk profile of the counterparty and "variation margin" in relation to the change in value of the contract over time. In addition to mitigating the risk of default, these measures are also intended to dissuade participants from entering into non-standardised contracts which could have been standardised and cleared centrally.
Bilateral non-cleared OTC contracts will also be subject to higher capital charges. The gap between the relative capital charges for cleared and non-cleared derivatives provided for within the Capital Requirements Directive ("CRD") will be widened and the Commission will work with the Basel Committee on Banking Supervision to amend the CRD appropriately (see "Further Commission Proposals for Minimising Operational Risk in OTC Derivatives Markets" below). As with margin, this increased relative cost for bilateral non-cleared OTC contracts is viewed to be consistent with the increased risk associated therewith.
The Commission intends that central clearing for all standardised contracts should be mandatory and will work with other non-EU G20 nations in order to develop a consistent approach to defining which contracts are in fact standardised. The key question as to what will constitute "standardised" and "non-standardised" contracts has not yet been agreed.
Non-Financial Institutions
Many non-standardised, bespoke contracts are industry or sector specific and often involve counterparties who are corporate non-financial entities and who need to hedge specific exposure. There is a concern that such corporate entities might be disadvantaged through having to post additional collateral in relation to their non-standardised contracts. While the Commission undertakes to take account of the relative difficulty that might be faced by non-financial corporate counterparties in posting collateral, it is cautious of creating loopholes that might be exploited. As a result, it is currently intended that regulation will be proposed permitting non-financial corporate entities to continue transferring risk using derivatives (especially when under a certain threshold) without posting additional collateral. Currently there is no definition for what constitutes a "non-financial corporate counterparty" however and there is an awareness that such definition, when finalised, should not allow institutions that compete with banks in the OTC derivatives market to have a regulatory and financial advantage.
Clearing
Clearing is the name given to the post-trade processes other than the final payment and discharge of obligations (i.e. settlement) and includes trade matching and confirmation. Both the G20 and the Commission view the use of central clearing counterparties ("CCPs") as the main tool to mitigate counterparty risk. CCPs have operated in Europe for some time but until recently were regulated by individual EU member states. Given the importance ascribed by the Commission to CCPs, the need for consistent Europe-wide regulation and supervision is something that the Commission has prioritised. The Commission therefore intends proposing legislation in 2010 to establish common safety, regulatory and operational standards for all CCPs.
What is a CCP and how could their use benefit the derivatives market?
In order to explain what CCPs are and how entering into derivatives transactions through them could benefit the derivatives markets (and thereby wider financial markets) it is necessary to explain the different effect on counterparty exposure that arises when transactions are carried out through a CCP as against when they are not.
Typically, where there is a bilateral derivatives master agreement under which Party A defaults, Party B is able to net any amount owed to Party A against any amount due to it from Party A, taking into account all the trades covered by the master agreement. This results in a single net figure representing a sum owing from or to Party A and thereby reduces potentially massive gross exposures.
Party A however is not likely to have entered into only one bilateral transaction but potentially hundreds of transactions with different counterparties and if Party A becomes bankrupt it is not usually possible for all these firms to combine their claims so that only one single amount is claimed against the bankrupt Party A. As a result, each firm will potentially have outstanding gross exposures for which it will need to account and, as a result, this potentially increases the risk of knock-on insolvencies.
Where parties deal through a CCP, the single master agreement is replaced by two back-to-back master agreements: one between Party A and the CCP and the other between Party B and the CCP. Under the terms of this arrangement, each trade between Party A and Party B is deemed to form two discrete contracts each of which mirrors the other. This arrangement also applies to each of the other numerous entities with whom Party A would otherwise have had a bilateral master agreement. The result of this is that, in the event of Party A's default, a global netting can take place whereby Party A's various net obligations to the CCP are set-off against the various debts owed by the CCP to Party A. In this way, the use of a CCP reduces the entire market's exposure to counterparty risk.
In addition to the mutualisation of claims, the use of CCPs also allows for the effective monitoring of market behaviour and provides regulators with accurate information on the trades taking place through it. The principal problem that could arise when using CCPs lies in the risk of insolvency of the relevant CCP itself. In order to mitigate this risk, CCPs will impose strict requirements as to initial margin and variation risk.
Key Concepts for CCPs
Two main areas need to be considered in order for CCPs to effectively work from the perspective of clearing members and their customers.
(i) Segregation
(ii) Portability
(i) Trade Repositories
(ii) Transparency and Market Integrity
Time line
The following time-line is taken from the October Communication and
sets out the action the Commission wants to take, and by when:
Objective |
Proposed actions |
Time line |
Reduce counterparty credit risk – strengthen clearing |
(1) Propose legislation on CCP requirements governing: |
Mid 2010 End-2010 |
Reduce operational risks - standardisation |
(3) Assess whether to re-shape the operational risk approach in
the CRD to prompt standardisation of contracts and electronic
processing. |
End-2010 On-going |
Increase transparency – trade repositories |
(5) Propose legislation on trade repositories: |
End 2010 |
Increase transparency - trading |
(6) Amend MiFID to require transaction and position reporting to
be developed in conjunction with CCPs and trade repositories; |
End-2010 |
Improve market integrity |
(10) Extend MAD to OTC derivatives; |
End-2010 |
This article was written for Law-Now, CMS Cameron McKenna's free online information service. To register for Law-Now, please go to www.law-now.com/law-now/mondaq
Law-Now information is for general purposes and guidance only. The information and opinions expressed in all Law-Now articles are not necessarily comprehensive and do not purport to give professional or legal advice. All Law-Now information relates to circumstances prevailing at the date of its original publication and may not have been updated to reflect subsequent developments.
The original publication date for this article was 10/12/2009.