UK: Reform Of OTC Derivatives – Overview Of The Changes Ahead

Last Updated: 25 August 2011
Article by James Cooper, Dianne Bell, Adam Blair and Rupert Connell

Deficiencies in the European derivatives markets are to be tackled under a proposed regulation known as the European Market Infrastructure Regulation (the EMIR). This draft regulation was published by the European Commission in September 2010 and aims to increase transparency and reduce counterparty risk (ie, the risk of default by one party to the contract) in the over-the-counter (OTC) derivatives markets. It also implements commitments made in 2009 by the G20 leaders that all standardised OTC derivatives should be cleared through central counterparties by the end of 2012 and that such arrangements should also be reported to trade repositories.

Standardisation implies a set of fixed parameters that define a product or contract in a manner that will support the trading interests of multiple market participants and enables, for example, trade matching and offsetting. Determining the level of standardisation can involve a number of factors such as legal standardisation (uniformity of contracts), operational standardisation (common trade processing and procedures) and market liquidity.

An amended version of EMIR was recently approved by the EU Parliament's Economic and Monetary Affairs Committee, but debate still continues in the Council of the European Union (the Council) on certain key elements ahead of reaching agreement on its own position and set of amendments. The rules themselves are unlikely to be finalised until autumn 2011. Globally, the new rules on OTC derivatives need to be implemented by the end of 2012 in order to meet the G20 agreed timetable.

Controversy has surrounded the negotiations over EMIR and the matters it seeks to regulate. A number of political issues and other contentious issues remain with the latest draft proposals. This briefing note provides a broad overview of the proposed changes and is the first in a series of briefing notes that will subsequently focus on the different aspects of EMIR and how it will affect European and national regulators and certain participants.

Background

The aim of the proposed regulation is to lay down uniform requirements for OTC derivative contracts, and for the performance of central counterparties (CPPs) and trade repositories. It is designed to address the four objectives raised by the Commission in its 2009 communication "Ensuring Efficient, Safe and Sound Derivatives Markets" made in reflection upon the financial crisis, namely to:

  • allow regulators and supervisors to have full knowledge about the transactions that take place in OTC derivatives markets as well as the positions that are building in those markets;
  • increase the transparency of OTC derivatives markets for their users, in particular, more and better information about prices and volumes should be available;
  • strengthen the operational efficiency of derivatives markets so as to ensure that OTC derivatives do not harm financial stability; and
  • mitigate counterparty risks and promote centralised structures.

EMIR is also one part of a broader initiative to regulate markets that is underway and involving MiFID, CRD IV and CSDs. Many parts of EMIR overlap with matters falling under the scope of MiFID (eg, transaction reporting issues) and will, therefore, depend upon the outcome of the MiFID II Review.

What activities does EMIR regulate?_

Four distinct sections or areas of regulation are covered under EMIR.

Clearing, reporting and risk mitigation of OTC derivatives

The Commission's aim is to bring in as many contracts as possible within the mandatory clearing regime. EMIR will require all "eligible" OTC derivative contracts that are entered into by financial counterparties to be cleared through a CCP. It will set out the process for determining whether a contract is "eligible" for mandatory clearing. There will also be a public register maintained and updated by the European Securities and Markets Authority (ESMA) containing "eligible" classes of derivatives and the CCPs authorised to clear them.

Certain details of OTC derivative transactions must also be reported to registered trade repositories (this will, broadly speaking, include details such as the parties, beneficiaries and main characteristics of the contract). The Commission hopes that such information will be easily accessible to ESMA, national regulators and central banks and will thus generate a greater sense of transparency and a reduction of risk in the OTC derivatives markets.

Different EMIR rules will apply to OTC derivative contracts that are not subject to mandatory clearing by a CCP (eg, nonstandardised or illiquid OTC derivative contracts). In these circumstances, financial counterparties (and some non-financial ones) must meet EMIR's provisions relating to risk mitigation. These involve onerous requirements which are designed to manage operational and credit risk.

Authorisation, supervision and Requirements for CCPs

Once EMIR comes into effect, CCPs will play a central role in the derivatives market and their regulation and supervision will be of critical importance. The provisions define a CCP as any entity that legally interposes itself between the counterparties to the contracts traded within one or more financial markets, becoming the buyer to every seller and the seller to every buyer. CCPs will be used to meet the clearing obligation and must be authorised in their home Member State. In order to be authorised, they must have access to adequate liquidity and will be subject to minimum capital requirements (currently set at EUR5 million under the EMIR). CCPs will also be subject to various organisational requirements, conduct of business rules and prudential requirements, which include having clear and transparent organisational structures; robust governance arrangements and being subject to frequent and independent audits.

Interoperability

EMIR contains provisions to enhance cooperation agreements (known as "interoperability") between clearing houses. Such an arrangement is defined in EMIR as an arrangement between two or more CCPs that involves a cross-system of transactions. The interoperability provisions are limited to cash securities. Under the current draft, CCPs can only enter into interoperability arrangements where certain risk management and approval requirements are met (eg, it has functioned in line with the standards for at least three years before it can apply for authorisation for interoperability).

Registration and surveillance of trade Repositories

A trade repository is an entity that centrally collects and maintains the records of OTC derivatives. These bodies must apply to, and be registered with, ESMA. They will be subject to similar general requirements to those of CCPs, ie, concerning clear organisational structures and suitable senior management systems and controls. The trade repositories will be required to publish aggregate positions by class of derivatives on the contracts reported to it. This information will be made available to EMSA, regulators and central banks.

Once registration with ESMA has been obtained, it will be effective for the EU. Third country trade repositories will be required, under EMIR, to seek recognition from ESMA and meet certain equivalence conditions.

What instruments does EMIR Apply to?

EMIR covers all areas of the OTC derivatives market, including equity, credit, interest rate, and most foreign exchange and commodities contracts. The Commission did not believe there was strong evidence to justify a blanket exclusion of any particular instrument from the scope of the proposals, so the scope is broad. All categories of OTC derivative contracts as set out in Annex 1 Section C of MiFID are covered by EMIR.

"Eligibility" – two processes

1 "Bottom-up" approach: a decision is made by a CCP to clear and it obtains authorisation to do so after informing its regulator. ESMA can then (after a public consultation) decide a clearing obligation should apply at all those contracts in the EU.

2 "Top-down" approach: classes of OTC derivatives contracts can be identified by ESMA (with the European Systemic Risk Board) at any time for inclusion on the public register.

There is no definition of the classes of derivatives that will be subject to the mandatory clearing provisions. Instead, and as mentioned above, EMIR sets out a process for determining whether a contract is "eligible" and therefore caught by the clearing obligation.

Which participants are covered by EMIR?

EMIR applies to financial counterparties and non-financial counterparties (as set out below) whose dealings with OTC derivatives exceed certain thresholds. It does not apply to European central banks, public bodies charged with or intervening in the management of public debt and multilateral development banks.

Financial counterparties

A broad definition of a "financial counterparty" is given in EMIR which covers the following institutions:

  • investment firms;
  • credit institutions;
  • insurance undertakings;
  • assurance undertakings;
  • reinsurance undertakings;
  • UCITS funds;
  • institutions for occupational retirement provision; and
  • alternative investment funds.

Non-financial counterparties

For non-financial counterparties, the scope of this widely framed requirement for CCP clearing has been narrowed. Any EU established undertaking that is not regarded as a "financial counterparty" will be subject to certain requirements under EMIR as a "non-financial counterparty". Where a contract is otherwise deemed eligible, nonfinancial counterparties will only be covered by EMIR where certain thresholds (to be determined later and in the form of technical standards) are exceeded:

  • A non-financial counterparty will only be required to clear trades if it takes positions in the OTC derivatives market that exceed a specified "clearing threshold". The concept of the clearing threshold is intended to assist those non-financial counterparties who use OTC derivative contracts to protect themselves against commercial risks directly linked to their commercial activities. EMIR excludes contracts that are "objectively measurable" as directly linked to the commercial activity of the non-financial counterparty.
  • Even where a non-financial counterparty is not caught within the scope of the clearing threshold, it may still be subject to EMIR's reporting obligation. This obligation will arise where the "information threshold" has been exceeded and will require the reporting of trades to trade repositories. This will enable regulators to identify where non-financials have accumulated significant positions within the OTC derivatives market.

Precise details of both these thresholds are not contained in EMIR. They will be set out in the form of technical standards which ESMA will develop in 2012.

Will EMIR operate retrospectively?

EMIR is not expected to have retrospective effect, but it is likely to impact all those OTC derivatives contracts that ESMA declares to be "eligible", which could mean that all those contracts entered into after EMIR itself came into force would need to be cleared and reported.

What is the status of EMIR now?_

The creation of a European regulatory regime for OTC derivatives has been a highly challenging task. As at the end of the Hungarian Presidency of the Council on 20 June 2011, EMIR continues to raise a number of political landmines and contentious regulatory issues that cannot be resolved until the political issues have settled. The major outstanding issues appear to be:

  • ESMA powers: the role of ESMA, including the process around the authorisation and registration of CCPs.
  • Scope: whether or not the scope of the clearing and reporting obligations should apply to all derivative contracts or just OTC contracts. There are sharply different views on this issue and the extent to which there should be exemptions by type of participant (eg, pension funds) and by asset class (eg, FX).
  • Third country provisions: concerning the recognition of third country CCPS (and the effort to mirror similar US provisions).

EMIR was originally expected to be adopted by the European Parliament at its plenary sitting scheduled for 5 July 2011, but this was postponed until autumn 2011 due to Member States' failure to agree on which derivatives contracts ought to be covered. Once the Council reaches an agreement on its set of amendments, the final EMIR text will be resolved. EMIR is subject to the EU's standard legislative "co-decision" procedure which involves approval by both the European Parliament and the Council. It is hoped that the vote which will take place in the autumn (likely sometime in September 2011) will result in agreement on the text and avoid the need to move to the second reading stage.

Comment

EMIR involves a radical shake-up of the OTC derivatives market and creates a number of new obligations and processes. The obligation to centrally clear OTC derivatives contracts is likely to lead to higher costs and more stringent collateral requirements for derivatives traders. Many financial institutions will already be subject to various pressures by the other structural and substantive financial regulatory reforms due for implementation at both the national and European-wide level.

Many fundamental aspects of the legislation remain unclear, creating uncertainty for special interest groups, including pension schemes, real estate investors and private equity funds.

It will be important for firms operating in this area to maintain a watching brief as EMIR progresses towards finalisation. As mentioned above, we plan to release further briefing notes on specific topics of interest arising under the EMIR proposals and plans for the regulation of OTC derivative contracts.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.