The financial crisis that started in 2008 saw the collapse, nationalisation or merger of a number of major financial institutions. The ensuing liquidity crisis prompted governments to pledge reform of the regulation of over-the-counter ("OTC") derivatives, with the aim of reducing counterparty risk and improving transparency. World leaders at the G20 summit in October 2009 proposed that OTC derivatives should be cleared through central counterparties ("CCPs"), and that these transactions should be reported to trade repositories.
Various global initiatives are being implemented to enact the proposed reforms, most importantly the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") in the United States and both the European Market Infrastructure Directive ("EMIR") and a revision of the Markets in Financial Instruments Directive ("MiFID") (the revisions being collectively known as "MiFID II") in the European Union.
This article looks at the scope of the above regulations and their approach to clearing, margin, trading venues, position limits and reporting.
Scope of Regulations
OTC derivatives contracts are defined as derivative transactions that are executed neither on an EU regulated market nor on a non-EU country market considered as equivalent to a regulated market.
A regulated market is defined under MiFID as a multilateral system operated and/or managed by a market operator. It brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments in the system and in accordance with its non-discretionary rules in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems. A regulated market must be authorised and function regularly in accordance with MiFID.
The definition of OTC derivatives covers a wide range of swaps, options, futures and other derivatives contracts on securities, currencies, interest rates, financial indices, credit, commodities and other underlyings specified under MiFID. Spot foreign exchange and forward foreign exchange contracts are currently not deemed to be OTC derivatives though this may be subject to revision.
Dodd-Frank is intended to cover nearly all OTC derivatives, which are regulated by both the U.S. Commodity Futures Commission ("CFTC") and the U.S. Securities and Exchange Commission ("SEC") and are divided into "swaps", which are regulated by the CFTC, and "security-based swaps", which are regulated by the SEC. Entities that use both "swaps" and "security-based swaps" are subject to regulation by both the CFTC and the SEC.
"Swaps" include options, contingent forwards, exchanges of payment or transactions that are based on an underlying financial product, and products that become known as swaps in the market. These include, among other things, interest rate swaps, commodity swaps, credit default swaps, currency swaps, foreign exchange swaps, forwards and options and total return swaps.
"Security-based swaps" are defined as swaps that are based on (i) a narrow-based security index (generally defined as containing nine or fewer components), (ii) a single security or loan or (iii) the occurrence or non-occurrence of an event relating to a single issuer of a security in a narrow-based security index, provided that such event directly affects the financial statements, financial condition or financial obligations of the issuer concerned.
These terms are defined in Dodd-Frank, which requires that the CFTC and SEC further define them via rulemaking (scheduled to be adopted in a joint rulemaking in 2012).
EMIR requires that certain classes of OTC derivatives between financial counterparties must be cleared through a CCP.
Financial counterparties include:
- investment firms;
- credit institutions;
- insurance, assurance and reinsurance companies;
- UCITS funds;
- pension funds; and
- alternative investment funds.
The CCP will be an intermediary and will be contractually placed in between the two financial counterparties to a given transaction. The CCP will be a buyer to every seller and a seller to every buyer. The CCP maintains its relationship with counterparties through clearing members, who complete the contractual link between CCPs and counterparties. CCPs reduce counterparty risk should one of the financial counterparties fail to make a payment or delivery due to insolvency, because the CCP will assume all counterparty risk and guarantee payment or delivery.
Non-financial counterparties are required to comply with the above central clearing obligation if they exceed a clearing threshold (still to be specified by the EU Commission). A non-financial counterparty is defined as any EU undertaking that is not a "financial counterparty", and so would include entities such as airlines and energy companies.
The following criteria will be used to determine whether a class of OTC derivatives should be subject to the central clearing obligation:
- the degree of standardisation within the contractual terms of the OTC derivatives concerned and the operational processes applicable to such contracts;
- the availability of fair, reliable and generally accepted pricing information in respect of the relevant class of OTC derivatives; and
- the volume of trading and liquidity.
Financial counterparties and certain non-financial counterparties who are subject to the central clearing obligation, but whose class of derivatives are deemed not to be subject to central clearing (i.e., highly bespoke, illiquid OTC derivatives), must make arrangements to monitor and mitigate operational and credit risk, which should include ensuring timely confirmation of transactions (ideally by electronic means) and the holding and exchange of appropriate capital.
The new central clearing obligation will require financial counterparties that use OTC derivatives to supplement their existing ISDA contracts to allow for a contractual relationship with a clearing member and, where relevant, enable the level of collateral required by the CCP concerned to be provided. The financial counterparty must also appoint clearing members to allow it to perform its clearing obligation, which will accrue additional cost.
EMIR provides for an exemption from the clearing obligation for intra-group transactions.
Dodd-Frank requires clearing of all designated swaps and security-based swaps, where accepted by a "derivatives clearing organisation" ("DCO") or "security clearing agency" and approved by either the SEC or the CFTC, as applicable. Swaps that are required to be cleared will also be required to be executed on a board of trade designated as a "contract market", an exchange or a swap execution facility ("SEF") (discussed below).
Dodd-Frank sets forth mandatory considerations for the relevant DCOs and review by the CFTC and SEC in determining whether an OTC contract must be cleared and exchange traded. The process pursuant to which contracts will be designated for clearing and exchange trading is subject to definition by further rulemaking.
There is an "end-user" exemption to the centralised clearing requirement for an entity that is not a "financial entity" (defined below) and that is using the relevant swap or security-based swap transaction to hedge or mitigate commercial risk. The exemption does not include speculative hedges or provide for an "intra-group" exemption. Financial entities that do not benefit from the end-user exemption include swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, commodity pools, some types of private funds, ERISA plans and banking entities.
Non-cleared contracts will still be subject to CFTC or SEC substantive recordkeeping, reporting and capital and margin requirements.
Counterparties to OTC derivatives transactions will be required under EMIR to post both initial margin and variation margin to the clearing member, who in turn will post the margin with the CCP. Variation margin is intended to cover the risk of fluctuations in the market value of a derivatives contract, while initial margin is an additional protection against potential risks not covered by variation margin.
A CCP can only receive highly liquid collateral with minimal credit and market risk to protect against initial and ongoing exposure to clearing members.
Under current bilateral contractual relationships between OTC derivatives counterparties, margin is not posted — instead, collateral is called based on negotiated collateral terms that are commonly found in a Credit Support Annex. This collateral can be one-way, where one of the counterparties is better capitalised, ensuring it receives rather than posts collateral. Under EMIR, both counterparties would have to meet the more stringent and frequent margin requirements that would be based on exposure to the other counterparty rather than bilateral negotiated terms.
Alternative investment funds that are required under the Alternative Investment Funds Managers Directive ("AIFMD") to maintain a depositary may experience operational issues by having to make frequent transfers of margin between the depositary they are required to appoint under the terms of the AIFMD, and the CCP.
Both initial and variation margin will be required for each swap and security-based swap that is entered into with a swap dealer, major swap participant, security-based swap dealer or security-based major swap participant.
For cleared swaps and security-based swaps, the margin requirement for swap dealers and major swap participants will be determined by the DCO or securities clearing agency, as applicable. Only a CFTC registered futures commission merchant ("FCM") can accept and hold margin for a cleared swap and only a SEC registered broker, dealer or security-based swap dealer can accept and hold margin for a cleared security-based swap. Buy-side users are currently negotiating annexes to their trading account agreements pursuant to which they will post required margin. The intermediaries will in turn be required to post certain amounts of margin to the relevant DCO or SEF.
Dodd-Frank put in place certain customer protection principles relating to margin posted to support OTC derivatives. The CFTC has adopted rules that impose requirements on FCMs and DCOs to protect cleared swap customer contracts and related collateral and enhance portability of cleared swaps in the event of an FCM's bankruptcy. The SEC is currently working on similar rules.
For non-cleared swaps, the margin requirement for swap dealers and major swap participants, security-based swap dealers and security-based major swap participants will be determined by the appropriate federal banking agency, or the CFTC or the SEC, as applicable.
For non-cleared swaps, Dodd-Frank provides that the counterparty that is a commercial end-user may require that the initial margin is segregated and held with a third-party custodian.
Many of the substantive margin requirements imposed by Dodd-Frank remain yet to be implemented by the CFTC or SEC, as applicable.
EMIR places reporting obligations in relation to cleared and uncleared derivatives contracts on financial and non-financial counterparties. Details of all concluded OTC or exchange-traded derivatives contracts must be reported to a registered or recognised trade repository no later than the working day following execution, clearing or modification of the relevant contract. At a minimum, the information must include the parties to the contract and the beneficiary of the rights and obligations arising from the contract.
Trade repositories are required to publish aggregate positions by class of derivatives on non-discriminatory terms. Where a trade repository is not available to record the details of an OTC derivatives contract, counterparties and CCPs are responsible for ensuring that the details of the OTC derivatives contracts are reported to the European Securities and Markets Authority ("ESMA").
Non-financial counterparties only have to report the details of OTC derivatives contracts where an information threshold has been exceeded. This threshold is still to be specified. If the threshold is not exceeded, then the reporting obligations will not apply to non-financial counterparties.
MiFID II gives EU Member State regulators the authority to demand information from any entity regarding the size and purpose of a derivative position. They may then require that entity to reduce the size of that position.
MiFID II will also require all trading venues to abide by identical transparency requirements. Pre-trade rules will require prices and the depth of trading interests to be published on a continuous basis during normal trading hours. Post-trade rules will require that the price, volume and time of transactions are published as close to real-time as possible.
In addition to the EMIR reporting obligations above, MiFID II has also extended the scope of its transaction reporting requirements so that the only instruments escaping the reporting requirement will be (i) instruments not admitted to trading on a multilateral trading facility ("MTF") or organised trading facility ("OTF"); (ii) instruments whose value does not depend on that of financial instrument admitted to trading or traded on an MTF or OTF; and (iii) traded instruments that will not have an impact on an instrument admitted for trading or traded on an MTF or OTF.
Every party that enters into any swap (or terminates, assigns, transfers or amends a swap, among other things) is potentially required to report such swap to a swap data repository or a security-based swap repository, or the CFTC or SEC, as applicable, if a swap data repository would not accept the relevant swap. The reporting requirements apply to most swaps, except for limited categories such as internal swaps between wholly owned subsidiaries, whether executed on a regulated trading platform (such as a swap execution facility) or off-exchange.
For swaps executed on a regulated trading platform, the platform must report the positions. For off-facility swaps, an entity that participates in such swaps will be required by the SEC or CFTC to maintain books and records in regards to such swaps, which will be open to inspection by the SEC or the CFTC, as appropriate. The responsibility for reporting such off-facility swaps depends upon which counterparty is better suited to make the report as designated in the applicable CFTC or SEC rules. The CFTC has adopted rules in this area, but the Dodd-Frank required reporting requirements have yet to be implemented by the SEC.
MiFID II requires that trading of standardised OTC derivatives on exchanges or electronic trading venues and which are capable of being cleared under EMIR be moved to one of the following: (i) a regulated market; (ii) an MTF; (iii) a systematic internaliser ("SI"); or (iv) a proposed new trading venue, the OTF.
OTFs have been designed to cover all unregulated trading that has until now taken place outside the official MiFID trading venues in unregulated arrangements such as broker-crossing systems and inter-dealer broker systems.
ESMA will identify and require certain classes of derivatives only to trade through regulated markets, MTFs, OTFs or non-EU trading venues located in a country that imposes requirements equivalent to those in MiFID II. It is envisaged that only ad hoc trading in shares, bonds and non-standardised derivatives will be allowed to continue on an OTC basis and outside of trading venues. In deciding whether a class of derivatives must trade through trading venues, ESMA will consider the liquidity of that class, evaluating such factors as size of positions and average frequency of transactions.
MiFID II will cause EU counterparties to be subject to the trading venue requirement when they enter into transactions with non-EU entities that would be subject to the EMIR clearing obligations if they were established in the EU. Even if there is no participation by an EU counterparty, third-country entities will be subject to the trading venue requirement where (i) they would be subject to the EMIR clearing obligation if they were domiciled in the EU and (ii) the contract has a "direct, substantial or foreseeable effect within the EU".
Dodd-Frank requires that all swaps and security-based swaps that are required to be cleared are also to be made available to trade on a regulated exchange or a swap or security-based swap execution facility ("SEF"), unless no SEF is willing to list the swap. An SEF is defined as a trading system or venue that is not an exchange but that is open to, and allows, multiple participants to execute or trade swaps by accepting bids and offers by other participants.
Where there is a significant price movement in a particular commodity derivative, trading venues that trade such commodity derivatives must apply clear, transparent and non-discriminatory limits to the number of contracts that traders can enter into over a short time period as determined by the EU Commission. In exceptional cases, national regulators can impose more restrictive limits for a period of six months.
In accordance with a Dodd-Frank mandate, the CFTC has established position limits for swaps relating to 28 physical commodities, including referenced energy, metal and agricultural exchange-traded futures, incorporating OTC derivatives into the CFTC's existing position limits regime. There is a limited exclusion for bona fide hedges in physical commodities.
These position limits will be aggregated across entities where, subject to certain limitations and exemptions, a person controls the trading decisions and all the positions in which that person has a ten percent or greater ownership interest (directly or indirectly) in the relevant swap (e.g., a 10% or greater owner of a fund). Swap positions entered into prior to the enactment of Dodd-Frank will be exempt from the position limits.
For security-based swaps, the SEC may impose limits on the size of positions held by any person, and may require reporting by such persons. Such limits may be required to be aggregated with positions in the securities or loans that the security-based swap is based upon or references, or to which it is related, or any group or index of securities that is the basis for a material term of the security-based swap or any instrument relating to the same security or group or index of securities.
The U.S. and EU regulations on OTC derivatives will affect financial services participants in profound and material ways. Affected clients will likely face higher operational costs, more stringent reporting requirements and the added burden of higher margin and collateral requirements. Existing ISDA master agreements will likely need to be amended to allow for the new clearing regimes.
The impact on existing derivatives products and what the level of collateral requirements for central clearing will be, is as yet unknown. It is worth noting, however, that the higher global banking capital requirements of Basel III may undermine regulators' commitment to uniformly high collateral requirements for central clearing, as the cost to the already beleaguered global banking industry may be too punitive in the context of a weakening global economy.
Whatever the consequences, institutions likely to be affected by the changes in OTC derivatives regulation should note that the impact of the proposals will be adverse cost implications, stricter operational and reporting requirements and the likelihood that there will be fewer types of derivatives products in the market.
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.