The European Commission has adopted an "equivalence" decision on the derivatives regulatory regimes for derivatives clearing organisations in the United States. This follows the decisions adopted in November 2015 for Canada, Mexico, the Republic of Korea, South Africa and Switzerland and in October 2014 for Australia, Hong Kong, Japan and Singapore. Further decisions are awaited for other jurisdictions and for other derivatives regulatory requirements. This paper summarises the equivalence decisions and technical advice that has been produced to date.
Under the European Market Infrastructure Regulation ("EMIR")1, the European Commission may adopt implementing acts declaring that the legal, supervisory and enforcement arrangements of a non-EU country are equivalent to the requirements in EMIR2. Such a decision is necessary for a central counterparty ("CCP") or trade repository ("TR") established in a non-EU country to provide their services in the EU. EMIR also requires equivalence decisions to be issued in respect of other obligations. These are relevant in circumstances where one of the counterparties to a trade subject to EMIR is established outside the EU, as an equivalence decision would permit both counterparties to comply with the non-EU country's equivalent regime instead.
Under EMIR the European Commission may request the European Securities and Markets Authority ("ESMA") to provide technical advice as to the equivalence of some non-EU jurisdictions which host major derivatives markets or CCPs which have applied for recognition. ESMA's assessment is a factual comparison of the rules in the relevant jurisdiction with the EU rules and advice to the Commission on how any differences might affect an equivalence decision or could be incorporated into an equivalence decision. The scope of the advice covers the recognition of non-EU CCPs and TRs, the clearing obligation, reporting obligation, non-financial counterparties ("NFCs"), portfolio reconciliation, dispute resolution, portfolio compression and margin requirements.
The Commission's equivalence decision will be based on ESMA's advice and an assessment of the outcomes of the third country's rules, including whether the rules mitigate any risks faced by market participants in the EU to the same extent that the EMIR rules are intended to do so. The trading volumes in a jurisdiction can be relevant to an assessment of the risks posed to clearing members of a third country CCP. Those CCPs with larger trading volumes operating in larger financial markets will need to be subject to more rigorous risk mitigation requirements than those operating in smaller financial markets.3
On 10 February 2016, the European Commission and the Commodity Futures Trading Commission ("CFTC") announced a common approach on the supervision of CCPs operating in the US and EU (the "Common Approach").4 The agreement was necessary because key differences between the EU and US regimes had been preventing the Commission from adopting an equivalence decision for the US. Notably, the crucial discrepancy on minimum liquidation periods5 has been resolved - the EU liquidation period for exchange-traded futures contracts must be at least two business days whereas in the US it is one day and for customer positions, EU rules provide that clearing members may post margin on a net basis whereas the US rules require clearing members to post margin on a gross basis.
The European Commission has now adopted an equivalence decision.6 The decision mirrors the stipulations set out in the Common Approach. The equivalence decision declares that the legal and supervisory arrangements of the CFTC for derivative clearing organisations ("DCOs") that have been declared systemically important derivatives clearing organisations ("SIDCOs") by the Financial Stability Oversight Council or DCOs that have opted into additional standards similar to the SIDCO regime (so-called "Subpart C DCOs") are equivalent to the EU requirements under EMIR, provided that the DCO's internal rules and procedures meet the following requirements:
- For derivatives contracts executed on regulated markets, a minimum liquidation period of two days for initial margin is applied to clearing members' proprietary positions;
- For all derivative contracts, measures are in place to limit procyclicality which are equivalent to the options under EMIR;7 and
- The DCO has sufficient pre-funded available resources enabling it to withstand the default of at least two clearing members to which it has the largest exposures under extreme conditions.
The equivalence decision provides that these additional conditions will not apply to US agricultural commodity derivatives traded and cleared domestically within the US, in light of the nexus of these contracts with the US economy, the importance of the contracts to US agricultural providers and the low degree of systemic interconnectedness of agricultural products with the rest of the financial system.
The CFTC is responsible for oversight of derivative contracts other than those based on a single security (a bond or share) or loan or narrow-based index of securities (which are subject to the oversight of the Securities and Exchange Commission ("SEC")). US CCPs that provide clearing services for those derivatives contracts that fall within the remit of the SEC are not covered by the equivalence decision. If a US CCP provides clearing services for derivatives under the purview of both the CFTC and the SEC, the decision relates only to those services that fall within the CFTC's jurisdiction.
Margin for Customer Positions
The equivalence decision also states that the US rules on margin for customer positions are equivalent to the EU rules. The Commission has determined that although the details of the US rules differ with those of the EU rules, the outcomes are equivalent. EU rules require margin for customer accounts to be collected on a net basis whereas the US rules require it to be collected on a gross basis. According to the Commission, the difference between the net and gross margin collection results in the same outcomes "which compensates for the difference in the liquidation period."
ESMA published proposals in December 2015 to amend the liquidation period for customer positions to allow for one day gross margin to be posted provided that certain conditions were met, including that the identity of the client is known to the CCP, the client is not an affiliate of a clearing member and the CCP implements procedures to: (i) calculate for each account, initial and variation margin requirements at least every hour during the day; and (ii) collect margins within one hour where the new margin requirement meets certain thresholds. Considerable industry concern was expressed in response to ESMA's proposals, including that the conditions are not required under the US rules.
Recognition Under EMIR
SIDCOs and Subpart C DCOs may therefore apply to ESMA for recognition under EMIR but will need to show that their internal rules and procedures meet the requirements set out above to obtain recognition. Following the announcement of the EU-US agreement in February 2016, ESMA announced that it will do everything in its powers to shorten the 180 day period that it has to make a recognition decision for CCPs under EMIR. The impetus for this approach is the incoming clearing obligation for certain IRS entered into with an EU counterparty. As a result, it seems likely that those DCOs that clear IRS may have their applications for recognition prioritized over the applications of other DCOs. Although ESMA has committed to act speedily, the DCOs may also need to implement changes to their rules and procedures to ensure that the additional requirements for recognition are met.
US Comparability Determination
Consistent with the Common Approach, the CFTC adopted, on 16 March 2016, its own substituted compliance determination for DCOs that are also EU CCPs. According to the determination, an EU CCP could comply with the EU requirements on financial resources, risk management, settlement procedures and default procedures instead of the CFTC requirements. Such substituted compliance will be available to EU CCPs that are currently registered as DCOs as well as EU CCPs seeking to become registered as DCOs. The CFTC staff has also clarified that certain CFTC requirements will not apply to non-Futures Commission Merchant clearing members (and their customers) of EU CCPs that are DCOs.
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1 Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories.
2 You may like to read our client note, "Extraterritoriality Revisited: Access to the European Markets by Financial Institutions, Funds and Others from Outside Europe," available here. The note sets out the requirements for non-EU entities to gain access to the EU markets under various European legislative requirements.
3 For example, the equivalence decision for South Africa notes that over the past three years, the total value of derivatives cleared in South Africa was less than 1% of the total value of derivatives cleared in the EU.
4 You may like to see our client note, "EU-US Agreement on Regulation of Central Counterparties," dated 16 February 2016, available here.
5 A liquidation period is the time period used for the calculation of the collateral that the CCP estimates is necessary to manage its exposure to a defaulting member. Essentially, a CCP examines the maximum predicted possible price movement over the liquidation period to calculate a baseline figure for initial margin.
6 The decision was published in the Official Journal of the European Union on 16 March 2016 and is available here.
7 EMIR provides for the following options: a) applying a margin buffer at least equal to 25 % of the calculated margins which it allows to be temporarily exhausted in periods where calculated margin requirements are rising significantly; (b) assigning at least 25 % weight to stressed observations in the lookback period calculated under EMIR; (c) ensuring that its margin requirements are not lower than those that would be calculated using volatility estimated over a 10 year historical lookback period.
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.