EU Finalises OTC Derivatives Market Rules

by Ulrika Lomas, LawAndTax-News.com, Brussels

14 February 2012

After a long period of negotiation, a deal on new European legislation to regulate trade in over-the-counter (OTC) derivatives, and aimed at increasing transparency and reducing risk, has been agreed between the European Parliament (EP) and the Council of the European Union (EU).

The regulation calls for the reporting of all segments of the OTC derivatives market (interest rate, credit, equity, foreign exchange and commodities) to trade repositories (that is, central data centres) and the clearing of standardized OTC derivative contracts through central counterparties (CCPs), in order to reduce counterparty risk.

It is intended that this will create greater security in the system. At present, most derivatives trades take place directly between buyer and seller, and each party is directly exposed if the other party cannot pay. The new rules should, therefore, reduce the risk that a crisis-hit financial institution can “infect” the rest of the financial system via the derivatives markets.

To be authorized, a CCP would, for example, have to hold a minimum amount of capital. If a contract is not eligible for clearing by a CCP, the draft regulation would require the application of different risk management techniques, including the exchange of collateral and the holding of additional capital.

The EP secured a requirement that all derivatives contracts (not only OTC derivatives), would have to be reported to central data centres, also known as trade repositories. These trade repositories would have to publish aggregate positions by class of derivatives, thereby offering market participants a clearer view of the derivatives market.

The European Securities and Markets Authority (ESMA), will be responsible for the surveillance of trade repositories and for granting and withdrawing their registration.

ESMA will also be responsible for the identification of contracts subject to the clearing obligation, while national competent authorities, subject to binding mediation by a college of supervisors and ESMA, would be responsible for authorizing and supervising CCPs.

CCPs from third countries will be recognized in the EU only if the legal regime of the third country in question provides for an effective equivalent system for recognition. However, it was stressed that this does not set a precedent for other legislation on the supervision and oversight of financial market infrastructures.

The obligation to clear OTC derivatives contracts through a CCP and report them to trade repositories would apply to financial firms, while non-financial firms would only be subject to the rules if their OTC derivatives positions reach specified information and clearing thresholds, to be set by ESMA and the European Commission (EC), and are considered to be systemically important.

Pension schemes will be subject to a “light touch” regime with regard to the clearing obligation for a period of three years, extendable by another two years plus one, subject to proper justification through a review clause.

In addition, the Council and the EC also agreed to a proposal by the EP to have the implementation of the legislation evaluated by the EC. The evaluation will include the effectiveness of the supervisory framework for CCPs, including the effectiveness of supervisory colleges, the respective voting arrangements and the role of ESMA, particularly during the process of authorizing CCPs. The EC will present a report, if necessary accompanied by proposals to the EP and the Council, no later than three years after the regulation's entry into force.

The regulation is aimed at implementing commitments made by G-20 leaders in September 2009, and would apply from the end of 2012. The compromise will have to be finally confirmed by the EP and the Council.

Finally, however, it is recognized that there will be a need to look at what other G-20 jurisdictions do and ensure consistency at a global level. In that respect, the remarks made by the United States Deputy Assistant Secretary Mark Sobel, at the recent European Financial Services Conference in Brussels, are also significant.

He called the record on international cooperation on the regulation of OTC derivatives contracts “good”. “In the US, the Dodd Frank Act,” he said, “creates a framework of oversight, protections and disclosure for OTC derivatives markets, consistent with the G-20 framework, and the Commodity Futures Trading Commission and the Securities and Exchange Commission are well into their rule-making process.”

He confirmed that the US and EU “have closely cooperated in crafting their frameworks, and the similarities in details are striking - whether it is central clearing, multi-dealer electronic trading platforms, capital, or the timely reporting to trade repositories”.

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