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What are derivatives?
A derivative is a financial contract linked to the future value or status of the underlying to which it refers (e.g. the development of interest rates or of a currency value, or the possible bankruptcy of a debtor).
Over-the-Counter (OTC) derivative contracts are not traded on an exchange (for example the London Stock Exchange) but instead privately negotiated between two counterparts (for example a bank and a manufacturer). OTC derivatives account for almost 90% of the derivatives markets. In December 2009, the notional value of outstanding OTC derivatives was around $615 trillion or €435 trillion. The OTC derivatives market comprises a wide variety of product types across several asset classes (interest rates, credit, equity, foreign exchange (FX) and commodities) with widely differing characteristics and levels of standardisation. OTC derivatives are used in a variety of ways, including for purposes of hedging, investing, and speculating. Contrary to derivatives traded on exchanges, OTC derivatives are not automatically cleared through CCPs (cf next question) or subject to reporting rules.
A hypothetical example of hedging: a plane manufacturer has a contract to build 6 planes in the next 6 months and will need 10 tonnes of steel per plane. He may want to guarantee that whatever the fluctuations in the market of the price of steel, he gets steel at a certain fixed price for the next 6 months so as to be able to deliver the planes on budget. To cover for the risk of steel rising, the plane manufacturer could enter into an OTC contract with a bank for example. They could agree on a set price for a set quantity of steel for 6 months. If, after 6 months, when the contract matures, the market price turned out to be lower, the bank would make a profit; but if the market price turned out to be higher, then the plane manufacturer would be able to purchase the steel a price lower than the market price and thus save money.
What are market infrastructures?
Central Counterparties (CCP)
A CCP is an entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. A CCP's main purpose is to manage the risk that could arise if one counterparty is not able to make the required payments when they are due –i.e. defaults on the deal.
CCPs are commercial firms. There are currently about a dozen CCPs, all but one located in Europe or the USA, clearing interest rates, credit, equity and commodities OTC derivatives. There is currently no CCP clearing FX OTC derivatives.
Trade repositories
A trade repository is a central data centre where details of derivatives transactions are reported.
Trade repositories are commercial firms. There are global trade repositories for credit, interest rate and equity OTC derivatives. Trioptima in Stockholm houses a global interest rate repository and DTCC Derivatives Repository Ltd in London houses a global equity derivatives repository and maintains global credit default swap data identical to that maintained in its New York based Trade Information Warehouse.
Why is the Commission proposing legislation on OTC derivatives?
Derivatives play an important role in the economy. But they are also associated with certain risks. The financial crisis, including the default of Lehman Brothers and the bail out of AIG, highlighted that these risks were not sufficiently mitigated, particularly in the OTC market where almost 90% of derivatives are traded. The European Commission committed to deliver, in its Communication on Driving European Recovery of March 2009, appropriate initiatives to increase transparency in the derivatives market and to address financial stability concerns.
In September 2009, at the G-20 Pittsburgh Summit, the leaders of the 19 biggest economies in the world and the European Union agreed that "all standard 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." Furthermore, they acknowledged that "OTC derivative contracts should be reported to trade repositories and that non-centrally cleared contracts should be subject to higher capital requirements."
The Commission's proposal meets the G20 commitments on OTC derivatives markets.
What are the objectives of the proposal?
The proposal's objectives are to increase transparency in the OTC derivatives market and to make it safer by reducing counterparty credit risk and operational risk.
To increase transparency, the proposal requires that i) detailed information on OTC derivative contracts entered into by EU financial and non-financial firms are reported to trade repositories and made accessible to supervisory authorities, and that ii) trade repositories publish aggregate positions by class of derivatives accessible to all market participants.
To reduce counterparty credit risk, the proposal introduces (i) stringent rules on prudential (e.g. how much capital they need hold), organisational (e.g. role of risk committees) and conduct of business standards (e.g. disclosure of prices) for CCPs, (ii) mandatory CCP-clearing for contracts that have been standardised (i.e. they have met predefined eligibility criteria), (iii) risk mitigation standards for contracts not cleared by a CCP (e.g. exchange of collateral)
To reduce operational risk. Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The proposal requires the use of electronic means for the timely confirmation of the terms of OTC derivatives contracts. This allows counterparties to net the confirmed transaction against other transactions and ensure accurate book keeping.
How does the proposal make the derivatives market more transparent?
Currently, there is little reliable information on what is going on in the OTC derivatives market. There are no public prices available, no public information as to who is entering deals with whom, over what period of time, relating to what underlying asset or for which amounts.
Under the Commission's proposal, detailed information on each OTC derivatives contract traded by a financial or a non-financial firm with large positions in the OTC derivatives market will have to be reported to trade repositories. The data in these trade repositories will then be available to regulators, giving them a much better overview of who owes what to whom so they can spot any potential problems early and be in a position to take action if need be. In addition, trade repositories will have to publish aggregate positions by class of derivatives, providing market participants with a clearer view of the OTC derivatives market. However, trade repositories will not publish data at trade level as the type of information is commercially sensitive.
To whom will the clearing and reporting obligations apply to?
The obligation to clear OTC derivatives contracts through a CCP and report them to trade repositories will apply to financial firms (banks – both universal banks and investment banks, insurance companies, funds etc.) and to non-financial firms (energy companies, airlines, manufacturers etc.) that have large positions in OTC derivatives.
Are any exemptions foreseen from the clearing and reporting obligations?
The proposal provides for some limited exemptions from clearing and reporting requirements for non-financial firms.
Contracts between two non-financial firms (a fraction of total contracts) where neither firm exceeds an 'information threshold' will not need to be reported to a trade repository. All other contracts, including all contracts between non-financial firms and financial firms, will need to be reported to trade repositories.
Contracts by non-financial firms below a 'clearing threshold' will not have to be cleared through a CCP. "Commercial hedging activities", i.e. when these firms use OTC derivatives to hedge risks related to their activities, will be subtracted from the firm's overall position which means that they will not count towards the threshold set for the clearing obligation. These activities do not need to be cleared. For example, commercial hedging could be when airlines using OTC derivatives to secure the price at which they buy fuel, or when exporters who use OTC derivatives to shield themselves from fluctuations of exchange rates.
These thresholds are not set out in the proposal. ESMA, the new European Securities and Markets Authority, together with ESRB, the new European Systemic Risk Board and other relevant authorities will draft technical standards on what these thresholds should be.
When setting these thresholds, ESMA will have to take into account the systemic relevance of the sum of net position and exposures by counterparty per class of derivatives (i.e. looking at how much overall risk they pose to the system). It is envisaged that the clearing and information thresholds will be different for different asset classes and even within an asset class. For example, for commodity derivatives, the clearing threshold may be different for oil and wheat.
Members of the European System of Central Banks, public bodies charged with or intervening in the management of the public debt, and multilateral development banks will not be subject to the clearing or reporting obligations in order to avoid limiting their powers to intervene to stabilise the market, if and when required.
Which OTC derivatives contracts will be eligible for mandatory clearing?
To have as many OTC contracts as possible cleared through a CCP, the Regulation introduces two approaches to determine which contracts must be cleared:
a 'bottom-up' approach - Where a competent authority has authorised a CCP to clear a class of derivatives, it will inform ESMA who will have the powers to decide whether a clearing obligation should apply to that class of derivatives in the EU
a 'top-down' approach - ESMA, on its own initiative and in consultation with the European Systemic Risk Board, will identify contracts that should be subject to the clearing obligation but for which no CCP has yet receive authorisation.
The 'top down' approach will ensure that if no CCP clears a product that should be subject to the clearing obligation, there are tools available to regulators to get this product cleared through a CCP. It will also ensure that new products will not fall through the net.
ESMA will use the following criteria when determining eligibility for the clearing obligation: reduction of systemic risk in the financial system, liquidity of contracts, availability of pricing information, ability of the CCP to handle the volume of contracts, and level of client protection provided by the CCP.
Why does the proposal not envisage mandating clearing for all OTC derivatives?
Because they are customised to meet particular counterparty or end-user needs, some bespoke OTC derivatives products will not have the level of standardisation required for central clearing.
How will the proposal reduce counterparty credit risk in OTC derivatives trading?
Currently, participants in the OTC derivatives market do not collect sufficient collateral (i.e. guarantees; usually they are in the form of cash or securities) to mitigate counterparty credit risk, which refers to the risk of loss arising from one party not making the required payments when they are due.
The Commission's proposal requires that OTC derivatives that are standardised will have to be cleared through central counterparties (CCPs). Since an OTC derivative contract cleared by a CCP usually involves the posting of higher amounts of collateral than an equivalent contract that is not cleared by a CCP, this will increase the amount of collateral held in the system.
As collateral will be held in a few places, there is an argument that risk will be concentrated there. To avoid CCPs becoming a source of risk to the financial system in themselves, the proposal introduces stringent conduct of business, organisational and prudential requirements so that CCPs manage risk properly and are therefore safe to use. Furthermore, the authorisation of a CCP will be subject to that CCP having access to adequate liquidity. Such liquidity could result from access to central bank or to creditworthy and reliable commercial bank liquidity, or a combination of both.
If a contract is not deemed eligible (e.g. prices are not available or the contract is not liquid), or if one of the parties to an eligible contract is not subject to the clearing obligation, then that contract will in all likelihood not be cleared by a CCP. For such contracts, the proposal will require the institutions subject to the clearing obligation to apply robust bilateral risk management technique, including marked-to-market on a daily basis of outstanding contracts and holding of additional capital.
Are commodity derivatives and foreign exchange included in the proposal?
The proposal covers all segments of the OTC derivatives market (interest rate, credit, equity, FX and commodities). While the segments differ in their characteristics, the Commission considers that there is no strong evidence to exclude any of them from the scope of the proposal.
There is, on the contrary, a strong incentive to adopt a comprehensive policy on OTC derivatives, as the failures uncovered by the financial crisis are present in all segments of the OTC derivatives market. Furthermore, there is a risk that excluding any segment from the outset would create a loophole that could be exploited by market participants. This is because any derivative contract can be partitioned and reconstructed into different but economically equivalent contracts. For example, if a specific contract is eligible for clearing but can be reconstructed into two other types of derivatives that are not covered by the Regulation and do not have to be cleared through a CCP, market participants would be able to avoid clearing requirements by modifying the original contract.
What will be the role of European Securities and Markets Authority (ESMA)? What will be the role of national financial supervisors?
The proposal gives ESMA a key role. ESMA will be responsible for the identification of contracts that will be subject to the clearing obligation, i.e. those that are standardised and must then go through CCPs. It will also be responsible for the surveillance of trade repositories and will be a member of the colleges supporting national authorities supervising CCPs operating in several members states. Finally, it will be required to draft a large number of specific binding technical standards for the application of the Regulation, for example with respect to the clearing and information thresholds.
Since the fiscal responsibility of a failure of a CCP would most likely be borne by the Member State in which the CCP is established, it is important that national supervisors retain responsibility for CCP authorisation and supervision. The proposal, however, foresees that in case a CCP offers its services in Member States other than the one where it is established then the national supervisor will be supported by a college of relevant authorities (including, among others, ESMA, the supervisory authorities of the markets served by the CCP and relevant central banks).
What about data protection for trade repositories?
The proposal will require those trade repositories that wish to be used for the purpose of the reporting obligation to register with ESMA. In order to obtain registration, a trade repository will have to comply, among other things, with strict requirements aimed at ensuring the confidentiality, integrity and protection of the information it receives and maintains.
How will the regulation interact with third countries?
Recognition of a third country CCP by ESMA will first require that the European Commission has ascertained the legal and supervisory framework of that third country as equivalent to the EU's, that the CCP is authorised and subject to effective supervision in that third country and that ESMA has established co-operation arrangements with the third country competent authorities. A CCP of a third country will not be allowed to perform activities and services in the EU if these conditions are not met.
Recognition of a third country trade repository will be subject to similar conditions as for CCPs in terms of equivalent legal regime and supervision. In addition, it will be subject to an international agreement being in place between the European Commission and that third country with regard to mutual access to data and exchange of information on OTC derivatives contracts held in trade repositories.
What does the proposal say with respect to interoperability of CCPs?
Interoperability is an essential tool to achieve an effective integration of the post-trading market in Europe. However, interoperability may expose CCPs to additional risks. For this reason, regulatory approval is required before entering into an interoperable arrangement. CCPs should carefully consider and manage the extra risks that interoperability entails and satisfy the competent authorities about the soundness of the systems and procedures adopted. In view of the complexity of derivatives markets and the early stage of development of CCP clearing for OTC derivatives, the proposal does not extend the provisions on interoperability to instruments other than cash securities.
What has been done at the global level on OTC derivatives?
In line with the EU's G20 commitments there have been a number of initiatives both by individual jurisdiction and international bodies. At national level, both the US (Dodd-Frank Act) and Japan have passed OTC derivatives legislation earlier this year. The Commission's proposal uses different approaches at times, but is very much in line with the legislation being adopted in other parts of the world. This is essential to ensure no regulatory arbitrage.
At international level, the Financial Stability Board set up a work stream, co-chaired by the Commission, in order to address the challenges related to the implementation of the G20 commitments. In addition, the OTC Derivatives Regulators' Forum was established to promote cooperation between regulators. Finally, CPSS/IOSCO has published guidance on the application of its 2004 recommendations for CCPs to OTC derivatives, and is currently in the process of reviewing these recommendations and preparing recommendations for trade repositories.
What additional proposals are foreseen in the OTC derivatives space?
Other measures relevant to OTC derivatives are planned for early 2011, notably the revision of the Capital Requirements Directive (e.g. differentiation of capital charges between CCP cleared and non-CCP cleared contracts), the Market in Financial Instruments Directive (e.g. ensuring trading of standardised contracts on organised trading venues, enhancing trade and price transparency across venues and OTC markets as appropriate) and the Market Abuse Directive (extending the scope of the Directive to OTC derivatives).
What are the next steps?
The proposal now passes to the Council and the European Parliament. The procedure is standard co-decision.
Member States undertook at the June 2010 European Council to conclude all negotiations relating to G20 commitments on financial reform by end of 2011.
In line with G20 commitments, the new rules should be fully in place and operational by the end of 2012.
More information is available at:
http://ec.europa.eu/internal_market/financial-markets/derivatives/index_en.htm
