In the aftermath of the financial crisis, regulators around the world have been stepping up regulation of the over-the-counter derivatives market.
The guiding principles were set in September 2009, when leaders of the G20 nations agreed that: “all standardised 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. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”
How much progress has been made in implementing these commitments varies from region to region. But in the European Union, a body of new legislation is emerging which promises to alter the derivatives market substantially.
New laws and renewed laws
In mid-September, the EU published a draft European Market Infrastructure Regulation (Emir), with new rules for OTC derivatives, central counterparties (CCPs) and trade repositories.
The Regulation is expected to take effect at the end of 2012, after detailed technical standards have been developed by the European Securities and Markets Authority (Esma), Europe’s new super-regulator, which came into being on January 1.
Other aspects of the market, especially trading of derivative contracts on exchanges and other platforms, will be addressed as part of the wider review of the Markets in Financial Instruments Directive (Mifid). Other measures affecting derivatives, including the Market Abuse Directive (Mad), are also being reviewed. Legislative proposals are expected to be published this spring.
Clashing regimes
But although these new regulations are taking shape, much still remains undefined. The scope of Emir, for example, is unclear. Its territorial reach might extend to entities or branches outside the EU, and there is debate as to whether foreign exchange derivatives should fall within its scope.
The territorial uncertainties could be particularly problematic in light of the US rules implementing the Dodd-Frank Act, as some entities might be subject to several, potentially conflicting, regimes.
Loopholes narrow
It seems very likely, however, that extensive new prudential and business conduct rules, including tougher requirements for capital and/or collateralisation, will apply to all market participants.
A key issue is the extent to which non-financial firms will be brought into the regulatory net. Early drafts of Emir covered non-financial firms only to the extent that they exceeded applicable reporting and clearing thresholds, to be set by Esma.
This meant that non-financial companies using derivatives only for treasury activities or commercial hedging should, in practice, have been able to avoid regulation. However, the latest draft of Emir, produced by the European Council on January 5, proposes extending the risk mitigation obligations to non-financial firms for all OTC derivatives not cleared by a CCP. This would apply regardless of whether the clearing threshold had been exceeded.
Furthermore, all derivatives, cleared or uncleared, will need to be reported to trade repositories.
Old contracts grandfathered
A central aim of Emir is to reduce the credit risks in derivatives trading through clearing of all “eligible” contracts. In respect of cleared contracts, users would post initial and variation margin at a CCP.
Helpful amendments are proposed in the January 5 draft of Emir, which would make the clearing obligation apply only to contracts entered into after Emir takes effect, rather than retroactively.
If accepted, this would bring Emir more into line with proposed US legislation, which will not require existing contracts that have been reported to trade repositories to be cleared.
The push to exchanges
To standardise the OTC market and make it more transparent, the recently published consultation on the Mifid review proposes to move trading of some derivatives to exchanges or electronic platforms.
This requirement would apply to all “clearing-eligible” derivatives that Esma determines to be sufficiently liquid.
Some market participants are worried that these proposals will constrain liquidity and make it harder for firms to hedge themselves effectively with OTC derivatives.
Critics argue that other proposals, such as mandatory clearing and transaction reporting to trade repositories, should be enough to achieve the perceived benefits sought by the G20.
New burdens for traders
A big feature of the new OTC landscape under Emir will be the reporting of trades – potentially including pre-existing ones – to trade repositories. This is intended to give regulators the tools to supervise the market.
Regulators plan to use the repositories’ data to monitor market participants’ overall positions in different types of derivatives.
The Mifid consultation also proposes that Esma draw up position limits for commodity derivatives traded on exchanges and OTC, which mirrors the US regime.
And building on Emir’s ideas to improve price transparency for OTC derivatives, the Mifid consultation also suggests extending pre- and post-trade transparency requirements to derivatives traded on exchanges and OTC.
This would include a requirement for firms to provide binding quotes for OTC contracts below a certain size and to include an “OTC flag” on post-trade transparency reports.
These proposals are likely to impose onerous new requirements on market participants and higher transaction reporting costs.
The end draws near
Emir is set to be debated by the European Council on February 15, with a view to reaching political agreement on a final proposal no later than May 17. The European Parliament could then approve the law in June.
But its full impact will remain unclear until Esma’s technical standards are adopted – something that is expected to happen by June 30, 2012.
The other legislative proposals, such as amendments to Mifid and Mad (expected in March this year), will also have to be considered.
Once that has happened, the OTC derivatives market can begin the job of calculating the full operational and financial consequences of the EU legislation.
It will also then be essential to compare the EU rules carefully with those being introduced in the US to implement the Dodd-Frank Act, so as to assess the differences between the two regimes.