Hedge Fund Industry Supports EU OTC Derivatives Legislation; Wants CCP Global Competition

The hedge fund industry generally supports the broad concepts for derivatives legislation set forth by the European Commission as the EU commits to the passage of legislation this year. In a letter to the UK House of Lords, which is collecting comments to form a broad consensus on the legislation, the Managed Funds Association opposed position limits and expressed concern about the international harmonization of OTC derivatives legislation.

US and EU derivatives legislation contain the same broad provisions, including mandatory central clearing, increased reporting to trade repositories, and greater transparency. However, the MFA noted that the European Commission would require market participants to use a European-based central counterparty to clear credit default swaps on European-reference entities and indices. The MFA believes that this requirement would frustrate the establishment of a globally harmonized regulatory framework for derivatives and lead to an unfair playing field for European-based central counterparties.

The MFA opposes derivatives regulation that would force segmentation of the market based on jurisdiction. Rather, the MFA supports competition among central counterparties and the clearing of standardized derivatives in both the US and EU.

Thus, the MFA support the US legislation that would permit non-U.S. market participants to register with the SEC or CFTC and reduce risks to the global financial system. Currently, the US legislation is consistent with the global harmonization of regulation over the OTC derivatives markets.

The second Barrosa Commission is committed to passing derivatives reform legislation in 2010. At his confirmation hearings before the European Parliament, Michel Barnier, the new Commissioner for the Internal Market, said that he would propose a coherent legislative framework to the Commission for the regulation of OTC derivatives, as well as for post-trade activities and infrastructure.

The MFA urged EU regulators to impose rules on central counterparties to protect customer positions and collateral, specifically initial margin, to open access and membership for end users, including hedge funds; and monitor the resources and infrastructure to prevent central counterparty failure.

The MFA views the protection of customer positions and collateral in a central clearing regime as absolutely critical to the success of central clearing initiatives and the reduction of counterparty and systemic risk. Thus, the MFA asks the European Commission to impose rules requiring: swap dealers and central counterparties to segregate initial margin in accounts that are separate and apart from the assets of the swap dealer. Central counterparties should be required to move customer positions in the event of the insolvency of a clearing member in order to reduce counterparty and systemic risk associated with the trading of OTC derivatives in the event of clearing member insolvency.

The European Commission intends to review the Market Abuse Directive and may extend its scope to authorize regulators to set position limits. The MFA does not believe that providing regulators with the authority to set position limits will improve the integrity of the derivatives markets. Position limits do not address market integrity or systemic risk concerns, said the group, which can be addressed through appropriate capital and margin charges, and disclosure.

As a general matter, the MFA believes that position limits should be imposed only for physically-delivered commodities and where the deliverable supply of the commodity is limited and, thus, susceptible to control and manipulation. The MFA did not take a position with respect to whether broadening the scope of the Market Abuse Directive to include OTC derivatives will improve market integrity.

The MFA strongly supports the use of trade repositories to record non-cleared OTC derivatives contracts since this will enhance market transparency and reduce systemic risk by ensuring that regulators have a comprehensive picture of market concentrations and exposures within a given asset class. In addition, a trade repository may provide operational benefits for market participants facilitating central clearing and reducing the notional amount of trades through trade portfolio compression.

The MFA also endorsed minimum collateral levels with respect to non-cleared derivatives transactions. In the association’s view, industry-wide collateral practices were inadequate prior to the near-failure of AIG, which was able to take very concentrated derivatives positions without having to post any collateral in connection with those positions.

In addition, MFA believes that the European Commission should impose rules that broadly encourage central clearing by allowing end-users (including hedge funds) to have fair and open access to central clearing either through direct participation in a CCP as a clearing member, or through a clearing member.

In addition, the MFA said that central counterparty governance should be transparent and take into account the views of all market participants. These measures will encourage end users to centrally clear their derivatives contracts, which will in turn reduce the interconnectedness that results from too much credit exposure flowing through a limited number of dealers.

Similarly, the European Commission should impose rules requiring central counterparties to have effective risk management practices to minimize risk of failure. By definition, reasoned the MFA, central counterparties are systemically significant entities, and therefore, it is essential that the Commission impose rules to ensure their viability and proper functioning.

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