The European Commission has proposed derivatives legislation that is broadly consistent with Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The draft would require that detailed information on OTC derivative contracts entered into by EU financial and non-financial firms be reported to trade repositories and made accessible to regulators and that trade repositories publish aggregate positions by class of derivatives accessible to all market participants. In addition, the proposal introduces stringent rules on prudential organization and conduct of business standards for central counterparties (CCPs), mandatory CCP-clearing for standardized contracts, and risk mitigation standards for contracts not cleared by a CCP. The proposed legislation must now be considered by the Council and the European Parliament.
According to the Commission, since the main elements of the Dodd-Frank Act are broadly consistent with the draft, at this stage it is possible to claim that there are no significant risks of regulatory arbitrage between the EU and the US. Whether this will remain the case after the final EU legislation is passed is very difficult to predict. The Commission promised to maintain a close dialogue with the US to prevent a major divergence in the two derivatives regulatory regimes.
The draft gives the new European Securities and Markets Authority a key role in the derivatives regulatory regime. ESMA will be responsible for the identification of derivatives contracts subject to the clearing obligation, such as those that are standardized and must then go through central counterparties. It will also be responsible for the surveillance of trade repositories and will be a member of the colleges of regulators supporting national authorities supervising CCPs operating in several members states. Finally, ESMAS will be required to draft a large number of specific binding standards for the application of the legislation, for example with respect to the clearing and information thresholds.
Another key to the new regime will be the central counterparties. 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.
Operational risk is the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events. The draft would require 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.
In order to clear as many OTC derivative as possible, the draft legislation incorporates two distinct approaches to determine which contracts must be cleared. There is a 'bottom-up' approach under which regulators authorize a CCP to clear a class of derivatives and then inform ESMA, which will have the power to decide whether a clearing obligation should apply to that class of derivatives. The ``top-down approach’’ involves ESMA, on its own initiative and in consultation with the European Systemic Risk Board, identifying contracts that should be subject to the clearing obligation but for which no CCP has yet received authorization. In the Commission’s view, 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 investor protection provided by the CCP.
The obligation to clear OTC derivatives contracts through a CCP and report them to trade repositories will apply to financial firms such as banks, investment banks, and funds, and to non-financial firms such as energy companies, airlines, and manufacturers, that have large positions in OTC derivatives. However, similar to the Dodd-Frank Act, the draft provides for some limited exemptions from clearing and reporting requirements for non-financial firms. Thus, derivative contracts between two non-financial firms 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. Also, contracts by non-financial firms below a clearing threshold will not have to be cleared through a CCP. Commercial hedging activities using OTC derivatives to hedge risks related to a firm’s 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.
Since these thresholds are not set out in the draft legislation, it is expected that the new European Securities and Markets Authority along with the new European Systemic Risk Board will draft technical standards on what these thresholds should be. According to the Commission, when setting these thresholds ESMA should take into account the systemic relevance of the sum of net position and exposures by counterparty per class of derivatives, looking at how much overall risk they pose to the system. The Commission envisions that the clearing and information thresholds will be different for different asset classes and even within an asset class. 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 stabilize the market, if and when required.