The US hedge fund industry generally supports draft EU legislation requiring the clearing and reporting of derivatives. In a letter to the European Commission, the Managed Funds Association enthused that the increased clearing of OTC derivatives will lead to greater
market transparency and competition, as well as diminished counterparty and systemic risks. More specifically, the MFA supports the draft’s clearing obligation requiring that all financial counterparties, including counterparties who enter into derivatives contracts with US counterparties, should clear all eligible derivative contracts with registered central counterparties (CCPs), as either a clearing member or a client. The MFA also agrees with the Commission’s view that certain OTC derivatives are not currently acceptable or appropriate for clearing and should continue to be transacted bilaterally, albeit with additional reporting requirements.
The MFA supports the draft’s “bottom-up approach” to central clearing under which each CCP would decide which contracts it would clear and then submit a list of such contracts to its regulator, who would then inform the European Securities and Markets Authority (ESMA), once the regulator approves the CCP’s list of contracts for clearing. Then, ESMA would determine whether a clearing obligation should apply to those contracts based on objective criteria aimed at systemic risk reduction and following public consultation. In the MFA’s view, this approach appropriately takes into account: that minimizing systemic risk should be an important criterion in deciding which classes of derivatives products should be subject to clearing and that CCPs and their risk committees should be responsible for making such a decision.
But the MFA has concerns related to the approval process for central clearing. First, with respect to the timing of the different stages in the bottom-up approval process, it is not clear whether a client may compel a clearing member to clear its counterparties’ derivatives contracts after the CCP’s risk committee and national regulator approve the contracts for clearing, but before ESMA issues a final determination. The MFA believes that the approval of a contract for clearing by both the CCP and national regulator creates a strong presumption that a contract should be cleared, and thus, clearing members should be required to clear any such contract at the request of a counterparty, pending ESMA’s final approval.
If, however, ESMA makes a final determination that, despite the CCP’s and national regulator’s approval, such contracts should not be subject to the mandatory clearing obligation, only then should a clearing member not have to clear such contracts. Additionally, the MFA asked for more detail regarding the timing of the approval process once ESMA has determined that a contract should be cleared.
The MFA is also concerned that cases may arise where a derivative contract might be of
the type that a CCP could clear but the entity’s governance processes might delay the CCP from permitting the clearing. In these instances, the MFA believes that ESMA should, after consulting with market participants and confirming that the contract may be suitably risk-managed by CCPs, be empowered to require that CCPs offer the product for clearing. The industry group also urged the Commission to clarify whether under the bottom-up approach the submission of contacts would apply to a broad class of OTC derivatives, such as credit default swaps generally, or a subset of such class such as index credit default swaps. The MFA believes that CCPs and national regulators should explicitly define and approve the subset or class of OTC derivatives that are eligible for clearing.
Despite concerns with the bottom-up approach, the MFA agreed that in principle access to a CCP should be granted on a non-discriminatory basis regardless of the venue of execution. But the association asked the Commission to clarify whether the mandatory clearing obligation will apply to OTC derivatives contracts with any European nexus, such as where one counterparty is European-based and/or the underlier is a European entity or index. The MFA urged the Commission to coordinate with US and other non-European policy makers and regulators with respect to such obligation in order to avoid jurisdiction-based market segmentation.
The MFA also said that any corporate end-user exemption in the final legislation should be limited to non-financial counterparties’ hedging of risks that occur in the conduct of their ordinary course, non-financial businesses. Indeed, the exemption should be sufficiently narrow to exempt only non-financial counterparties with a demonstrable, non-financial interest for whom clearing would cause a material hardship. Further, in order to prevent abuse of this exemption, and to install safeguards against the build-up of systemically risky exposure, the MFA called for the creation of clearing and information reporting thresholds for non-financial counterparties.
Non-financial counterparties that take positions exceeding the clearing threshold should be subject to the clearing obligation for eligible OTC derivatives contracts. In addition, OTC derivatives contracts qualifying for the clearing exemption must be subject to the same reporting requirements as all other OTC derivatives contracts to provide regulators with a comprehensive view of each participant’s risk to the system.
An important requirement fully supported by the hedge fund group is the rule that CCPs establish categories of admissible clearing members and non-discriminatory and transparent admission criteria. This requirement will ensure that all market participants have fair, objectively risk-based and open access to CCPs. Also, client access must be supervised to allow the clearing of transactions executed both between clients and CCP clearing members, as well as between clients and executing brokers that are not CCP clearing members.
The MFA believes that the legislation should require all CCPs to establish a default fund, thereby ensuring that CCPs have the financial resources to minimize risk of their failure. By definition, CCPs are systemically significant entities, reasoned the MFA, and it is thus essential that the Commission impose rules to ensure the viability and proper functioning of CCPs that operate in Europe. MFA also believes each CCP’s methodology for determining margin and pricing should be transparent and objectively risk-based.
Noting that it is inappropriate to place jurisdictional-based requirements on central clearing, the MDA said it backed draft language allowing US and other third country-based CCPs to provide clearing services to EU entities. Further, in the MFA’s view, the draft legislation’s three criteria for the recognition of non-European CCPs to provide clearing services in the EU are sufficient and will balance the European Commission’s desire to mitigate risks while permitting competition.
Thus, before non-EU CCPs are permitted to provide clearing services in the EU, they should be authorized and subject to stringent supervision by non-European regulators, the Commission should formally decide whether to recognize the OTC derivatives regulatory frameworks of non-European countries, and cooperation agreements must be in place between the relevant competent authorities.