Tuesday, March 08, 2011

EU Economic Affairs Committee Working on Draft Derivatives Legislation with Expanded Role for ESMA

Work on EU legislation to regulate derivatives trading has begun officially in the Economic Affairs Committee with the presentation of draft legislation by Werner Langen (MEP, DE), who will be steering the legislation through Parliament. Mr. Langen said that the legislation should govern only privately-traded derivatives rather than all kinds, as some Member States had wished. His draft also advocates limited exemptions, and scrapping proposed co-operation arrangements between clearinghouses. Mr. Langen said that the goal is to reach an agreement which regulates these trades as much as possible to reduce risk without setting costs which are too high for market participants.

He disagreed with suggestions by some EU Member States that all derivatives should be regulated. Rather, he advocates keeping to the original European Commission proposal, which would limit the scope of the new rules to OTC derivatives.

The draft also rejects arguments that certain sectors, such as the energy sector or pension funds, should be exempted from regulation. Instead, it seeks to restrict exemption possibilities. During the debate, Mr Langen insisted that pension funds should not benefit from a general exemption, but envisions the lesser obligation of bilateral clearing.

Mr Langen is against a proposal to allow co-operation arrangements between clearing houses, known as interoperability, whereby traders would be allowed to choose where their trades are cleared. Such arrangements, he feared, could cause a build-up of systemic risk. These arrangements should undergo further assessment and be dealt with in separate legislation, he said.

The draft accepts that applying clearing obligations retroactively to existing contracts, would result in legal difficulties and create major problems for counterparties. It does provide however for this possibility with regard to reporting obligations and asks the European Securities and Markets Authority (ESMA) to assess how reporting retroactivity could be introduced if the information in question were essential to regulators.

Committee members will be able to submit amendments to the draft legislation, which was reworked from a Commission proposal, until March 16 and a committee vote is envisioned for April 20.

Under the draft legislation, OTC derivative contracts would have to be reported to a registered trade repository within one day of being entered into. Reporting obligations would apply to all financial and non-financial counterparties which have entered into OTC derivative agreements over and above a specific volume.

The legislation distinguishes between eligible OTC derivatives, which would be regulated more strictly, and non-eligible OTC derivatives, which would be regulated less strictly. Following public consultation, ESMA would rule on which OTC derivatives should be regarded as eligible. Eligible OTC derivatives would have to be cleared via authorized 'central counterparties. The clearing obligation would apply to all financial counterparties which have concluded eligible OTC derivative contracts with other financial counterparties, and to non-financial counterparties with a derivatives volume exceeding the clearing threshold.

Each central counterparty would have to be authorized by the national regulatory authority in the Member State in which it was established. Liquidity and capital would be prerequisites for authorization, such that the central counterparty would have to have access to central bank funds or credit lines at commercial banks, or a combination of the two, plus a permanent, available and separate initial capital of at least EUR 5 million.

Clearing members would have to post margins with their central counterparties as collateral. Only highly liquid margins with a low default and price change risk would be acceptable as collateral. Each central counterparty would have to set up a default fund with members' compulsory contributions. Central counterparties would be required to treat their members and their clients fairly. They would also have to disclose governance rules plus prices, fees and discount conditions.

Trade repositories would have to apply to the ESMA for registration, which would be valid in all EU Member States. The ESMA would supervise trade repositories; they would disclose details for all classes of derivatives under rigorous data protection conditions.

Central clearing via a central counterparty can reduce default risk and hence the financial market stability risks of OTC derivatives. Unlike bilateral clearing between two parties, central counterparties can net-off a large number of mutual claims, thus reducing the scale of the residual risk. Restricting the clearing obligation to financial counterparties and to non-financial counterparties with large volumes of derivatives is seen as appropriate, since only their losses pose a direct threat to financial market stability.

The Commission proposed colleges as part of a complicated authorizing and supervisory system involving national regulatory authorities and ESMA. The draft deletes the colleges and steps up cooperation between the competent national authority and ESMA. The information threshold provided for in the Commission proposal was deleted, and the obligation to report details of OTC derivatives to trade repositories would be applied across the board, though a de minimis rule for SMEs should be considered.