Friday, May 27, 2011

EU Parliamentary Committee Approves Legislation Regulating OTC Derivatives

New EU legislation designed to regulate derivatives moved a step closer to enactment with a favorable vote by the European Parliament's Economic Affairs Committee. The legislation will now go to the full Parliament for a possible vote in July. The committee's report, drafted by Werner Langen (EPP, DE), is strict regarding exemptions to the derivatives clearing obligation. However, for pension funds there will be a special regime, provided that the national capital requirements provide a guarantee similar to cleared contracts.

The draft legislation, European Markets Infrastructure Regulation (EMIR), on OTC derivatives, central clearing parties and trade repositories aims to bring greater transparency and stability to the OTC derivatives market. Information on OTC derivative contracts would have to be reported to trade repositories and be accessible to supervisory authorities. OTC derivative contracts would need to be cleared through central counterparties, thus reducing counterparty credit risk. Under the new regulatory regime, a key supervisory role is envisaged for the new European Securities and Markets Authority, which will work closely with national supervisory authorities, and have an important role in authorizing new central counterparties.

The Committee rejected suggestions by some EU Member States that all derivatives should be governed by the Regulation. Instead, the rules would apply only to OTC derivatives, as the European Commission proposed and as was agreed to by the G-20. However, to ensure ESMA has the full picture, reporting obligations would apply to all derivatives.

The Regulation would introduce a reporting obligation for OTC derivatives, a clearing obligation for eligible OTC derivatives, common rules for central counterparties, and measures to reduce counterparty credit risk and operational risk, and rules on the establishment of interoperability between central counterparties. Co-operation arrangements between clearing houses, known as interoperability, whereby traders would be allowed to choose where their trades are cleared, are limited to cash securities. A central counterparty has to have functioned in line with the standards for at least three years before it can apply for authorization for interoperability.

The Committee accepted the reasoning that applying clearing obligations retroactively to existing contracts would result in legal difficulties and create major problems for counterparties. Therefore, clearing will only be mandatory from the moment the regulation enters into force. It does, however, provide for the possibility of retroactivity with regard to reporting obligations and asks ESMA to assess how reporting retroactivity could be introduced if the information in question were essential to regulators.

Ultimately, the Regulation will have to be implemented by the Member States. Looking at EMIR, UK Finance Secretary Mark Hoban welcomed the idea that central counterparties should be used to clear certain classes of derivatives. If implemented proportionately, he said, this will reduce the systemic risk presented by the derivatives market. But the Minister emphasized the importance of properly formulating the Regulation and avoiding the creation of unnecessary burdens. His remarks were delivered at the recent Markit conference in London.

Not all derivatives deemed eligible for central clearing will necessarily be suitable for platform trading, he noted. But at the same time it is important that the scope of the Regulation be sufficiently broad. When it comes to deciding which derivatives should be covered by EMIR, he continued, there are two different roads that could be taken. The first road would see all trades covered by this Regulation, regardless of their venue of execution, while the second would see only those derivatives executed outside of an exchange being subject to this legislation.

All the arguments clearly favor the first approach, the Minister noted, because the purpose of clearing derivatives is to reduce systemic risk and it is not obvious why a derivative would need to be cleared if traded off-exchange, but not if traded on an exchange. Also, there is the issue of market distortion. Restricting the scope would create a sizeable regulatory loophole which, if exploited, would lead to damaging asymmetry in the market. He said that the arguments against a broad scope are hard to fathom, and seem to be about preventing competition in clearing.