The US hedge fund industry strongly supports the European Union Regulation promoting central clearing designed to increase transparency of the derivatives market and reduce counterparty and operational risk in trading. In a comment letter on the proposed Regulation, the Managed Funds Association broadly posited that balanced central counterparty governance is critical to promoting competition in the derivatives market and that clients have an interest in sound governance requirements that foster fair and objective risk-based access, broad product offerings and competitive pricing.
In that spirit, the MFA said that EMIR (European Market Infrastructure Regulation) should affirmatively mandate the inclusion of non-dealer, client representatives on central clearing counterparty boards and risk committees. As a significant proportion of the trading volume in the OTC derivatives market, clients are important stakeholders. Thus, the MFA reasoned that they should have their views reflected in the critical decisions of these bodies and should be entitled to attend and vote at meetings, not merely consulted.
The MFA feared that, without such a mandate, narrow interests will dominate and central counterparties may not adequately take into account the views of all market participants. In addition, in order to completely effect fair representation and balanced governance of central counterparties, no single group of market participants should constitute a controlling majority of any boards or risk committees.
The MFA also suggested that the Regulation allow central counterparty employees to have representation on risk committees. Such employees are motivated to expand the scope of central counterparty products and services, offer optimal capital, margin and cost management and maintain risk management procedures, which prevent losses to the central counterparty, clearing members and the market. Moreover, such employees provide further counterbalance to the potential conflicts of interest of other constituencies represented on risk committees.
The MFA also supports portability measures facilitating a client’s ability to transfer freely all or part of its portfolio and related margin between clearing members. Clients should be able to negotiate transfers of their positions to another clearing member at any time, whether prior to or following the default of their current clearing member.
The Regulation should clarify that ceding clearing members must effect such transfers as promptly as technologically feasible and without imposing fees or other conditions that could act as a barrier or deterrent to portability and competition in the provision of clearing services. If a central counterparty transfers only part of a portfolio, the untransferred portion must be appropriately margined, in accordance with the margining methodology agreed to by the clearing member and client, or absent express agreement, as previously applicable to the client’s portfolio.
It is also important for the Regulation to permit netting arrangements allowing parties to net initial and variation margin amounts across a broad range of exposures and assets, including across cleared and uncleared exposures, as well as across related legal entities. Such netting will reduce aggregate counterparty credit risk, lower trading costs, allow for efficient use of capital, provide better transparency as to counterparty risk and reduce complexity and settlement risk. Without permitting robust netting arrangements, liquidity will drain from the derivatives market as participants seek other execution strategies to prevent over-collateralization.
The European Securities and Markets Authority (ESMA) will draft technical standards specifying the minimum margin standards, including the percentage of margin that central counterparties must collect as well as the related time horizons. The MFA urged ESMA to be mindful of the increased costs that margin regulation may impose on clients both in terms of the margin amount and of the increased administrative costs associated with collecting margin and verifying calculations.
Praising real time clearing, the MFA urged that the Regulation require immediate acceptance or rejection of a trade upon submission for clearing by both central counterparties and clearing members. Providing open access to real-time clearing of trades will promote market efficiency by enabling participants to reduce their counterparty credit risk without delay, said the hedge fund group, and by ensuring unrestricted access to the broadest range of executing counterparties, more liquidity and competitive pricing.
Real-time clearing will also enhance market transparency and protect the anonymity of a client’s executing counterparties and will avoid the imposition of additional credit limits, fragmentation of liquidity, delays in acceptance of trades and/or the imposition of barriers to access to clearing such as inappropriate execution documentation.
The MFA has consistently advocated for the protection of client collateral in cleared and bilateral trades based on its belief that segregation protects investor positions and margin from clearing member insolvency. The EU Parliament Text of the Regulation provides greater protections for clients than the EU Council Text as there is a positive segregation requirement with an opt-out in the Parliament Text as opposed to a requirement to offer an opt-in. Specifically, the Parliament Text requires that a clearing member must distinguish in separate accounts with the central counterparty the positions of the clearing members from those of its clients. The MFA strongly supports providing clients with a robust level of protection for both their positions and assets that also promotes efficient portability.
The hedge fund group supports the recognition of third country central counterparties. The three criteria for the recognition of third country central counterparties set out in the Commission’s proposal remain in the Council and Parliament texts but with certain amendments. In particular, the Council Text reflects the MFA’s suggestion that coordination with non-European regulators on the approval procedures would ensure that the equivalency test applied is reasonable and not unduly restrictive towards the regulatory frameworks of third countries.
In addition, both the Council Text and the Parliament Text contain a reciprocity requirement, which provides that ESMA may only recognize a central counterparty established in a third country when ESMA deems the legal framework of that third country to provide for an effective equivalent recognition of central counterparties authorized in the EU.
In the MFA’s view, this restriction would be difficult to implement in practice, does not significantly increase the protections available to EU entities, and is likely to have the effect of unduly restricting the ability of EU entities to access third country central counterparties. As a result, the MFA recommends eliminating this reciprocity requirement.