The hedge fund industry has expressed a strong interest for transparency and sound governance around the derivatives central counterparties established by the European Market Infrastructure Regulation (EMIR). In a letter to the European Securities and Markets Authority, the Managed Funds Association said that entities with a contractual relationship with a clearing member that enables them to clear transactions with the relevant central counterparty should have their views reflected in the critical decisions of central counterparty governing bodies. These clients are crucial stakeholders in the derivatives markets, said the MFA, in that they collectively represent a significant portion of the outstanding risk for most classes of derivatives and have sophisticated derivatives product and risk management expertise. They also have interests that are highly aligned with the EMIR core goals of mitigating systemic risk conjoined with increasing transparency, efficiency and competition. ESMA has proposed technical standards implementing EMIR.
EMIR establishes a reporting obligation for OTC derivatives; a clearing obligation for eligible OTC derivatives; measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives, as well as common rules for central counterparties and trade repositories.
Broadly, the MFA agrees with ESMA that central counterparty governance arrangements should promote sound and prudent management, support financial stability and foster fair and efficient markets. Balanced and effective CCP governance is critical to promoting competition in the derivatives market, posited the MFA, and clients have an interest in sound governance requirements that foster fair and objective risk-based access, broad product offerings and competitive pricing.
Specifically, the MFA embraces the provisions in EMIR requiring the participation of clients in the risk committees of central counterparties and urges ESMA to promulgate standards mandating appropriate levels of transparency and client participation. EMIR envisions that the risk committee will advise the board of the central counterparty on any arrangements that might impact the risk management of the central counterparty.
The hedge fund association also supports EMIR requirements limiting the representation of any group on central counterparty committees to a percentage lower than a controlling majority. The MFA called these requirements essential to the mitigation of conflicts of interest. In addition, the MFA urged ESMA to mandate that central counterparties adopt policies subjecting any decision potentially resulting from conflicts of interests to checks and balances. In particular, where a central counterparty committee makes a decision, the board of the CCP should, consistent with general corporate governance principals, have the ability to review and overturn the decision, subject to EMIR provisions requiring reporting of such a decision.
Moreover, while the MFA believes that all members have an implied fiduciary duty to the CCP governing body, the association urged ESMA to expressly set out the existence of these duties in standards, which would reinforce the alignment of interests between governing body members and the CCP and further mitigate any potential conflicts of interest. These fiduciary duties should minimally include obligations to exercise independent judgment, to avoid conflicts of interest; to disclose an interest in a proposed arrangement, and not to accept benefits from third parties.
The MFA supports ESMA’s transparency-enhancing proposal requiring disclosure of the CCPs’ rules, governance arrangements and admission criteria. Similarly, the standards should require disclosure of, and access to, CCP committee charters and procedural rules in order to ensure that market participants unable to participate directly in CCP governance will have insight into its operations. The MFA also recommends that each central counterparty disclose the minutes of its governing bodies’ proceedings to the extent it would not be prejudicial to business secrets. The MFA also supports ESMA’s proposal that a CCP name a chief risk officer, a chief technology officer and a chief compliance officer.
In the comment letter, the MFA urged ESMA to require central counterparties to disclose all relevant information on their design and operations as well as on the rights and obligations of their clearing members and the clearing members’ clients. As a significant proportion of the trading volume in the OTC derivatives market, reasoned the association, clients are important participants. Thus, they should receive the same level of information as clearing members. It is important that clients are also able to identify and manage the risks and costs associated with using the facilities of central counterparties.