While supporting the objectives of the EU Regulation on OTC Derivatives, a global hedge fund association said that the central legislative principles of risk mitigation, transparency and enhanced competition necessitate a mandate for real time acceptance or rejection for clearing of OTC derivatives contracts immediately following execution. In a letter to the European Securities and Markets Authority ESMA), which has proposed standards implementing the European Market Infrastructure Regulation (EMIR), the Alternative Investment Management Association reasoned that allowing extensive periods to pass between execution and submission to a central counterparty would cause numerous market inefficiencies, including unnecessary exposure to counterparty credit risk leading to consolidation of the sell-side market among a few large participants and a corresponding increase in systemic risk.
The association also noted straight through processing would provide extensive competition benefits since participants would be able to execute with a larger number of counterparties due to the removal of counterparty credit exposure and, as a result, compress bid-offer spreads for all participants. It is also implicitly linked to the regulatory initiative to move OTC derivatives to regulated trading platforms. Without straight through processing, cautioned the hedge fund association, OTC derivatives will not be able to make the transition to truly electronic execution with anonymous central limit order books.
With the emphasis on cross-border coordination of derivatives regulation, it is also important to note that straight through processing has been explicitly mandated in the
US by recent CFTC rulemaking. The majority of central counterparties and dealers
within the EU will, therefore, already be implementing the necessary
operational procedures to perform straight through processing.
The association supports EMIR’s governance provisions for central counterparties, particularly the inclusion of client representation on the governance of central counterparties. Moreover, eEchoing a comment letter from the Managed Funds Association, AIMA said it is important to adopt measures preventing the circumvention of these governance provisions. Also similar to MFA concerns, the association urged ESMA to consult as soon as reasonably possible on the cross-border issues around derivatives regulation, including derivatives contracts with a direct, significant and foreseeable effect within the EU.
AIMA is concerned that the implementation of the mandatory clearing obligation may result in certain netting-sets being inadvertently split, due to the second contract being un-clearable at the time, and so imposing additional market, legal and operational risk on participants. The group asked that the application of the mandatory clearing obligation to specific contracts consider any adjacent unclearable contracts within netting-sets.
The association is also concerned that the concept of liquidity fragmentation could be used by central counterpaties for anticompetitive purposes. Thus, ESMA was urged to define liquidity fragmentation in clear and absolute terms subject to a very narrow interpretation limiting it to only the most exceptional of circumstances.