Tuesday, September 04, 2012

Fund Industry Seeks Stakeholder Involvement of Central Counterparty Governance in ESMA Draft Standards on OTC Derivatives Regulation

The Investment Company Institute has asked the European Securities and Markets Authority (ESMA) to require that the risk committees of central counterparties be required to include a wide range of client representatives as part of sound corporate governance and risk management in ESMA’s proposed standards implementing the European Market Infrastructure Regulation (EMIR). In a letter to ESMA, the Institute also asked for clarification of risk mitigation techniques for uncleared derivatives. The Authority plans to submit draft standards implementing EMIR to the European Commission by September 30, said ESMA Chair Steven Maijoor in recent remarks at the Europlace Financial Forum in Paris.

ESMA contemplates that in order to comply with the clearing obligation a counterparty must become a clearing member, a client, or establish indirect clearing arrangements. The draft does not provide details regarding indirect clearing arrangements, noted the ICI. Protections should be provided to indirect clearing arrangements, said the Institute, particularly if these arrangements facilitate the ability of non-EU market participants to conduct transactions in the EU or with EU counterparties.

The ICI urged ESMA to revise the draft to provide indirect clients with an equivalent level of protection as direct clients, as required by EMIR. Although appreciative of ESMA for proposing an omnibus client account at the central counterparty level for the purpose of holding assets and positions of indirect clients, the Institute requested that indirect clients be provided the right to request that individually segregated accounts be established at the central counterparty level.

For OTC derivative contracts that are not subject to the clearing obligation, counterparties are required to mitigate risks by using different techniques specified by ESMA. The ICI has concerns with these risk mitigation techniques. ESMA proposes to require timely confirmation of transactions and specifies the timeframe for confirmations. While supporting efforts to mitigate counterparty risk by requiring parties to confirm transactions promptly via electronic means, the ICI sought clarification with respect to the parties responsible for the timely confirmations and has concerns with the timeframe imposed on all counterparties.

The ICI also asked for clarification regarding the practical aspects of how counterparties may comply with the obligation to provide timely confirmation. Specifically, given the meaningful and practical differences among market participants with respect to resources, readiness and expertise, the ICI recommended that the confirmation obligation be required of the dealer, rather than the client, with respect to the key economic terms of the transaction. The parties can then negotiate and agree to the final terms of the confirmation to be signed by the parties without a specific time limitation on this process.
If ESMA disagrees with this recommendation and instead intends to require both derivatives dealers and funds as counterparties to confirm and sign the confirmation, the ICI asked the Authority to extend the timeframe from the end of the same business day to a more realistic period of time and apply this requirement on a proportionality basis. The speed of processing and agreeing to a confirmation often depends on the nature of counterparties, noted the ICI, and, while a derivatives dealer might have the resources and operational infrastructure to execute same day confirmations, funds and their managers are unlikely to have the operational systems in place to do the same. Mandating funds to be equally subject to the obligation to execute a confirmation of the transaction by the end of the same business day as a derivatives dealer would require funds and their managers to undergo significant and costly systems modifications that may not be feasible for a small to medium-sized investment manager.

Under current market practices, the dealer will typically produce the confirmation and the client will then be allowed a sufficient amount of time to review and agree to this confirmation. In many cases, the confirmation might not be agreed to by the parties for several days or, in some cases, weeks. Moreover, although same day entry into confirmations may be possible with certain derivatives that are currently traded on electronic platforms operated by dealers, the same may not be achieved with respect to other less frequently traded types of derivatives. Therefore, the ICI recommended that, if ESMA determines to require funds, in addition to their counterparties, to confirm and sign the confirmation, the obligation should apply proportionately, taking into account the nature of the counterparties, the class of OTC derivative, and the scale and complexity of each counterparty’s operations.

With respect to the risk mitigation practices of regular portfolio reconciliation and portfolio compression, the ICI supports the proportionality approach proposed by ESMA in that the frequency of portfolio reconciliations should be appropriate to the characteristics of the portfolio. The ICI urged ESMA to clarify that these practices should apply on an individual fund or portfolio level in recognition of the fact that the regulations for funds that are publicly offered generally apply at this level, treating individual funds and series funds as if the separate portfolios were separate investment companies.

 For example, in the United States, in creating funds, a sponsor may establish each fund as a new, separately organized entity under state law or as a new series company, that has the ability to create multiple individual mutual funds or series. The requirements under the federal securities laws safeguard the assets in an individual portfolio from market or other risks that may negatively affect another portfolio, and consequently the shareholders invested therein and the fund complex more broadly. For example, liquidation of one fund series is isolated to that series. The ICI understands that similar considerations apply in the case of umbrella fund structures established in certain EU jurisdictions, such as Luxembourg. Thus, the ICI believes that contracts held across different funds under the management of a single manager must not be aggregated for the purposes of determining whether the relevant thresholds are met.

The ICI supports the principle incorporated in the draft standards that stakeholder accountability should be a key component of sound governance arrangements for central counterparties. The ICI  believes that stakeholder involvement in the governance of central counterparties will minimize conflicts of interests by balancing the commercial interests of central counterparties with the interests of stakeholders. Given the importance of the board of directors of a central counterparty in monitoring and controlling conflicts of interest, reasoned the ICI, it is imperative that the composition of central counterparty boards include stakeholder representatives.

Guaranteeing stakeholder representation on the board also would level the playing field for all central counterparties by creating a uniform governance structure in which all of them will operate under similar restraints on the influence of their owners. For similar reasons, the ICI urged ESMA to require risk committees of central counterparties to include a wide range of client representatives. Since central counterparty risk committees will be responsible for making decisions capable of having profound effects on the OTC derivatives markets, reasoned the Institute, market participants have a strong interest in ensuring adequate and diverse stakeholder representation on risk committees as well as transparency as to the committee’s decision-making processes.

Specifically, the ICI asked that the draft require adequate representation of each category of member of the risk committee included in Article 28 of EMIR, including clients of clearing members and require central counterparties to disclose the membership of their risk committees. Article 28 also provides that the risk committee may invite employees of the central counterparty and external independent experts to attend risk committee meetings in a non-voting capacity.