Monday, September 03, 2012

In Letter to ESMA, US Hedge Fund Industry Supports Straight Through Processing of Derivatives Transactions

The US hedge fund industry supports the straight-through processing of derivatives transactions under the European Market Infrastructure Regulation (EMIR) in order to reduce counterparty credit risk and improve the efficiency of the OTC derivatives markets. In a letter to the European Securities and Markets Authority (ESMA), which has proposed standards implementing EMIR, the Managed Funds Association said that straight-through processing is a predicate to the fulfillment of a number of key EMIR objectives, including open market access, standardization of operational market processes, and the reduction of concentration and interconnectedness.

In the view of the hedge fund group, the failure to include a positive mandate for straight-through processing would undermine the fundamental policy goals of clearing by impeding optimal risk management, competitive liquidity and open access to the market. Given the benefits of straight-through-processing, the MFA urged ESMA to ensure the same real-time processing timeframe for all transactions submitted for clearing, regardless of the execution method used or whether or not the transaction is subject to mandatory clearing.

Further, in order to facilitate international harmonization of regulations and to ensure full realization of the benefits of client clearing, ESMA should draft standards on client clearing models that support straight-through processing. The MFA noted that the CFTC has demonstrated its support for straight-through processing by issuing final rules that minimize or effectively eliminate the time between transaction execution and acceptance into clearing and mandate straight-through processing for all derivatives transactions regardless of the mode. The CFTC has noted that prudent risk management dictates that once a transaction has been submitted to a clearing member or a central counterparty, the clearing member or central counterparty must accept or reject it as quickly as possible.

The MFA is concerned that, absent straight-through processing, client clearing arrangements could impose barriers on the ability of clients to access clearing and competitive execution. In particular, it is important that such arrangements do not expose clients to the credit risk of their executing counterparty, which would undermine the risk reduction purpose of clearing. To address this concern, the MFA has consistently supported straight-through processing of transactions to clearing. Straight-through processing of derivatives transactions ensures that parties to derivative transaction are informed in real-time whether the transaction has been accepted for clearing. Once the transaction is accepted for clearing, the parties’ counterparty risk exposure is to the central counterparty rather than to the other market participant.

Article 11 of EMIR sets forth requirements related to mitigating risks of each non-cleared transaction, noted the hedge fund association, and consistent with this risk mitigation element, the final regulations should mandate the compression or effective elimination of the time between execution and confirmation of clearing acceptance, as is the norm in other cleared derivatives markets, including futures, equity options, and energy derivatives. Indeed, the MFA emphasized that the final regulations should require straight-through processing and clearing of derivatives transactions regardless of the execution method used by the parties and whether or not the transaction is subject to the EMIR clearing obligation.

More broadly, the MFA said that straight-through-processing benefits all market participants by giving them certainty of clearing immediately following execution, which in turn allows them to hedge more efficiently and effectively manage risk. It is also an important factor in encouraging the implementation of broad, mandatory clearing, noted the MFA, and is essential to electronic trading, particularly central limit order book trading, since it is not possible to enter into an electronic transaction on an anonymous basis without both the immediate confirmation of the execution of the transaction and its acceptance for clearing. Straight-through processing also promotes accessible, competitive markets and access to best execution by ensuring parties to a cleared transaction have immediate confirmation that they will face the relevant central counterparty , thus eliminating the need to negotiate individual credit arrangements with each of their counterparties, as is required in bilateral derivatives markets.

The MFA fears that if a client faces any delay in a central counterparty’s acceptance of any transaction for clearing it will result in the client trading with fewer counterparties, and that this will, by extension, increase concentration in the market, since it is typically the largest dealers that pose lower long-term counterparty credit risk and with whom clients are more likely to have in place bilateral master agreements. Central counterparties have a strong interest in ensuring the solvency of clearing members, posited the hedge fund association, thus straight-through processing can broaden the number of suitable counterparties available and increase competition among them.