US Hedge Fund Industry Comments on ESMA Proposed Standards Implementing EU Derivatives Regulation

The US hedge fund industry strongly supports the final EU Regulation on OTC derivative transactions, central counterparties and trade repositories. The European Market Infrastructure Regulation (EMIR) is an important step towards central clearing of OTC derivatives, increasing market transparency and reducing systemic risk.  In particular, the Managed Funds Association applauds the mandatory inclusion of client representatives on central counterparty  risk committees and the requirement that central counterparties offer both omnibus and individual client collateral segregation arrangements. 

In this spirit, the MFA commented on the proposed standards of the European Securities and Markets Authority (ESMA) implementing EMIR in an effort to assist ESMA in finalizing the standards in a way that will enhance the governance of central counterparties, increase clearing certainty and the protections and information provided to clients, and ensure consistent and effective global regulation of the OTC derivatives markets. In a letter to ESMA, the hedge fund group said that clients should be represented on the governing bodies of central counterparties. Thus, the MFA  supports the ESMA proposal requiring central counterparty governance arrangements to include processes for ensuring accountability to stakeholders. In addition, the MFA urged ESMA to include anti-circumvention measures in the final standards.

These measures would obligate the central counterparty governing bodies to refrain from making decisions regarding their governance and operations with the intention of circumventing any  EMIR client protection or transparency requirement, and to actively consider the interests of all stakeholders, including clients, in providing clearing services and managing the central counterparty. The final standards should also guard against  circumvention of the EMIR transparency requirements by requiring central counterparties to give client representatives and independent directors rights to attend all meetings of all central counterparty governing bodies, including subcommittees, if such meetings deal with matters that directly affect clients’ interests, such as changes to margin valuation

Models.

The MFA also asked that central counterparties be required to disclose the identity of the members of its board, of the risk committee and other significant board subcommittees.  ESMA should also mandate disclosure of central counterparty ownership interests held by central counterparty directors and senior management. Mandating this level of transparency would not only expose any conflicts of interest, noted the MFA, but it would also ensure consistent global derivatives regulation since it would be consistent with proposed SEC and CFTC requirements.

The hedge fund association commended ESMA for providing a framework for sound portfolio margining practices that permit offsets across correlated financial instruments,

 with a single default fund covering all financial instruments under the same portfolio  margining arrangements. The association urged ESMA to allow give counterparty risk managers and risk committees the flexibility to determine the permitted parameters of portfolio margining models for different products and asset classes, including offsets and risk correlation levels, subject to regulatory oversight. The MFA reasoned that risk managers and risk committees are in the best position to determine, and adjust as market conditions evolve, the proper level of negative correlation and offset for different financial instruments, subject to regulatory supervision.

Cross-Border Application of EMIR 

ESMA will deal with the extraterritorial application of EMIR to non-EU counterparties at a later time. The MFA urged ESMA to publish a consultation as soon as possible addressing the application of EMIR to transactions between US non-EU counterparties that have a direct, substantial and foreseeable effect within the EU. Due to the cross-border nature of derivatives markets, the MFA urged ESMA to draft standards setting out clearly and precisely the circumstances in which ESMA considers an OTC derivative contract to have a direct, substantial and foreseeable effect within the EU; and that it is necessary or appropriate to apply the clearing and risk mitigation obligations to contracts between US and other third-country counterparties in order to prevent the evasion of the requirements under EMIR.

 Particularly, ESMA should consider a number of factors in drafting the standards, said the MFA, including the domicile of the hedge fund and the fund manager, the domicile of the counterparty, and the location of the market. The standards should clarify that transactions between two US or other third-country entities are not within the scope of EMIR simply because there is an EU reference security or other EU underlying instrument.

However, if ESMA should subject a contract between two US or other third-country parties to EMIR’s clearing obligation due to the contract having an EU reference security or other underlying, the hedge fund group asked that the standards provide that it can be deemed to have a direct, substantial and foreseeable effect within the EU only if it satisfies three specific factors.

The first factor is that, for derivatives referencing a security, such as equity derivatives and credit default swaps, the reference entity must be domiciled and have its principal place of business in the EU; and for foreign exchange derivatives, the Euro or another currency of an EU member state must be one of the relevant currencies. The second factor is that the settlement currency of the contract must be in Euros or the currency of another EU member state. The third factor is that the notional amount of the contract must be substantial.