OTC Credit Default Swaps (CDS) mandatory clearing

 

 


 

 

In the OTC Credit Default Swaps (CDS) asset class the number of active European counterparties oscillated between around 2,000 in February 2015 and 2,800 one year later (quite impressive dynamics, by the way).

 

However, less than 400 counterparties (the ones with portfolios of OTC credit derivatives above EUR 500mn) represent 98.6% of the activity, and 14.5% in terms of number of counterparties.

 

This means the CDS market is highly concentrated one and that an important number of counterparties account for only a small fraction of the total volume (Consultation Paper on the clearing obligation for financial counterparties with a limited volume of activity, 13 July 2016, ESMA/2016/1125, p. 11 - 13).

 

Credit derivatives are cleared by only one EU CCP (Commission Staff Working Document Impact Assessment Accompanying the document Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority) and amending Regulation (EU) No 648/2012 as regards the procedures and authorities involved for the authorisation of CCPs and the requirements for the recognition of third-country CCPs, SWD/2017/0246 final - 2017/0136 (COD), 13.06.2017, p. 18).

 

Mandatory clearing with respect to CDS asset class covers the following types of contracts:

 

- untranched iTraxx Index credit default swaps (Europe Main, five-year tenor, series 17 onwards, with EUR as the settlement currency)

 

- untranched iTraxx Index credit default swaps (Europe Crossover, five-year tenor, series 17 onwards, with EUR as the settlement currency).

  

The legal base for the clearing obligation with respect to CDS derivatives is the Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation.

 

The detailed specification of Credit Default OTC derivatives classes subject to the clearing obligation is as follows:

 

 

European untranched Index CDS Classes

 

  

id   Type 
 Sub-type 
 Geographical Zone 
Reference Index
Settlement Currency
Series 

Tenor

B.1.1

Index CDS     

 Untranched Index Europe   iTraxx Europe Main  EUR 17 Onwards

 5Y

B.1.2 Index CDS          
Untranched Index   Europe iTraxx Europe Crossover   EUR 17 Onwards

5Y 

 

  

Overall, these rules supplement the European Market Infrastructure Regulation (EMIR) and form part of the implementation of the agreement by G20 leaders in 2009 that standardised OTC derivative contracts should be cleared through central counterparties (CCPs).

 

In this respect ESMA consulted stakeholders in July 2014 (ESMA's document of 11 July 2014 ESMA/2014/800).

 

Although the feedback received to this consultation was broadly positive, ESMA temporarily suspended the delivery of the final proposal to the European Commission until the first rules on the Interest Rate Swaps (IRS) mandatory clearing were finalised.

 

ESMA adopted the Final draft Regulatory Technical Standard for CDS on 2 October 2015.

 

The respective Regulatory Technical Standard for CDS has been adopted by the European Commission on 1 March 2016 (C (2016) 1165 final)).

 

On 19 April 2016, the said EU Commission Delegated Regulation has been published in the European Union's Official Journal.

 

The said RTS defines types of CDS contracts, which will have to be centrally cleared, the types of counterparties covered by the obligation and the dates by which central clearing of CDS will become mandatory.

 

The new rules on Index CDS mirror the overall approach of the first RTS on IRS mandatory clearing, in particular with regards to the categorisation of counterparties, the scope for frontloading and the treatment of intragroup transactions.

  

They will be phased in over three years.

 

The Delegated Regulation confirms the start date for the mandatory clearing of the relevant credit derivative contracts from 9 February 2017 onwards, subject to phase-ins, as detailed in the Delegated Regulation.

 

Certain firms will also be subject to the frontloading requirement from 9 October 2016.

 

Among the most vital points are: the counterparties' categorisation, dates from which the CDS mandatory clearing takes effect, intragroup treatment and frontloading (of note is the fact that the European Commission's propositions as regards the reform of the EMIR framework published in May 2017 provide for the removal of frontloading requirements - see point (b) of Article 1(2) the Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 of 4 May 2017).

 

For the purposes of the clearing obligation counterparties in the CDS asset class are broadly categorised in the following manner:

 

- Clearing members for at least one of the classes of OTC CDS subject to clearing;

 

- Financial counterparties and alternative investment funds (AIFs) which are not clearing members and which have a higher level of activity in OTC derivatives (to be measured against the quantitative threshold (i.e. with individual portfolios above EUR 8 bn);

 

- Financial counterparties and alternative investment funds (AIFs) which are not clearing members and which have a lower level of activity in OTC derivatives (to be measured against the aforementioned quantitative threshold);

 

- Non-financial counterparties not included in the other categories.

 

This is expressed in Article 2 and Recitals 3 - 7 of the Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation.

 

When it comes to the breakdown of the cleared volumes in the credit derivative asset class to the above categories, analytical data show the following:

 

- clearing members (Category 1) represent 85.6% of the volume and 0.7% of the number of counterparties;

 

- counterparties classified in the Category 2 (i.e. with individual portfolios above EUR 8 bn) represent 9.3% of the volume and 5.9% of the number of counterparties;

 

- counterparties classified in the Category 3 (i.e. with individual portfolios below EUR 8 bn) represent 5.1% of the volume and 93.5% of the number of counterparties (Consultation Paper on the clearing obligation for financial counterparties with a limited volume of activity, 13 July 2016, ESMA/2016/1125, p. 19).

 

However, these numbers may be somewhat skewed as a financial counterparty with a portfolio of CDS derivatives below EUR 8 bn may be classified primarily under Category 3 whereas in reality, it may belong to Category 2 because it is part of a larger group (the fact recalled by the ESMA itself).

 

See below in the boxes some excerpts in this regard.

  

 

 

Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation 

 

Article 2

Categories of counterparties


1. For the purposes of Articles 3 and 4, the counterparties subject to the clearing obligation shall be divided in the following categories:

(a) Category 1, comprising counterparties which, on the date of entry into force of this Regulation, are clearing members, within the meaning of Article 2(14) of Regulation (EU) No 648/2012, for at least one of the classes of OTC derivatives set out in the Annex to this Regulation, of at least one of the CCPs authorised or recognised before that date to clear at least one of those classes;

 

(b) Category 2, comprising counterparties not belonging to Category 1 which belong to a group whose aggregate month-end average of outstanding gross notional amount of non-centrally cleared derivatives for January, February and March 2016 is above EUR 8 billion and which are any of the following:
(i) financial counterparties;
(ii) alternative investment funds as defined in Article 4(1)(a) of Directive 2011/61/EU of the European Parliament and of the Council (3) that are non-financial counterparties;

 

(c) Category 3, comprising counterparties not belonging to Category 1 or Category 2 which are any of the following:
(i) financial counterparties;
(ii) alternative investment funds as defined in Article 4(1)(a) of Directive 2011/61/EU that are non-financial counterparties;
(d) Category 4, comprising non-financial counterparties that do not belong to Category 1, Category 2 or Category 3.

 

2. For the purposes of calculating the group aggregate month-end average of outstanding gross notional amount referred to in point (b) of paragraph 1, all of the group's non-centrally cleared derivatives, including foreign exchange forwards, swaps and currency swaps, shall be included.

 

3. Where counterparties are alternative investment funds as defined in Article 4(1)(a) of Directive 2011/61/EU or undertakings for collective investment in transferable securities as defined in Article 1(2) of Directive 2009/65/EC of the European Parliament and of the Council, the EUR 8 billion threshold referred to in point (b) of paragraph 1 of this Article shall apply individually at fund level.

 

Recitals 3 - 7 

 

(3) Different counterparties need different periods of time for putting in place the necessary arrangements to clear the credit OTC derivatives subject to the clearing obligation. In order to ensure an orderly and timely implementation of that obligation, counterparties should be classified into categories in which sufficiently similar counterparties become subject to the clearing obligation from the same date.

 

(4) A first category should include both financial and non-financial counterparties which, on the date of entry into force of this Regulation, are clearing members of at least one of the relevant CCPs and for at least one of the classes of credit OTC derivatives subject to the clearing obligation, as those counterparties already have experience with voluntary clearing and have already established the connections with those CCPs to clear at least one of those classes. Non-financial counterparties that are clearing members should also be included in this first category as their experience and preparation towards central clearing is comparable with that of financial counterparties included in it.

 

(5) A second and a third category should comprise financial counterparties not included in the first category, grouped according to their levels of legal and operational capacity regarding OTC derivatives. The level of activity in OTC derivatives should serve as a basis to differentiate the degree of legal and operational capacity of financial counterparties, and a quantitative threshold should therefore be defined for division between the second and third categories on the basis of the aggregate month-end average notional amount of non-centrally cleared derivatives. That threshold should be set out at an appropriate level to differentiate smaller market participants, while still capturing a significant level of risk under the second category. The threshold should also be aligned with the threshold agreed at international level related to margin requirements for non-centrally cleared derivatives in order to enhance regulatory convergence and limit the compliance costs for counterparties. As in those international standards, whereas the threshold applies generally at group level given the potential shared risks within the group, for investment funds the threshold should be applied separately to each fund since the liabilities of a fund are not usually affected by the liabilities of other funds or their investment manager. Thus, the threshold should be applied separately to each fund as long as, in the event of fund insolvency or bankruptcy, each investment fund constitutes a completely segregated and ring-fenced pool of assets that is not collateralised, guaranteed or supported by other investment funds or the investment manager itself.

 

(6) Certain alternative investment funds ('AIFs') are not captured by the definition of financial counterparties under Regulation (EU) No 648/2012 although they have a degree of operational capacity regarding OTC derivative contracts similar to that of AIFs captured by that definition. Therefore AIFs classified as non-financial counterparties should be included in the same categories of counterparties as AIFs classified as financial counterparties.

 

(7) A fourth category should include non-financial counterparties not included in the other categories, given their more limited experience and operational capacity with OTC derivatives and central clearing than the other categories of counterparties.

 

 

 

 


 

 

 

 

Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation 

 

Article 3


Dates from which the clearing obligation takes effect

 

1. In respect of contracts pertaining to a class of OTC derivatives set out in the Annex, the clearing obligation shall take effect on:

 

(a) 9 February 2017 for counterparties in Category 1;

 

(b) 9 August 2017 for counterparties in Category 2;

 

(c) 9 February 2018 for counterparties in Category 3 (note that point (c) to Article 3(1) of Commission Delegated Regulation (EU) 2016/592 is proposed in the Consultation Paper on the clearing obligation for financial counterparties with a limited volume of activity, 13 July 2016, ESMA/2016/1125 to be replaced by the following: '(c) 9 February 2020 for counterparties in Category 3;' and the Final Report on the clearing obligation for financial counterparties with a limited volume of activity, 14 November 2016, ESMA/2016/1565 modifies this proposal with the date 21 June 2019), the latter date is upheld by the Commission Delegated Regulation (EU) of 16.3.2017 amending Delegated Regulations (EU) 2015/2205, (EU) 2016/592 and (EU) 2016/1178 as regards the deadline for compliance with clearing obligations for certain counterparties dealing with OTC derivatives, 16.3.2017 C(2017) 1658 final;

 

(d) 9 May 2019 for counterparties in Category 4.

 

Where a contract is concluded between two counterparties included in different categories of counterparties, the date from which the clearing obligation takes effect for that contract shall be the later date.

 

2. By way of derogation from points (a), (b) and (c) of paragraph 1, in respect of contracts pertaining to a class of OTC derivatives set out in the Annex and concluded between counterparties other than counterparties in Category 4 which are part of the same group and where one counterparty is established in a third country and the other counterparty is established in the Union, the clearing obligation shall take effect on:

 

(a) 9 May 2019 in case no equivalence decision has been adopted pursuant to Article 13(2) of Regulation (EU) No 648/2012 for the purposes of Article 4 of that Regulation covering the OTC derivative contracts set out in the Annex to this Regulation in respect of the relevant third country; or

 

(b) the later of the following dates in case an equivalence decision has been adopted pursuant to Article 13(2) of Regulation (EU) No 648/2012 for the purposes of Article 4 of that Regulation covering the OTC derivative contracts set out in the Annex to this Regulation in respect of the relevant third country:
(i) 60 days after the date of entry into force of the decision adopted pursuant to Article 13(2) of Regulation (EU) No 648/2012 for the purposes of Article 4 of that Regulation covering the OTC derivative contracts set out in the Annex to this Regulation in respect of the relevant third country;
(ii) the date when the clearing obligation takes effect pursuant to paragraph 1.

 

This derogation shall only apply where the counterparties fulfil the following conditions:

 

(a) the counterparty established in a third country is either a financial counterparty or a non-financial counterparty;

 

(b) the counterparty established in the Union is:
(i) a financial counterparty, a non-financial counterparty, a financial holding company, a financial institution or an ancillary services undertaking subject to appropriate prudential requirements and the counterparty referred to in point (a) is a financial counterparty;
(ii) either a financial counterparty or a non-financial counterparty and the counterparty referred to in point (a) is a non-financial counterparty;

 

(c) both counterparties are included in the same consolidation on a full basis in accordance to Article 3(3) of Regulation (EU) No 648/2012;

 

(d) both counterparties are subject to appropriate centralised risk evaluation, measurement and control procedures;

 

(e) the counterparty established in the Union has notified its competent authority in writing that the conditions laid down in points (a), (b), (c) and (d) are met and, within 30 calendar days after receipt of the notification, the competent authority has confirmed that those conditions are met.

   

 

 

Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation

 

Article 4

 

Minimum remaining maturity

 

1. For financial counterparties in Category 1, the minimum remaining maturity referred to in point (ii) of Article 4(1)(b) of Regulation (EU) No 648/2012, at the date the clearing obligation takes effect, shall be:

(a) 5 years and 3 months for contracts entered into or novated before 9 October 2016 that belong to the classes in the table set out in the Annex;

(b) 6 months for contracts entered into or novated on or after 9 October 2016 that belong to the classes in the table of the Annex.

 

2. For financial counterparties in Category 2, the minimum remaining maturity referred to in point (ii) of Article 4(1)(b) of Regulation (EU) No 648/2012, at the date the clearing obligation takes effect, shall be:

(a) 5 years and 3 months for contracts entered into or novated before 9 October 2016 that belong to the classes in the table set out in the Annex;

(b) 6 months for contracts entered into or novated on or after 9 October 2016 that belong to the classes in the table set out in the Annex.

 

3. For financial counterparties in Category 3 and for transactions referred to in Article 3(2) of this Regulation concluded between financial counterparties, the minimum remaining maturity referred to in point (ii) of Article 4(1)(b) of Regulation (EU) No 648/2012, at the date the clearing obligation takes effect, shall be 5 years and 3 months.

 

4. Where a contract is concluded between two financial counterparties belonging to different categories or between two financial counterparties involved in transactions referred to in Article 3(2), the minimum remaining maturity to be taken into account for the purposes of this Article shall be the longer remaining maturity applicable. 

 

 

 

 

 

Removal of the frontloading requirement

 

The European Commission's propositions as regards the reform of the EMIR framework published in May 2017 provide for the removal of frontloading requirements (see point (b) of Article 1(2) the Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 of 4 May 2017).

 

Point (b) of Article 1(2) of the said draft removes the requirement laid down in point (ii) of point (b) of EMIR Article 4(1) to clear OTC derivative contracts entered into or novated on or after notification by a competent authority to ESMA on an authorisation of a CCP to clear a class of OTC derivatives but before the date from which the clearing obligation takes effect if the contracts have a remaining maturity higher than the minimum remaining maturity determined in a Commission Delegated Regulation on clearing obligations under Article 5(2)(c).

 

Recital 8 of the said draft Regulation foresees that:


"The requirement to clear certain OTC derivative contracts concluded before the clearing obligation takes effect creates legal uncertainty and operational complications for limited benefits. In particular, the requirement creates additional costs and efforts for the counterparties to those contracts and may also affect the smooth functioning of the market without resulting in a significant improvement of the uniform and coherent application of Regulation (EU) No 648/2012 or of the establishment of a level playing field for market participants. That requirement should therefore be removed."

 

 

 

 

 

 

IMG 0744

    Documentation    

 

 

 

 

Commission Delegated Regulation (EU) of 16.3.2017 amending Delegated Regulations (EU) 2015/2205, (EU) 2016/592 and (EU) 2016/1178 as regards the deadline for compliance with clearing obligations for certain counterparties dealing with OTC derivatives, 16.3.2017 C(2017) 1658 final

 

Final Report on the clearing obligation for financial counterparties with a limited volume of activity, 14 November 2016, ESMA/2016/1565

 

Consultation Paper on the clearing obligation for financial counterparties with a limited volume of activity, 13 July 2016, ESMA/2016/1125

 

Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation

 

Commission Staff Working Document Impact Assessment Accompanying the document Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority) and amending Regulation (EU) No 648/2012 as regards the procedures and authorities involved for the authorisation of CCPs and the requirements for the recognition of third-country CCPs, SWD/2017/0246 final - 2017/0136 (COD), 13.06.2017

 

 

 

 

 

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    Links    

 

 

 

  

 

Antitrust: Commission seeks feedback on commitments by ISDA and Markit on credit default swaps

 

 

 

 

 

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Last Updated on Monday, 17 July 2017 13:41
 

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