|Flawed inception of mandatory clearing|
|Tuesday, 09 August 2016 10:00|
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 a quantitative threshold) will likely benefit from extended deadlines for mandatory clearing.
Is there anybody who can see the sense in amending three EU mandatory clearing regulations as soon as they have been adopted...?
Theoretically, the reason is laudable - to reduce bureaucratic burden on firms and give them more time to prepare.
However, as always, there are some flaws in this bright situation.
But a few words, as a background, first.
Under EMIR, the clearing obligation is established via Commission Delegated Regulations based on draft regulatory technical standards (RTS) developed by ESMA.
The said three RTS took the form of:
- the First Commission Delegated Regulation (Commission Delegated Regulation (EU) 2015/2205 of 6 August 2015 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation) covering interest rate derivatives in the G4 currencies,
- the Second Commission Delegated Regulation (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) covering European index CDS,
- the Third Commission Delegated Regulation (Commission Delegated Regulation (EU) 2016/1178 of 10 June 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 covering interest rate derivatives in NOK, PLN and SEK.
Mandatory clearing for OTC derivatives has gone live already - since 21 June 2016, clearing members are required to clear their OTC interest rate swaps denominated in the G4 currencies (EUR, GBP, JPY and USD) and the clearing obligation will gradually become applicable to the other categories of counterparties.
However, on 13 July 2016 ESMA has released Consultation Paper on the clearing obligation for financial counterparties with a limited volume of activity (ESMA/2016/1125), where the EU financial market's watchdog proposes to amend mandatory clearing deadlines set in the aforementioned all three Commission Delegated Regulations. The extension is intended to apply to Category 3 counterparties: i.e. 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 a quantitative threshold).
The key dates and compliance deadlines for the clearing obligation are summarised in the table below.
To explain its initiative ESMA refers to some primary characteristics of the OTC market and recalls the fact that to comply with the clearing obligation, counterparties which do not have pre-existing clearing arrangements can become a clearing member, a client, or establish indirect clearing arrangements with a clearing member.
ESMA argues that:
- First - for the financial counterparties with a limited volume of activity, it is not feasible to access CCPs directly by becoming a clearing member, because of a range of reasons, in particular: cost (e.g. minimum capital requirements), risk (e.g. mutualisation of default fund resources) and other legal issues. For those counterparties, it is therefore necessary to become the client of a clearing member, or to establish indirect clearing arrangements.
- Second, the clearing members' appetite to provide client clearing services beyond the most important and biggest clients for their franchise and/or beyond the most active clients has so far been relatively limited. One of the most significant reasons thereof appears to be the costs, and in particular the capital allocation for this business line as a result of the leverage ratio framework being developed under Basel III and the Capital Requirements Regulation (CRR). These capital requirement considerations are usually quoted as being the main reason why several market participants have stopped providing this service. Although the framework for the leverage ratio is not fully developed, the uncertainty over it is apparently preventing banks from extending their client clearing offering.
- Third, the conclusion of indirect clearing arrangements is well established in the exchange traded derivatives market, but no similar development has yet occurred in the OTC derivative market (ESMA's recent draft RTS to facilitate indirect clearing arrangements in the OTC market is in the consultation phase only and the timing thereof is not synchronised with the clearing obligation timeframes).
My understanding of the facts recalled by ESMA is that in the ESMA's opinion certain markets are not sufficiently mature to accommodate regulatory requirements as regards mandatory clearing - at least with respect to some categories of counterparties.
However, reasons invoked in the recitals to the ESMA's draft Commission Delegated Regulation amending Commission Delegated Regulation (EU) 2015/2205 of 6 August 2015, Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 and Commission Delegated Regulation (EU) 2016/1178 of 10 June 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 have not appeared just now, they existed already at the time when the three mandatory clearing regulations were adopted.
Moreover, the market has not changed since that time and will not change in the next six months, presumably.
What the EU legislators had in mind, then, when adopting all three Commission Delegated Regulations?
It has to be noted that the legislative process encompasses in this case such respectable institutions as the European Parliament, the Council, not to mention the European Commission and the ESMA itself.
All this gives an impression of improvisation on the part of the EU legislators, similarly to the MiFID II delayed dates of entry into force, where the implementation issues for the FIRDS were not sufficiently considered in advance.
Uncertainty in the market is high due to objective circumstances (such as for example Brexit) and adding, by legislators, to this regulatory chaos only worsens situation.
Companies are already facing significant problems when identifying their counterparties for the purposes of mandatory clearing categories.
To ease the process of counterparties' categorisation ESMA has issued on 6 June 2016 a clarification (see box above), but - in the context of the aforementioned draft regulation - it has already become partially outdated. This is only one example of regulatory mess currently present.
The legislative strategy adopted for the mandatory clearing implementation is also questionable - the legislative framework specifying derivatives subject to the clearing obligation consists of several separate European Commission's delegated regulations.
Division lines between these legislative pieces are drawn not only between different asset classes (IRS vs. CDS) but also between currencies within IRS type of contracts (IRS denominated GBP, EUR, JPY and USD vs. IRS denominated in SEK, NOK and PLN).
Is this system user-friendly? I dare to say, it isn't.