Indirect clearing
European Union Electricity Market Glossary

 


 

 

Indirect clearing considerations and risks' evaluations are important, in particular, as an element of market participants' preparations for mandatory clearing with the central counterparty (CCP) of OTC trades - under circumstances specified by the EMIR Regulation

 

Indeed, access to clearing means the ability to access trading itself.

 

In order to comply with the clearing obligation, a counterparty must become a clearing member, a client or establish indirect clearing arrangements (the second subparagraph of Article 4(3) of EMIR).

 

In the move to widen and to facilitate access to clearing, in the Questions and Answers on MiFID II and MiFIR market structures topics of 7 July 2017 (ESMA70-872942901-38) ESMA stressed that trading venues should not require members or participants to be direct clearing members of a CCP.

 

In the said document the regulator said:

 

"Given the protections afforded to non-clearing members under MiFIR and EMIR, as well as the rules on straight through processing (STP), a trading venue should not require all its members or participants to be direct clearing members of a CCP.

Trading venues may however require members or participants to enter into, and maintain, an agreement with a clearing member as a condition for access when trading is centrally cleared."

 

The clearing obligation enforces the urgent review of existing documentation (procedures and contracts).

 

It will be necessary to spend time and costs in determining which CCP to use. Adapting to  regulatory changes will also require examining fees for clearing services CCPs are likely to charge as well as fees charged by clearing members for services provided by them to client firms.

 

The strategic choices to be made are, among others, between direct or indirect clearing arrangements for CCP services (or, possibly, clearing member option).

 

Indirect clearing is equally on the agenda when it comes to mandatory as well as voluntary clearing.

 

 

Legal definitions

 

 

 

Indirect clearing services enable counterparties to access clearing when they are not or can't be a direct member of a CCP or the direct client of a clearing member, thus widening access to CCPs to a larger set of counterparties.

This access to clearing in general underpins the ability of these counterparties to access trading of certain derivatives.

MiFIR thus recognises the importance of indirect clearing for these counterparties and aims at ensuring an appropriate level of protection, i.e. an equivalent level of protection as referred to in EMIR

 

ESMA Annual Report 2015. 15 June 2016, ESMA/2016/960, p. 42

 

Determination of the most beneficial option of market access is made sometimes difficult by the fact that the meaning of the indirect client relationship and its implications are often confused. 

 

Legal definitions for „indirect client‟ and „indirect clearing arrangement‟ are included at the very beginning (Article 1) of the Commission Delegated Regulation (EU) No 149/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP (Regulatory Technical Standards or RTS), hence for the purpose of EMIR:

 

(1) „indirect client‟ means the client of a client of a clearing member;

 

(2) „indirect clearing arrangement‟ means the set of contractual relationships between the CCP, the clearing member, the client of a clearing member and indirect client that allows the client of a clearing member to provide clearing services to an indirect client.

 

Before the RTS adoption, the very meaning of indirect client relationship had been interpreted in a divergent way, there was, in particular, confusion whether the definition of an indirect clearing arrangement encompasses traditional client relationships with CCP clearing members.

 

ESMA explained, however, (ESMA Q&As updated on 11 February 2014 (ESMA/2014/164)) that the provisions of Article 4 of EMIR and Article 2 of Commission Delegated Regulation (EU) No 149/2013 on indirect clearing apply only to OTC derivatives and not to all products (this is on account of they are lodged within Article 4 of EMIR and are said to be for the purpose of meeting the clearing obligation).

 

 

Commercial context of indirect clearing

 

 

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 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 final} {SWD(2017) 149 final}, 4.5.2017 SWD(2017) 148 final (p. 30, 43 - 45) underlines the fact the direct access to a CCP implies costs at least some of market participants are not in a position to bear.

 

Direct access to a CCP entails a dedicatation of a large amount of resources that smaller counterparties do not necessarily have at their disposal.

 

Minimum revenues or clearing fees range from EUR 95 000 to EUR 265 000 - this may be a significant fixed cost for a small financial counterparty with a very limited volume of OTC derivatives activity.

 

Prices for OTC clearing services can differ significantly from CCP to CCP and from product to product (see for example Overview of Fee Models of the EurexOTC Clear for Interest Rate Swaps).

 

Moreover, a tailor-made pricing is a common practice.

 

Different fees are charged including admission fees, license fees, fees per cleared trade and/or volume and maturity, booking fees, maintenance fees, fees for different collateral services, etc. Costs of one trading screen can be about EUR 100 000 per year. Assuming a minimum fee of USD 100 000, the clearing of 10 trades per year would cost USD 10 000 per trade.

 

Minimum fees in this price range essentially exclude clients from clearing services which execute only very few trades per year.

These costs undermine the economic feasibility of centralised clearing for small counterparties with infrequent trading patterns.

 

In effect, they are prevented from taking advantage of the benefits of the clearing market such as increased liquidity.

 

Individual segregated accounts are even more costly so that they are typically out of question for (very) small counterparties from an economic point of view.

 

But even if the small counterparties would overcome the above problems, this would not necessarily mean that (all) CCPs were in a position to accept smaller participants as clearing members for infrastructure or risk management reasons.

 

 

Where a DEA Provider allows a client to sub-delegate the DEA access it receives to its own clients, the DEA Provider must be able to identify the different order flows from the sub-delegated entities.

 

For these purposes, it will not be necessary for the DEA Provider to know the identity of these sub-delegated entities.

 

Guidance ICE Futures Europe and ICE Endex Guidance on Member Requirements under MiFID II, June 2017, p. 9

 

To be a direct participant in a CCP firms are required to put in place specific infrastructures and possess financial and knowledge resources (for details see below) - efforts that are only economically reasonable to make if they can be spread over a high business volume most of small, non-financial counterparties do not have.

 

Common observation is that non-financial counterparties typically do not fulfil the regulatory requirements for a direct access to clearing.

 

For these small counterparties, it is therefore necessary to become the client of a clearing member, or to establish indirect clearing arrangements.

 

The above impediments notwithstanding, the indirect clearing structures may also be driven by a need to pool clearing related activities within groups.

 

The problem is the counterparties are currently often unable to access CCPs by becoming an indirect client of a clearing member, because of the scarcity of the offer.

 

CCPs in the EU have between 3 (ICE Clear Netherlands) and 186 (Eurex Clearing) clearing members, nevertheless, the aforementioned Commission Staff Working Document of 4 May 2017 observes that very few clearing members are currently offering client clearing services and indirect clearing services to financial counterparties and NFCs+, or at least not to the smallest ones, that the offer is not sufficient and/or is concentrated on very few clearing members in the market.

 

 

Clearing access requirements

 

 

The membership requirements vary from CCP to CCP. Clients of clearing members do not face these costs as they access the CCP indirectly via a clearing member. They thereby only need to satisfy any requirements imposed by the clearing member. However, these requirements are typically in line with those of the CCP.

 

Who is responsible for what is, in such cases, typically governed by an agreement between the CCP, the clearing member and the client.

 

In cases of indirect clearing even more counterparties are involved.

 

Investment firms acting as general clearing members are required:

 

1. as regards due diligence assessments of prospective clearing clients:

 

a) to make an initial assessment of a prospective clearing client against the following criteria:


- credit strength, including any guarantees given,


- internal risk control systems,


- intended trading strategy,


- payment systems and arrangements that enable the prospective clearing client to ensure a timely transfer of assets or cash as margin, as required by the clearing firm in relation to the clearing services it provides,


- systems settings and access to information that helps the prospective clearing client to respect any maximum trading limit agreed with the clearing firm,


- any collateral provided to the clearing firm by the prospective clearing client,


- operational resources, including technological interfaces and connectivity,


- any involvement of the prospective clearing client in a breach of the rules ensuring the integrity of the financial markets,

including involvement in market abuse, financial crime or money laundering activities,


b) to review annually the on-going performance of clearing clients against the criteria listed above (the binding written agreement should contain those criteria and set out the frequency at which the clearing firm will review its clearing clients' performance against those criteria, where this review is to be conducted more than once a year, the said agreement should also set out the consequences for clearing clients that do not comply with those criteria);

 

2. as regards position limits:

 

- to set out and to communicate to its clearing clients appropriate trading and position limits to mitigate and manage its own counterparty, liquidity, operational and other risks,

 

- to monitor its clearing clients' positions against position limits as close to real-time as possible,


- to have appropriate pre-trade and post-trade procedures for managing the risk of breaches of the position limits (by way of appropriate margining practice or other appropriate means),

 

- to document in writing the procedures referred to above and to record whether the clearing clients comply with those procedures;

 

3. as regards disclosure of information about the clearing services:

 

- to publish the conditions of the offers for clearing services,


- to offer clearing services on reasonable commercial terms,


- to inform its prospective and existing clearing clients of the levels of protection and of the costs associated with the different levels of segregation offered (information must include a description of the main legal effects of the respective levels of segregation, including information on the insolvency law applicable in the relevant jurisdiction).

 

The legal base for the said requirements are Articles 24 - 27 of the Commission Delegated Regulation (EU) 2017/589 of 19 July 2016 supplementing Directive 2014/65/EU of the European Parliament and of the Council with regard to regulatory technical standards specifying the organisational requirements of investment firms engaged in algorithmic trading.

 

 

Cross-border issues 

 

 

When a jurisdiction is assessed as having equivalent requirements to EMIR for CCPs, the recognised third country CCPs would not need to comply with the requirements on indirect clearing established in the EU.

 

In effect, the recognised third country CCPs would not necessarily offer the same segregation options as the ones required under EU regulation for indirect clearing.

 

Thus, EU clearing members of these recognised third country CCPs would face a similar situation as the one they face for client clearing with these third country CCPs.

 

As with other EU rules, the applicable EU requirements for the provision of financial services within the European Union apply and therefore the regulatory technical standards on indirect clearing adopted in the EU will apply to third country entities when they provide services to EU entities (Final Report Draft regulatory technical standards on indirect clearing arrangements under EMIR and MiFIR, 26 May 2016, ESMA/2016/725, p. 5).

 

 

Indirect clearing obligation on clearing members?

 

 

Regulatory Technical Standards also prejudge that facilitating indirect clearing arrangements is not mandatory for clearing members – the second contentious issue as yet.

 

Regulatory Technical Standards state that where a clearing member is prepared to facilitate indirect clearing, any client of such clearing member will be permitted to provide indirect clearing services to one or more of its own clients, provided that the client of the clearing member is an authorised credit institution, investment firm or an equivalent third country credit institution or investment firm.

 

On the basis of the said provision it may be concluded that providing indirect clearing services:

 

1) has been restricted to authorised credit institutions and investment firm, and

 

2) is legally required of such a firms only “where a clearing member is prepared to facilitate indirect clearing”.

 

It can be inferred a contrario that “where a clearing member is not prepared to facilitate indirect clearing” he has not legal obligation to do so. 

 

Another aspect is the criteria applied by clearing members may provide for additional verification of clients that want to provide indirect clearing services.

 

Recognising the additional risk and complexity associated with indirect clearing, and in line with EMIR Article 37(3), clearing members are permitted to request that their clients offering indirect clearing have additional resources and operational capacity to perform this activity.

 

However, these criteria need to apply to all clients in a non-discriminatory manner.

 

This means that all the clients meeting these additional criteria should be allowed to provide indirect clearing services.

 

 

Clearing members' obligation to offer clearing services on fair, reasonable and non-discriminatory terms (FRAND)

 

 

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 May 2017 introduces amendments with a view to incentivise clearing and to increase access to it (EMIR Articles 4 and 39). 

 

 

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, May 2017

 

Recital 9

 

Counterparties with a limited volume of activity in the OTC derivatives markets face difficulties in accessing central clearing, be it as a client of a clearing member or through indirect clearing arrangements. The requirement for clearing members to facilitate indirect clearing services on reasonable commercial terms is therefore not efficient. Clearing members and clients of clearing members that provide clearing services directly to other counterparties or indirectly by allowing their own clients to provide those services to other counterparties should therefore be explicitly required to do so under fair, reasonable and non-discriminatory commercial terms.

 

New Article 4 paragraph 3a of EMIR:

 

"3a. Clearing members and clients which provide clearing services, whether directly or indirectly, shall provide those services under fair, reasonable and non-discriminatory commercial terms.

 

The Commission shall be empowered to adopt a delegated act in accordance with Article 82 to specify the conditions under which commercial terms referred to in the first subparagraph are considered to be fair, reasonable and non-discriminatory."

 

Point (c) of Article 1(2) of the said draft Regulation inserts a new paragraph 3a to EMIR Article 4(3) according to which clearing members and their clients who provide clearing services to other counterparties or offer their clients the possibility to provide such services to other counterparties to do so under fair, reasonable and non-discriminatory commercial terms.

 

The European Commission is empowered through delegated acts to specify what are fair, reasonable and non-discriminatory terms.

 

FIA Response of 18 July 2017 to the European Commission EMIR Review Proposal – Part 1 (REFIT Proposals) observed that the above FRAND requirements will not of themselves promote better access to clearing – rather it is economic, commercial and risk considerations that restrict a potential client’s access to clearing.


According to the FIA further clarity is required:


- on the interaction between FRAND under EMIR and other conflicting EU regulation such as MiFID II (that requires clearing services to be provided on “reasonable commercial terms” and for clearing members to “publish the conditions under which it offers clearing services”, etc.);


- on the meaning of FRAND requirements, especially the words “non-discriminatory”; and

 

- on the geographical (EU only?) and product scope (OTC derivatives clearing, but not exchange-traded derivatives) of the FRAND requirements.


FIA argues that FRAND requirements should:


- not result in a mandatory obligation on clearing brokers to offer a clearing service to all potential clients or on mandatory terms but should enable them to offer a clearing service in a competitive, commercial and prudent risk-mitigating manner; and

 

- be set out at Level 1.

 

FIA highlights that the issue with clients accessing clearing services is driven by inter alia whether it makes economic sense for clearing members to offer such services when set against the regulatory capital and leverage ratio constraints that clearing members operate under, the low interest rate environment, the credit quality of the potential client and its access to liquidity in order to meet its margining obligations, etc.

 

FIA is, therefore, concerned that FRAND, and in particular the “non-discriminatory” element, implies that in certain circumstances clearing members would be obliged to mandatorily provide clearing services to clients without the ability to choose not to act as their clearing members on both risk and/or commercial grounds.

 

In the same vein go also ISDA's remarks (International Swaps and Derivatives Association (ISDA) comments on the ‘EMIR Refit’ proposal, 18 July 2017), which accentuate that "FRAND requirements should not result in a mandatory clearing offering".

 

 

The procedure for indirect clearing contract

 

 

Contractual terms for an indirect clearing arrangement are to be agreed obviously between the client of a clearing member and the indirect client, but RTS specify that it should be done after consultation with the clearing member on the aspects that can impact the operations of the clearing member.

 

The procedure must include contractual requirements on the client to honour all obligations of the indirect client towards the clearing member. RTS envision that these requirements refer only to transactions arising as part of the indirect clearing arrangement, the scope of which must be clearly documented in the agreed contracts.

 

 

Risk mitigation techniques

 

 

It is noteworthy, pursuant to the draft Commission Delegated Regulation supplementing Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories of the European Parliament and of the Council with regard to regulatory technical standards for risk-mitigation techniques for OTC derivative contracts not cleared by a CCP (attached to the ESAs' Second Consultation on margin RTS for non-cleared derivatives of 10 June 2015 (JC/CP/2015/002), indirectly cleared OTC derivative contracts are considered as centrally cleared and are therefore not subject to the risk management procedures prescribed in the said Regulation.

 

See more on the collateral requirements under the EMIR Regulation...

 

 

Portability and segregation

 

 

According to the RTS, at the request of a clearing member, the CCP must maintain separate records and accounts enabling each client to distinguish in accounts held with the CCP the assets and positions of the client from those held for the accounts of the indirect clients of the client.

 

Such a rule of the RTS can be viewed as a second step in accounts segregation in comparison with Article 39 of the EMIR.

 

Article 30 of MiFIR envisions that indirect clearing arrangements with regard to exchange-traded derivatives are permissible provided that those arrangements do not increase counterparty risk and ensure that the assets and positions of the counterparty benefit from protection with equivalent effect to that referred to in Articles 39 and 48 of the EMIR Regulation.

 

Moreover, the European Commission is granted the power to develop draft regulatory technical standards to specify the types of indirect clearing service arrangements, where established, that meet the above conditions.

 

Article 39 of EMIR prescribes the CCP to keep separate records and accounts that enable it, at any time and without delay, to distinguish in accounts with the CCP the assets and positions held for the account of clearing member from:

1) the assets and positions held for the account of any other clearing member and from its own assets; and

2) from those held for the accounts of its clients (‘omnibus client segregation’).

 

The said provision also mandates a CCP to offer to keep separate records and accounts enabling each clearing member to distinguish in accounts with the CCP the assets and positions held for the account of a client from those held for the account of other clients (‘individual client segregation’). Upon request, the CCP shall offer clearing members the possibility to open more accounts in their own name or for the account of their clients.

 

EMIR is not clear as regards segregation of indirect client account as it only requires that a clearing member must keep separate records and accounts that enable it to distinguish both in accounts held with the CCP and in its own accounts its assets and positions from the assets and positions held for the account of its clients at the CCP.

 

However, the choice between omnibus client segregation and individual client segregation is left to the competence of the client of the clearing member. The consequences of this decision are significant, however, this is an interesting topic for another entry (see: Client segregation and portability under EMIR).

 

In any case, when facilitating indirect clearing arrangements, a clearing member must implement the following segregation arrangements as indicated by the client:

 

(a) keep separate records and accounts enabling each client to distinguish in accounts with the clearing member the assets and positions of the client from those held for the accounts of its indirect clients; or

 

(b) keep separate records and accounts enabling each client to distinguish in accounts with the clearing member the assets and positions held for the account of an indirect client from those held for the account of other indirect clients.

 

The requirement to distinguish assets and positions with the clearing member is met where:

 

(a) the assets and positions are recorded in separate accounts;

 

(b) the netting of positions recorded on different accounts is prevented;

 

(c) the assets covering the positions recorded in an account are not exposed to losses connected to positions recorded in another account.

 

Practical implications of the above structure are as follows:

 

- at the level of each clearing member, at least three separate types of accounts, e.g. own trading, omnibus client, segregated client, need to be kept in order to allow for the correct operational and regulatory treatment of risks and positions,

 

- the netting at the level of CCP is carried out per each of the separate accounts of the clearing member, 

 

- the derivatives trades concluded by the clearing member on own account may face the CCP directly or may be also versus one of its clients (Final Report, Draft technical standards on data to be made publicly available by TRs under Article 81 of EMIR, 10 July 2017, ESMA70-151-370, p. 14).

 

Another key point for indirect clients is to contractually ensure the possibility for transferring the positions and assets to an alternative client or clearing member in case of the default of a client that provides indirect clearing services. In order to do so, from an indirect client point of view it is necessary to verify the procedures, the clearing member possesses to manage the default of a its clients.

 

RTS specify that a client or clearing member is not obliged to accept these positions unless it has entered into a prior contractual agreement to do so. The clearing member must also ensure that its procedures allow for the prompt liquidation of the assets and positions of indirect clients and the clearing member to pay all monies due to the indirect clients following the default of the client.

 

RTS also impose an obligation on clients that provide indirect clearing services to keep separate records and accounts that enable it to distinguish between its own assets and positions and those held for the account of its indirect clients.

 

Indirect clients must be offered a choice between the above-specified alternative account segregation options and fully informed of the risks associated with each segregation option. The information provided by the client to indirect clients must also include details of arrangements for transferring positions and accounts to an alternative client.

 

The specific segregated account held at the CCP by the client that provides indirect clearing services must be for the exclusive purpose of holding the assets and positions of its indirect clients.

 

When referring to the above issues it is also important to mention Article 48(7) of EMIR, which stipulates that clients’ collateral distinguished in segregated accounts may be used exclusively to cover the positions held for their account.

 

Any balance owed by the CCP after the completion of the clearing member’s default management process by the CCP must be readily returned to those clients when they are known to the CCP or, if they are not, to the clearing member for the account of its clients.

 

The practical importance of the above considerations is highlighted by Lehman and MF Global instances where in both cases, which involved cleared derivatives, clients suffered losses whereas clearing members did not (the fact referred to by the International Swaps and Derivatives Association (ISDA) in a document of 3 April 2012 ‘Industry Response to the European Banking Authority, European Securities Markets’ Association and European Insurance and Occupational Pensions Authority Joint Discussion Paper on Risk Mitigation Techniques for Trades not Cleared by a Central Counterparty’).

 

Admittedly, ISDA is right emphasising the key issue, which is the segregation depends on local law and insolvency regulation and the interactions between jurisdictions can be lengthy and complex.

 

Read more on client segregation and portability under EMIR

 

 

Trading venue's status and REMIT reporting

 

 

Annex III to the TRUM (p. 2) accentuates a crucial delineation involved with the kind of trading venue's participation when it comes to REMIT reporting.

 

ACER underlines, for derivatives related to EU wholesale gas or electricity products that are only for financial settlement, only the person entering into the transactions in the EU gas or electricity derivatives traded on venues, via its own trading membership, is the REMIT market participant for the purpose of reporting.

 

For example, a client of an exchange member that places orders to trade on the order book of the venue to trade EU gas or electricity derivatives for financial settlement or it is equivalent (e.g. trading on futures for the physical delivery without having arrangements to take or make the delivery of the commodity) should not be considered a market participant unless the client of the exchange member is itself a member of the exchange for the purpose of this trade.

 

This seems to entail that clients and indirect clients (not being themselves the members of the trading venue) are not subject to REMIT transactions and orders reporting requirements.

 

 

 

 

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Last Updated on Sunday, 29 October 2017 18:50
 

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