Explanatory Memorandum to COM(2010)484 - OTC derivatives, central counterparties and trade repositories - Main contents
Please note
This page contains a limited version of this dossier in the EU Monitor.
| dossier | COM(2010)484 - OTC derivatives, central counterparties and trade repositories. |
|---|---|
| source | COM(2010)484  |
| date | 15-09-2010 |
The financial crisis has brought over-the-counter (OTC) derivatives to the forefront of regulatory attention. The near-collapse of Bear Sterns in March 2008, the default of Lehman Brothers on 15 September 2008 and the bail-out of AIG the following day highlighted the shortcomings in the functioning of the OTC derivatives market. Within that market, regulators devoted particular attention to the role that credit default swaps (CDS) played during the crisis.
The Commission responded rapidly. In its broad Communication of 4 March 2009 on “Driving European Recovery”[1], the Commission committed to deliver, on the basis of a report on derivatives and other complex structured products, appropriate initiatives to increase transparency and to address financial stability concerns. On 3 July 2009, the Commission adopted a first Communication[2] that specifically examined the role played by derivatives in the financial crisis and looked at the benefits and risks of derivatives markets. That Communication assessed how the identified risks could be reduced i.
In September 2009, G-20 Leaders agreed in Pittsburgh that:
All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.
In June 2010, G20 Leaders in Toronto reaffirmed their commitment and also committed to accelerate the implementation of strong measures to ' improve transparency and regulatory oversight of over-the-counter derivatives in an internationally consistent and non-discriminatory way '.
On 20 October 2009, the Commission adopted a second Communication[4] that set out the future policy actions the Commission intended to propose to increase transparency of the derivatives market, reduce counterparty and operational risk in trading and enhance market integrity and oversight. That Communication also announced the Commission's intention to proceed with legislative proposals in 2010, to ensure implementation of the G20 commitments to clear standardised derivatives i, and that Central Counterparties (CCPs) comply with high prudential standards and adequate regulation of trade repositories. This proposal for a Regulation delivers the Commission's commitments to proceed rapidly and with determination. It takes also into account the strong support and the many of the measures suggested in the Resolution of the European Parliament of 15 June 2010, on 'Derivatives markets: future policy actions' (Langen-report).
As already indicated above, this initiative is part of a larger international effort to increase the stability of the financial system in general, and the OTC derivatives market in particular. Given the global nature of the OTC derivatives market an internationally coordinated approach is crucial. It is therefore important that this proposal takes into account what other jurisdictions intend to do or have already done in the area of OTC derivatives regulation to avoid the risk of regulatory arbitrage.
In this context, this proposal is consistent with the recently adopted US legislation on OTC derivatives, the so-called Frank-Dodd Act. The Act has a broadly identical scope of application. It contains similar provisions requiring the reporting of OTC derivative contracts and the clearing of eligible contracts. Furthermore, it puts in place strict capital and collateral requirements for OTC derivatives that remain bilaterally cleared. Finally, it puts in place a regulatory framework for trade repositories and upgrades the existing regulatory framework for CCPs. Similarly to the Commission's proposal, the Act foresees the further elaboration of a number of technical rules.
Contents
- RESULTS OF CONSULTATIONS WITH THE INTERESTED PARTIES AND IMPACT ASSESSMENT
- LEGAL ELEMENTS OF THE PROPOSAL
- BUDGETARY IMPLICATION
- 3. IMPACT ASSESSMENT
- 4.1. Legal basis
- 4.2. Subsidiarity and proportionality
- 4.3. Detailed explanation of the proposal
- 4.3.1. Title I (Subject matter, scope and definitions)
- 4.3.2. Title II (Clearing, reporting and risk mitigation of OTC Derivatives)
- 4.3.3. Title III (Authorisation and supervision of CCPs)
- 4.3.4 . Title IV (Requirements for CCPs)
- Prudential requirements
- 4.3.5 . Title V (Interoperability)
- 4.3.6. Title VI (Registration and surveillance of trade repositories)
- 4.3.7 . Title VII (Requirements for trade repositories)
- 5. FINAL PROVISIONS
Since October 2008, the Commission services have been engaged in almost continuous, extensive consultation with stakeholders to determine the appropriate policy response. This interaction has taken the form of many bilateral and multilateral meetings, two public consultations and a conference.
Initially the Commission services’ attention focused solely on the Credit Default Swap (CDS) market which was at the centre of attention with Bear Sterns and Lehman's. In order to facilitate the monitoring of the major dealers’ commitment in this area, the Commission established the Derivatives Working Group (DWG), that included representatives from the financial institutions that committed to clear European referenced CDS by July 2009 i, representatives from central counterparties, trade repositories and other relevant market participants and from relevant European (ECB, CESR, CEBS and CEIOPS) i and national (AMF, BaFin and FSA) i authorities. In addition to the meetings of the DWG, the Commission held separate, ad-hoc bilateral and multilateral meetings with a large number of stakeholders in the CDS market.
Following industry compliance with the above-mentioned commitment and to prepare legislative measures, the Commission formed a Member States Experts Working Group on Derivatives and Market Infrastructures. It discussed regulatory approaches with experts representing Member States, the ECB, CESR and CEBS. It held a series of meetings from January to July 2010.
The Commission has also gained valuable information by participating in various international fora, in particular the OTC Derivatives Regulators Group and the Basel Committee's Risk Management and Modelling Group. The Commission has recently also gained observer status on the steering committee of the joint CPSS-IOSCO i working group that is currently reviewing the recommendations for CCPs and preparing recommendations for trade repositories. In addition, the Commission has engaged in frequent dialogue with non-EU authorities, in particular US authorities (the CFTC, the SEC i, the Federal Reserve Bank of New York and the Federal Reserve Board and the US Congress) and is co-chairing a work stream of the Financial Stability Board (FSB) focusing on addressing the challenges related to the implementation of the reporting, clearing and trading obligations agreed at G20 level.
In parallel with the publication of the first Communication, DG MARKT launched a public consultation i from 3 July to 31 August 2009. The Commission services received 111 responses, 100 of which have been authorised for publication and have been published on the consultation website i. A summary of responses including an introductory analysis of the public stakeholder consultation is available on DG MARKT’s website i. This was followed by a major conference in Brussels, on 25 September 2009 i. Three panels of academics, industry representatives and regulators, coming from the EU and the US, presented their views on the need (or lack thereof) to reform the OTC derivatives market to an audience of more than 400 participants and answered their questions. The conference broadly confirmed the views and information obtained through the public consultation.
A second open consultation was organised from 14 June to 10 July 2010 to obtain feedback from interested stakeholders on the contours of the legislative measures. The Commission services received 210 responses, which were for the most part supportive of the suggested reforms.[15]
The Regulation is accompanied by an impact assessment i analysing the options to reduce systemic risk by increasing the safety and efficiency of the OTC derivatives market. Following the analysis, the impact assessment concludes that the largest net benefits would be achieved through the adoption of measures that would:
- require the use of CCP clearing for OTC derivatives that meet predefined eligibility criteria;
- set specific targets for legal and process standardisation;
- set specific targets for the bilateral clearing of OTC derivatives transactions;
- require market participants to report all the necessary information on their OTC derivatives portfolios to a trade repository or, if that would not be possible, directly to regulators; and
- require the publication of aggregate position information.
The proposal is based on Article 114 TFEU as the most appropriate legal basis for a Regulation in this field. A Regulation is considered to be the most appropriate legal instrument to introduce a mandatory requirement directed to all actors to clear standardised OTC derivatives through CCPs and to ensure that CCPs, that will as a consequence assume and concentrate significant risk, are subject to uniform prudential standards in the EU. A Regulation is the appropriate legal instrument to confer new powers on ESMA as the sole authority with the responsibility to register and exercise surveillance of trade repositories in the EU.
A uniform process at EU-level is needed to determine which OTC Derivatives are eligible for mandatory clearing through CCPs. This can not be left to the discretion of Member States as this would give rise to different and inconsistent application of the clearing obligation throughout the EU. A central role needs therefore to be given to the European Commission and ESMA in identifying the eligible class of derivatives that must be centrally cleared. Furthermore, as the use of CCPs becomes compulsory under EU-law, they must be subject to rigorous organisational, conduct of business and prudential requirements.
In respect of authorisation and supervision of CCPs the Regulation aims at striking a balance between the need for an important central role of ESMA, the competences of national authorities, and the interests of other competent authorities. It takes into account the potential fiscal responsibility of Member States and the cross-border nature of the CCP business.
ESMA will have a central role in the college of competent authorities for the authorisation, withdrawal of authorisation and amendment of authorisation of a CCP. In order to establish a single process and avoid discrepancies between Member States, ESMA is also responsible for recognising a CCP from a third country that seeks to provide clearing services to entities established in the European Union, if certain conditions are met.
As regards the reporting requirement, given the fact that information reported to a trade repository will be of interest to all competent authorities in the European Union and given the need to ensure that all competent authorities will have the same degree of unfettered access under the same conditions to that information, this should be regulated at the EU-level. ESMA is therefore empowered to deal with both the registration and surveillance of trade repositories.
For these reasons, the provisions are in accordance with the principles of subsidiarity and proportionality as set out in Article 5 of the Treaty, as the objectives of the proposal cannot be sufficiently achieved by the Member States and can therefore be better achieved by the European Union.
The scope of the Regulation is wide and lays down uniform requirements covering financial counterparties, non-financial counterparties (exceeding certain thresholds) and all categories of OTC derivative contracts. Its prudential parts apply to central counterparties as a result of the clearing obligation and, for the reporting requirement, to trade repositories. It is important to note, however, that the authorisation and supervision requirements for CCPs apply irrespective of the financial instrument the CCPs clear: OTC or other. This is clarified in Article 1 i. Exemptions are explicitly foreseen for the members of the European System of Central Banks, public bodies charged with or intervening in the management of the public debt, and to multilateral development banks, in order to avoid limiting their powers to intervene to stabilise the market, if and when required.
This part of the regulation is central to implementing the obligation to clear all standardised OTC derivatives as agreed in the G-20. In order to implement this commitment into legislative obligations, standardised contracts will mean those contracts that are eligible for clearing by CCPs. In order to apply this, the Regulation establishes a process that will take into account the risk aspects connected to mandatory clearing. The process is devised so as to ensure that a clearing obligation for OTC derivative contracts will in practice achieve its final objective of reducing risk in the financial system, rather than increasing it: forcing a CCP to clear OTC contracts that it is unable to risk-manage may have adverse repercussions on the stability of the system.
However, in order to establish a process that ensures that as many OTC contracts as possible will be cleared, the Regulation introduces two approaches to determine which contracts must be cleared:
1. a bottom-up approach, according to which a CCP decides to clear certain contracts and is authorised to do so by its competent authority, who is then obliged to inform ESMA once it approves the CCP to clear those contracts. ESMA will then have the powers to decide whether a clearing obligation should apply to all of those contracts in the EU. ESMA will need to base that decision on certain objective criteria;
2. a top-down approach according to which ESMA, together with the European Systemic Risk Board, will determine which contracts should potentially be subject to the clearing obligation. This process is important to identify and capture those contracts in the market that are not yet being cleared by a CCP.
Both approaches are necessary because, on the one hand, meeting the G20 clearing commitment cannot be left entirely to the initiative of the industry. On the other hand, a regulatory check at European level of the appropriateness of certain arrangements is necessary before the clearing obligation enters into force.
It is important to note that counterparties that are subjected to the clearing obligation cannot simply avoid the requirement by deciding not to participate in a CCP. If those counterparties do not meet the participation requirements or are not interested in becoming clearing members, they must enter into the necessary arrangements with clearing members to access the CCP as clients.
Furthermore, and in order to avoid the erection of barriers and to preserve the global nature of OTC derivatives, CCPs should not be allowed to accept only those transactions concluded on execution venues with which they have a privileged relationship or which are part of the same group. For these reasons, a CCP that has been authorised to clear eligible derivative contracts is required to accept clearing such contracts on a non-discriminatory basis, regardless of the venue of execution.
As regards non-financial (corporate) counterparties, they will in principle not be subject to the rules of this Regulation, unless their OTC derivatives positions reach a threshold and are considered to be systemically important. Because their derivatives activities are generally assumed to cover those derivatives that are directly linked to their commercial activity rather than speculation, those derivatives positions will not be covered by this Regulation.
In concrete terms, this means that the clearing obligation will only apply to those OTC contracts of non-financial counterparties that are particularly active in the OTC derivatives market and if this is not a direct consequence of their commercial activity. For example, this may be the case for energy suppliers that sell future production, agricultural firms fixing the price at which they are going to sell their crops, airlines fixing the price of their future fuel purchases or any commercial companies that must legitimately hedge the risk arising from their specific activity.
There are, however, reasons for not granting non-financial counterparties a full exemption from the scope of this Regulation.
First, non-financial counterparties are active participants in the OTC derivatives market and often transact with financial counterparties. Excluding them entirely would diminish the effectiveness of the clearing obligation. Second, some non-financial counterparties may take systemically important positions in OTC derivatives. Leaving systemically relevant non-financial counterparties whose failure may have a significant negative effect on the market completely outside the scope of regulatory attention would not be an acceptable course of action. Third, a full exclusion of non-financial counterparties could lead to regulatory arbitrage. A financial counterparty could easily circumvent the obligations set out in the Regulation by establishing a new non-financial entity and direct its OTC derivative business through it. Finally, their inclusion in the scope of application is also necessary to ensure global convergence with third countries. The US legislation does not provide a complete exemption of non-financial counterparties from the reporting and the clearing obligations.
In view of the above, the Regulation sets out a process that helps to identify the non-financial institutions with systemically important positions in OTC derivatives and subjects them to certain obligations specified under the Regulation. The process is based on the definition of two thresholds:
a) an information threshold;
b) a clearing threshold .
These thresholds will be specified by the European Commission on the basis of draft regulatory standards proposed by ESMA, in consultation with the European Systemic Risk Board ("ESRB") and other relevant authorities. For example, in case of energy markets, ESMA would have to consult the Agency for the Cooperation of Energy Regulators established by Regulation (EC) No 713/2009 in order to ensure that the particularities of the energy sector would be fully taken into account.
The information threshold will allow financial authorities to identify non-financial counterparties that have accumulated significant positions in OTC derivatives. This is necessary, because those counterparties are usually not subject to the supervision of these authorities. In practice, when the Regulation foresees that when the positions of a non-financial counterparty exceed the information threshold, the non-financial counterparty will be required to notify the competent authority defined in the Regulation of this fact. In addition, that counterparty will automatically become subject to the reporting obligation and will be required to provide justification for taking those positions.
The clearing threshold, on the other hand, will be used to establish whether a non-financial counterparty will become subject to the clearing obligation. In practice, if the positions of the counterparty will exceed that threshold, then the counterparty will become subject to the clearing obligation for all its contracts. If some of those contracts will happen to be not eligible for CCP clearing, then the non-financial counterparty will be subject to the capital or collateral requirements specified in the Regulation (see below).
Both thresholds will be defined taking into account the systemic relevance of the sum of net positions and exposures by counterparty per class of derivatives. However, and importantly, and as clarified and confirmed above, in calculating the positions for the clearing threshold, derivative contracts should not be taken into account if they have been entered into to cover the risks arising from an objectively measurable commercial activity.
As not all OTC derivatives will be considered eligible for central clearing, there remains a need to improve arrangements and the safety of those contracts that will continue to be managed on a so-called bilateral basis. The Regulation therefore requires the use of electronic means and the existence of risk management procedures with timely, accurate and appropriately segregated exchange of collateral, and an appropriate and proportionate holding of capital.
Finally, financial counterparties and non-financial counterparty above the clearing threshold must report the details of any derivative contract they have entered into and any modification thereof (including novation and termination) to a registered trade repository. Greater transparency of the OTC market is critical for regulators, policymakers, and the marketplace. In the exceptional case that a trade repository is not capable of recoding the details of a particular OTC derivatives contract, the Regulation requires that this information should be provided directly to the relevant competent authority. The Commission will need to be empowered to determine the details, type, format and frequency of the reports for the different classes of derivatives, following draft technical standards to be developed by ESMA.
To ensure that CCPs established in the European Union are safe, the authorisation of a CCP will be subject to that CCP having access to adequate liquidity. Such liquidity could result from access to central bank or to creditworthy and reliable commercial bank liquidity, or a combination of both.
National competent authorities should retain the responsibility for authorising (including withdrawal) and supervising CCPs, as they remain best placed to examine how the CCPs operate on a daily basis, to carry out regular reviews and to take appropriate action, where necessary. Given the systemic importance of CCPs and the cross-border nature of their activities, it is important that in the authorisation process a central role is played by ESMA. This will be achieved in the following ways:
- the adoption of this legislative act in the specific form of a Regulation will give ESMA a central role and responsibility for ensuring its common and objective application, as clearly specified in the ESMA Regulation;
- ESMA will be required to develop a number of draft technical standards in critical areas for the correct application of the Regulation;
- ESMA will facilitate the adoption of an opinion by the college.
As CCPs are considered to be systemically relevant institutions, the relevant competent authorities in the college of competent authorities must define contingency plans to cope with emergency situation. Furthermore, the Commission in its future initiative on crisis management and resolution will need to define the specific policy and measures to address a crisis situation in a systemically relevant institution.
As regards CCPs from third countries, ESMA will also have the direct responsibility of recognising such CCPs, if certain conditions are met. In particular, the recognition will require that the Commission has ascertained the legal and supervisory framework of that third country as equivalent to the EU one, that the CCP is authorised and subject to effective supervision in that third country and ESMA has established co-operation arrangements with the third country competent authorities. A CCP of a third country will not be allowed to perform activities and services in the Union, if these conditions are not met.
Organisational requirements
As the Regulation will introduce a mandatory clearing obligation for OTC derivatives, critical attention needs to be awarded to the robustness and regulation of CCPs. To begin with, a CCP must have in place robust governance arrangements. These will respond to any potential conflicts of interest between owners, management, clearing members and indirect participants. The role of independent board members is particularly relevant. The roles and responsibilities of the risk committee are also clearly defined in the Regulation: its risk management function should report directly to the board and not be influenced by other business lines. The Regulation also requires governance arrangements to be publicly disclosed. In addition, a CCP should have adequate internal systems, operational and administrative procedures, and should be subject to independent audits.
All of these measures are considered more effective in addressing any potential conflicts of interest that may limit the capacity of CCPs to clear, than any other form of regulation which may have undesirable consequence on market structures (e.g. limitation of ownership, which would need to extend also to so-called vertical structures in which exchanges own a CCP).
As the CCP will be a counterparty to every position, it bears the risk that one of its counterparties might fail. Similarly, any counterparty of a CCP bears the risk that the CCP itself might fail. The Regulation therefore provides that a CCP must mitigate its counterparty credit risk exposure through a number of reinforcing mechanisms. These include stringent, but non-discriminatory participation requirements, financial resources, and other guarantees.
By virtue of its central role, a CCP is a critical component of the market it serves. Consequently, the failure of a CCP would in almost all cases become a potential systemic event for the financial system. In view of their systemically important role and in view of the proposed legislative requirement to clear all standardised OTC derivatives through CCPs, the need to subject them to strict prudential regulation at EU-level cannot be over-emphasized. As the present national laws regulating CCPs differ between Member States, the resulting unlevel playing field also makes the cross-border provision of CCP services potentially less safe and more costly than would be desirable and represents a barrier to the integration of the European financial market.
Outsourcing of functions by a CCP will only be allowed, if it does not impact on the proper operation of the CCP and on its ability to manage risks, including those arising from the outsourced functions. Thus, CCPs must always monitor and have full control of the outsourced functions and continuously manage the risks they face. In practical terms, no risk management functions will be allowed to be outsourced.
A minimum quantum of capital must be required for authorisation to exercise the activities of a CCP. A CCP’s own capital is also its last line of defence in the event of the default of one or more members, after the margins collected from the defaulting member(s), the default fund and any other financial resources have been exhausted. If a CCP decides to use part of its capital as an additional financial resource to be used for risk management purposes, then this portion must be in addition to the capital needed to perform the services and activities of a CCP on an on-going basis.
The Regulation will require a CCP to have a mutualised default fund to which members of the CCP will have to contribute. A default fund enables loss-mutualisation and thus represents an additional line of defence that a CCP can use in case of the insolvency of one or more of its members.
The Regulation also introduces important rules on segregation and portability of positions and corresponding collateral. These are critical to effectively reduce counterparty credit risk through the use of CCPs, to achieve a level playing field among European CCPs and to protect the legitimate interests of clients of clearing members. This responds to a call by clearing members and their clients for greater harmonisation and protection in this field. It also responds to the issues highlighted by Lehman's demise.
Interoperability is an essential tool to achieve an effective integration of the post-trading market in Europe. However, interoperability may expose CCPs to additional risks. For this reason regulatory approval is required before entering into an interoperable arrangement. CCPs should carefully consider and manage the extra risks that interoperability entails and satisfy the competent authorities about the soundness of the systems and procedures adopted. In view of the complexity of derivatives markets and the early stage of development of CCP clearing for OTC derivatives, it is not appropriate to extend the provisions on interoperability to instruments other than cash securities at this point in time. However, this exclusion should not limit the possibility of CCPs to enter into such arrangements in a safe manner, subject to the conditions provided in the Regulation.
As mentioned above (section 4.3.2) the Regulation provides for a reporting requirement of OTC derivative transactions to increase the transparency of this market. The information must be reported to trade repositories. The latter will therefore hold regulatory information which will be relevant for a number of regulators. In view of the central role of trade repositories in the collection of regulatory information, the Regulation gives ESMA the powers to register trade repositories, withdraw the registration and to perform the surveillance of trade repositories. Granting surveillance powers to authorities in the Member State where a trade repository is established would create an unbalanced situation between competent authorities of the different Member States. Furthermore, as there are no fiscal responsibilities implications connected to the surveillance of trade repositories, a national supervisory approach is not necessary. ESMA's role will also ensure an unfettered access to all the relevant European authorities and a unique counterparty representing Europe to deal with competent authorities of third countries trade repositories.
The Regulation also contains provisions for trade repositories to guarantee their compliance with a set of standards. These are designed to ensure that the information that trade repositories maintain for regulatory purposes is reliable, secured and protected. In particular, trade repositories will be subject to organisational and operational requirements and ensure appropriate safeguarding and transparency of data.
In order to be registered, trade repositories must be established in the EU. However, a trade repository established in a third country can be recognised by ESMA if it meets a number of requirements designed to establish that such trade repository is subject to equivalent rules and appropriate surveillance in that third country. In order to ensure that there are no legal obstacles in place that would prevent an effective mutual exchange of information and unfettered access to data maintained in a trade repository located in a third country, the Regulation foresees the need to conclude an international agreement to that effect. The Regulation stipulates that if such an agreement is not in place a trade repository established in that third country would not be recognised by ESMA.
The Commission should be empowered to adopt delegated acts in accordance with Article 290 of the Treaty on the Functioning of the European Union in respect of the details to be included in the notification to ESMA and in the register and the criteria for the decision of ESMA on the eligibility for the clearing obligation, on the information and clearing threshold, on the maximum time lag regarding the contract, on liquidity, on the minimum content of governance rules, on details of record keeping, on minimum content of business continuity plan and the services guaranteed, on percentages and time horizon for margin requirements, on extreme market conditions, on highly liquid collateral and haircuts, on highly liquid financial instruments and concentration limits, on details for performance of tests, on details concerning the application of a trade repository for registration with ESMA, on fines and on details concerning the information that a trade repository should make available, as referred to in this Regulation. ESMA should draft regulatory technical standards for these delegated acts and carry out appropriate impact assessments.
The Commission should be empowered to determine the format of reports, record keeping and the format for the registration application of a trade repository. According to Article 291 TFEU, rules and general principles concerning mechanisms for the control by Member States of the Commission's exercise of implementing powers are to be laid down in advance by a Regulation adopted in accordance with the ordinary legislative procedure. Pending the adoption of that new Regulation, Council Decision 1999/468/EC of 28 June 1999 laying down the procedures for the exercise of implementing powers conferred on the Commission continues to apply, with the exception of the regulatory procedure with scrutiny, which is not applicable.
The proposal has no implication for the Union budget.