At the G-20 meeting in Pittsburgh in September 2009, the G-20 leaders made the following commitments to regulate standardized over-the-counter (“OTC”) derivatives markets:
As a result of these commitments, multiple regulatory reform initiatives are taking place globally. Many of these initiatives have extraterritorial effect. For end users with global trading operations, it is possible that difficult compliance and choice-of-law questions will arise as the new global regulatory landscape for OTC derivatives evolves.
This update provides a high level comparison of the new rules for OTC derivatives regulation in the United States (U.S.) and the European Union (EU). It is important to note that other financial centres such as Hong Kong and Singapore have also introduced initiatives that provide regulatory reform of OTC derivatives.
U.S. and EU OTC derivatives rules – overview and extraterritorial reach
In the U.S., Title VII of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) sets out provisions requiring OTC derivatives to be centrally cleared and traded on trading platforms. The Dodd-Frank Act was passed in July 2010 and is currently undergoing the contemplated rule-making process by the relevant agencies (in particular the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”) (collectively, “Commissions”)).
In the EU, the rules requiring OTC derivatives to be centrally cleared and traded on trading platforms are being addressed in two separate pieces of legislation:
Both the Dodd-Frank Act and EMIR/MiFID II anticipate the need for international coordination of OTC derivatives reforms and regulation. EMIR and MiFID II apply to OTC derivative contracts eligible for clearing/trading on trading venues which have a “direct, substantial and foreseeable effect within the EU” or where such obligation is necessary or appropriate to prevent the evasion of any provision of EMIR/MiFID II. Similarly, Title VII of the Dodd-Frank Act applies where activities relating to CFTC-governed swaps have a “direct and significant connection with activities in, or effect on, commerce of the United States”. Regarding SEC-governed security-based swaps, Title VII of the Dodd-Frank Act contains an exclusion from the applicability of its substantive provisions as to “any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States,” unless such business contravenes SEC anti-evasion rules or regulations. OTC options that are not commodity options continue to be regulated by the SEC as securities. They therefore remain subject to jurisdictional provisions under prior law that are similar to those for security-based swaps.
There is not yet clarity as to the meaning of the words “direct, substantial and foreseeable effect within the EU”. There is a similar lack of clarity on the analogous Dodd-Frank Act wordings (“direct and significant connection with activities in, or effect on, commerce of the United States” and “without the jurisdiction of the United States”). Thus U.S. and other non-EU firms face uncertainty in relation to the clearing and trading obligations under EMIR and MiFID II, respectively. Conversely, EU firms and other non-U.S. firms face uncertainty under the broadly similar provisions in the Dodd-Frank Act.
Monitoring an evolving regulatory landscape for derivatives in a single jurisdiction is already challenging for many end users. This effort becomes even more challenging for those end users who may need to think about compliance obligations in multiple jurisdictions. To help understand in general terms what the derivatives compliance framework may look like for end users once regulatory reforms take effect, we have set forth below a summary and comparison of key terms in the Dodd-Frank Act, MiFID II and EMIR.
|Issue||Dodd-Frank Act||EMIR/ MiFID II||Commentary|
|Legislative and Regulatory Framework||
Title VII of the Dodd-Frank Act and rules and regulations promulgated thereunder establish the legislative and regulatory framework under U.S. law.
Primary regulatory authority is generally divided between the CFTC for swap transactions and the SEC for security-based swap transactions, each as defined under the Dodd-Frank Act and joint CFTC and SEC regulations.
Security-based swaps are essentially limited to swaps based on single securities, single loans or narrow-based securities indices. The CFTC regulates all other swaps, including interest rate swaps, currency swaps and swaps based on broad-based securities indices.
EMIR and MiFID II together set out the EU’s regulatory approach to derivatives contracts.
Broadly speaking, EMIR covers the obligation for OTC derivatives to be cleared and for the reporting of all derivatives contracts (not merely OTC derivatives) to trade repositories, while MiFID II covers the obligation for sufficiently liquid derivatives to be traded on trading venues (and for those derivatives to be cleared through CCPs). Greater detail on the specifics of EMIR and MiFID II is provided below.
Both in the U.S. and in the EU, derivatives market participants need to comply with legal requirements that derive from multiple sources.
In the U.S., primary jurisdiction is divided between two regulatory agencies, depending on the nature of the asset underlying the derivative. This may require end users to have twice the compliance infrastructure they have had historically. Adding to the new challenges, the CFTC and SEC have not synchronized the timetable for proposing and adopting regulations to implement the Dodd-Frank Act. Moreover, they have not committed to taking consistent approaches in following through on their legislative mandate.
In the EU, market participants compliant with EMIR by year end 2012 may have to adapt and fine-tune their compliance infrastructure as MiFID II is implemented during the years that follow.
There may be a need for further substantive rules and amendments to the Dodd-Frank Act and EMIR to close regulatory gaps and hence avoid arbitrage between the EU, U.S. and other major jurisdictions. Indeed, EMIR already prescribes a review of certain matters in 2015.
|Scope of OTC Derivatives Covered||
The Title VII definition of “swap” is intentionally broad, covering any agreement, contract or transaction that is, or in the future, becomes commonly known to the trade as a swap, and including a transaction “that provides for any purchase, sale, payment or delivery (other than a dividend on an equity security) that is dependent on the occurrence, nonoccurrence or extent of occurrence of an event or contingency associated with a potential financial, economic or commercial consequence” or “that provides on an executory basis for the exchange, on a fixed or contingent bases, of 1 or more payments based on the value or level of 1 or more... quantitative measures, or other financial or economic interests or property of any kind... and that transfers... financial risk... without also conveying a current or future direct or indirect ownership interest in an asset... or liability”.
However, it does not cover options on securities, spot foreign exchange transactions, foreign exchange swaps and forwards. Physically settled commodities, options on securities and physically settled forward transactions in securities are also excluded. Additional regulatory guidance on what constitutes a swap or a security-based swap is still forthcoming.
In relation to the obligation under EMIR to centrally clear all OTC derivatives, an “OTC derivative” is defined in EMIR as: “a derivative contract the execution of which does not take place on a regulated market ...or on a third country market considered as equivalent to a regulated market...”. In other words, the clearing obligation applies to bilateral contracts not executed on a trading venue. Futures contracts are traded on an exchange and so do not fall within this definition.
In relation to the obligation under MiFID II to trade derivatives on trading venues, the obligation applies to derivatives which are capable of being cleared under EMIR, or a sub-set thereof, if applicable.
|Unlike the U.S., the EU (EMIR) does not expressly provide any exemption for foreign exchange derivatives. It is unclear as to whether some form of an exemption will be introduced during the Level 2 process, in order to reduce the scope of regulatory arbitrage between the U.S. and EU.|
|Entities Subject to the Clearing and Trading Obligations||Exemptions to the clearing requirement apply to a party that is not a financial entity and that is using the relevant swap or security-based swap transaction to hedge or mitigate commercial risk. To qualify for the end user exemption, a party must notify the CFTC or SEC, as applicable, how it meets its financial obligations with respect to swaps and security-based swaps. Note that the definition of financial entity (parties ineligible for the end user exemption) covers swap dealers, security-based swap dealers, major swap participants, major security-based swap participants, commodity pools, some private funds, ERISA plans and banking entities.||
The clearing obligation applies to “financial counterparties” (generally speaking, regulated entities) as well as to “non-financial counterparties” whose OTC derivatives positions exceed a clearing threshold to be determined based on technical standards published by the European Securities and Markets Association (“ESMA”).
EMIR provides for an exemption from the clearing requirement for intra-group transactions. The risk mitigation and collateral requirements for uncleared OTC derivatives (see below) will not apply to such intra-group transactions, provided that “there is no current or foreseen practical or legal impediment to the prompt transfer of own funds or repayment of liabilities” between the group entities.
In addition, for three years after the entry into force of EMIR, the clearing obligation will not apply to OTC derivative contracts that are objectively measurable for purposes of hedging risks in pension schemes arrangements. OTC derivative contracts entered into by pension schemes which are exempt from clearing are, however, subject to the risk mitigation requirements for contracts not cleared by a CCP.
The trading obligation under MiFID II applies to “financial counterparties” and “non-financial counterparties” (which exceed the clearing threshold) as defined in EMIR. There is an exemption for intra-group transactions, but not for pension funds.
In the U.S., speculative hedges will not be eligible for the end user exemption. Note also that in the U.S., no exemption analogous to the exemption for intra-group transactions applies.
In the EU, in setting the clearing threshold for non-financial counterparties, ESMA is to take into account the systemic relevance of the sum of net positions and exposures by counterparty per class of contract. In determining its OTC derivatives positions, the non-financial counterparty can exclude positions which are “objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty”. It is possible that ESMA will set the threshold at a low level and that the test will aggregate different classes of derivatives.
In relation to the intra-group exemption, it appears that only transactions between two counterparties belonging to the same group where: (i) the two counterparties are established in the EU, or (ii) a counterparty is established in an EU member state and the other counterparty is established in a third country jurisdiction with rules in place equivalent to the EU rules , qualify as intra-group transactions and therefore benefit from the exemption.
|Registration/ Authorisation Requirement||Certain market participants that hold themselves out as OTC derivative dealers, or that trade in volumes that could pose a high degree of risk to the U.S. financial system, will be required to register with the appropriate Commission as either a dealer or major participant (in swaps or security-based swaps) and, accordingly, adhere to business conduct standards, meet margin and capital requirements, and comply with recordkeeping and real-time reporting of swap activity.||The existing MiFID framework requires entities who deal in derivatives to be authorized and regulated by the regulator in the relevant EU Member State. Certain exemptions from authorisation are available under the existing MiFID (e.g., for hedging). However MiFID II reduces the scope of these exemptions so that certain entities which are currently exempt from authorisation (e.g., in particular, certain commodity derivatives dealers) may be required to become authorized under MiFID II.||
A majority of end users will not qualify as a registered entity in either category under the Dodd-Frank Act.
Banks which satisfy the definitions of either a swap dealer or major swap participant will be required to register with either or both the CFTC and SEC and comply with the relevant rules adopted by the agencies. However, the Dodd-Frank Act instructs U.S. federal banking regulators to adopt special uncleared swaps margin and capital rules for swap dealers that are banks. In April 2011, the U.S. bank regulators proposed rules for the collection of initial and variation margin for uncleared swaps by swap dealers and major swap participants that are banks, but proposed to rely on existing risk-based capital regulations for these banks because the regulators concluded that these regulations already take into account the unique risks arising from derivatives transactions.
The Dodd-Frank Act imposes a clearing requirement applicable to swaps and security-based swaps that meet certain criteria. The CFTC and SEC are tasked with determining which swaps are subject to this requirement. When making this determination, the Commissions must consider:
(i) the availability of a rules framework, capacity, operational expertise and resources and credit support infrastructure to clear the contract on terms consistent with the material terms and trading conventions on which the contract is then traded;
(ii) the existence of significant outstanding notional exposures, trading liquidity and adequate pricing data;
(iii) the effect on the mitigation of systemic risk;
(iv) the effect on competition, including appropriate fees and charges applied to clearing; and
(v) the existence of reasonable legal certainty in the event of the insolvency of the relevant derivatives clearing organization (“DCO”) or one or more of its clearing members with regard to the treatment of customer and swap counterparty positions, funds and property.
The Commissions are authorized to identify classes of swaps that would otherwise be subject to clearing but which no DCO has listed for clearing, investigate and take necessary actions. Generally, the Commissions have 90 days following submission of a class of swaps to be accepted for clearing by a DCO to determine whether the class is required to be cleared.
Where a Member State regulator authorizes a CCP to clear a class of OTC derivatives, ESMA is required, within six months, to develop draft technical standards for implementation, determining whether the class of derivatives should be subject to the clearing requirement, when the requirement should take effect and which existing OTC derivative transactions shall be subject to the requirement.
The criteria to be followed in identifying whether a class of contracts should be subject to clearing include:
(i) the degree of standardization within the contractual terms and operational processes applicable to such contracts;
(ii) volume of trading and liquidity; and
(iii) the availability of fair, reliable and generally accepted pricing information in respect of the relevant class.
In determining when the clearing requirement should take effect (including whether it should be phased in), ESMA must consider expected trading volumes of the class of derivatives, the types and numbers of counterparties active in the market, whether CCPs already clear the class of derivatives, whether CCPs can handle expected trading volumes, what tasks will need to be completed for a category of counterparties to clear a contract and how long that will take as well as the risk management, legal and operational capacity of the counterparties.
It is also possible for ESMA to invite CCPs to clear a certain class of OTC derivatives.
As a consequence of, and if subject to the clearing obligation, end users of derivatives will need to supplement the terms of their existing ISDA master agreements to allow for the intervention of a clearing member and, where necessary, provide for the delivery of margin/collateral at the level that may be required by the CCP. End users must also establish relationships with one or more clearing members providing the end user with the facility to fulfill its clearing obligation.
There are broader questions as to the systemic risk that could be built up as a result of the concentration of risk in CCPs (i.e., will CCPs themselves become “too big to fail”). International discussions on resolution regimes for CCPs will need to be carried out in order to address this issue.
|Trading Venue Requirement||The Dodd-Frank Act requires that all swap and security-based swap contracts that are subject to the clearing requirement and that are “available to trade” be traded on a swap or security-based swap execution facility (“SEF”).||
MiFID II requires that sufficiently liquid derivatives be traded only through the trading venues specified in MiFID II, or on non-EU (“third country”) trading venues in “equivalent” jurisdictions. The trading venues are: regulated markets (e.g., the main market of the London Stock Exchange), multilateral trading facilities (“MTFs” such as BATS/Chi-X) and organised trading facilities (“OTFs” – a new kind of trading venue introduced in MiFID II).
In determining whether a derivative is “sufficiently liquid”, the European Commission must consider the liquidity of the class based on factors including average frequency and size of trades. ESMA will have a significant role in determining whether a class of derivatives is sufficiently liquid for trading on trading venues.
In the U.S., there is as yet not much guidance about how the SEF requirement will work. Current CFTC proposals will require that transactions be executed through an order book or request for quote system. The parameters surrounding these requirements are not yet clear. Buy-side participants have pre-trade transparency and liquidity concerns about these methods. (See discussion of pre-trade transparency below.)
In the EU, unlike in Title VII, the criteria for identifying derivatives which are suitable for clearing under EMIR, on the one hand, and trading under MiFID II, on the other hand, are not the same. It may be that they will ultimately be aligned as MiFID II is finalized, but as it stands the MiFID II criteria are less comprehensive and granular than the EMIR criteria.
Separately, the MiFID II OTF category, which is entirely new, is proving controversial in the negotiation process for MiFID II. EU Exchanges and MTFs argue that there is no need for yet another type of trading venue, while others argue that the OTF category is too vague in scope to be useful.
One point worth noting is that the OTF category, as proposed by the European Commission (i.e., the final definition may be different), is wider than the U.S. SEF in that while SEFs relate specifically to “swaps”, OTFs relate to all financial instruments.
|Margin Requirements for Cleared OTC Derivatives||CTFC rules require a derivatives clearing organization (“DCO”) to impose initial margin requirements that are risk based, as well as daily variation margin requirements based on exposure resulting from changes in the market value of a position since it was executed, or the previous time it was marked to market. Initial margin is to be calculated in a manner that will cover a DCO’s potential future exposures to clearing members based on price movements in the interval between the last collection of variation margin and the time the DCO estimates that it could be able to liquate a defaulting clearing member’s position. In addition, most clearing members require customers to post margin based on the clearing member’s own risk models, which could result in a customer posting margin in excess of DCO requirements.||Under the terms of the contract with the CCP, the counterparty will be required to post two types of margin to the relevant clearing member (and the clearing member will be required to post the same to the CCP): variation margin and initial margin. Variation margin is intended to protect against fluctuations in the market value of the contract, whereas initial margin is intended to absorb and protect against losses suffered under the derivative contract (where such losses exceed the collateral posted by the defaulting counterparty or the clearing member and therefore are not already covered). EMIR requires that variation margin and initial margin be in the form of “highly liquid collateral with minimal credit and market risk.”||
Unfortunately for end users in both the U.S. and EU it will be difficult to know at the outset of the trade what the margin requirements for that transaction will be. Neither the U.S. nor the EU provide for transparency as to how margin requirements are calculated. This marks a significant transition from the transparency and methodology that currently applies to bilateral swap transactions.
It is likely that CCPs will have standard terms of business that will set out how margin received is held and accounted for in its records. End users may not have much scope to negotiate such terms. Nevertheless, end users must have a clear understanding of their CCP’s approach to segregation of margin and also an understanding of how their positions with the CCP or clearing member may be transferred (i.e., ported) to another CCP or clearing member in the event of a default by the first CCP or clearing member. Such analysis will enable an end user to select a clearing member and CCP whose terms are more suitable for it.
In relation to EMIR, it is possible that that the only collateral that will be eligible for such purposes will be cash and government bonds, but not corporate bonds or equity. If so, then the global demand for liquid assets will increase, given that liquid assets will be needed not only in relation to OTC derivatives regulation but also for the purposes of banks satisfying new liquidity coverage ratios under the Basel III framework.
In order to satisfy the various margin and bilateral risk mitigation obligations, parties may have to change their internal operational systems and processes, for example, in order to effect a timely, accurate and appropriate exchange of margin/collateral. The costs associated with this may well be significant, particularly, perhaps, for non-financial counterparties.
|Segregation of Collateral – Cleared OTC Derivatives||
For swaps, the CFTC has proposed legal segregation with operational commingling (“LSOC”), which would require each swap dealer, CCP and DCO to segregate on its books and records the cleared swaps of each individual customer and relevant collateral.
Operationally, each swap dealer, CCP and DCO would be permitted to hold or commingle the relevant collateral in one account. Such account would be separate from any account holding swap dealer, CCP or DCO property or holding property belonging to non-cleared swaps customers. Permitted investments of customer collateral are limited and a clearing member’s obligation to “top up” any investment losses is currently under review. The LSOC model is designed to protect against fellow customer risk in that it allows a DCO to go after only defaulting customer collateral in the event a clearing member becomes insolvent as a result of a customer default. It is possible that LSOC structure may conflict with U.S. Bankruptcy Code Section 766 which requires all customers of an insolvent futures commission merchant to share on a pro rata basis in any shortfall.
The SEC has not made any proposals yet for segregation of collateral for cleared security-based swaps.
The Chicago Mercantile Exchange has recently proposed an alternative segregation model whereby the CME Clearinghouse would hold the collateral of swaps customers, bypassing the swap dealer.
CCPs are required to offer to keep separate records and accounts, enabling each clearing member to distinguish the assets and positions of that clearing member from those held for the accounts of its clients (“omnibus client segregation”), as well as to offer to keep separate records and accounts, enabling each clearing member to distinguish the assets and positions held for the account of a client from those held for the accounts, of other clients (“individual client segregation”). CCPs are required to offer clearing members the possibility to open more accounts in their own name or for the account of their clients to facilitate this.
Clearing members are required to offer their clients, at a minimum, the choice between individual client segregation and omnibus client segregation and inform them on the costs and levels of protection associated with each option. Each client must confirm its choice in writing.
When a client opts for individual client segregation, any excess margin over and above the client’s requirement should also be posted to the CCP and distinguished from other clients’ or clearing members’ margins and should not be exposed to losses connected to positions recorded in another account. EMIR does, however, permit a CCP to use/rehypothecate margin or default fund contributions it has collected by way of a security financial collateral arrangement. A CCP must publicly disclose this right of use/rehypothecation.
The EU appears to provide more comprehensive protection of collateral, at least when comparing the U.S. LSOC model with the EU individual client segregation model.
At this time, many details regarding protection of customer collateral are still in development. For example, in the U.S., we do not know how LSOC will apply for portfolio margined transactions. We also do not know what protections will be implemented for margin posted for security-based swap transactions.
|Margin and Capital Requirements for Uncleared OTC Derivatives Transactions||
The CFTC has proposed regulations that would require a swap dealer to require its counterparty to post initial margin and variation margin to it. There is no regulatory proposal requiring a customer to hold collateral from its swap dealer. This could result in an end user not having a right to hold collateral.
At this time, the SEC has not proposed any regulations on this point.
U.S. bank regulators have proposed margin and capital requirements for swap dealers and major swap participants that are banks, as discussed in this chart under Regulated Entities above.
EMIR requires that for uncleared swaps, market participants that are subject to the clearing obligation should have “risk management procedures that require the timely, accurate and appropriately segregated exchange of collateral” and should mark-to-market (or where this is not possible, mark-to-model) on a daily basis the value of outstanding derivative contracts. In addition, financial counterparties must hold an appropriate and proportionate amount of capital to manage the risk not covered by the appropriate exchange of collateral.
ESMA has indicated that for non-cleared derivatives, mark-to-model calculations will be preferred over mark-to-market calculations since such derivatives are likely to be illiquid.
Note that EMIR contemplates bilateral exchanges of collateral for uncleared swap transactions.
Note also the points made above in relation to firms needing to prepare for margining (under “Margin Requirements for Cleared OTC Derivatives”).
|Segregation of Collateral – Uncleared OTC Derivatives||The Dodd-Frank Act requires swap dealers and major swap participants to offer customers the opportunity to segregate with an independent third-party custodian any collateral that does not constitute variation margin that is posted in connection with uncleared OTC derivatives.||As noted above, EMIR requires that the collateral be “appropriately segregated”.||The term “appropriately segregated” in EMIR suggests that any method of segregation may be used so long as it is effective. The existing MiFID rules on client money may require a firm to treat excess cash collateral as client money and to segregate such excess money accordingly. Save where collateral is transferred by title transfer, the current MiFID rules on client assets require firms to safeguard clients’ ownership rights over securities and to prevent use of client securities on the firm’s own account, except with the client’s express consent.|
|Cross Margining||The Dodd-Frank Act authorizes the infrastructure that will allow a financial institution to offer cross margining to its customers. Once such infrastructure is established, it will enable collateral requirements to be calculated on an aggregated basis across different product lines. In March of 2012, CME Group announced that it will offer portfolio margining of over-the-counter interest rate swap positions and Eurodollar and Treasury Futures for house accounts for clearing members. While this will not have immediate benefits to buy side customers, over time this could facilitate cross-product margining for end users.||EMIR has no analogous provision.||Current market practice is for collateral requirements to be calculated across all OTC derivative transactions governed by the same master agreement (regardless of type of derivative). Under the Dodd-Frank Act’s proposals, it is possible, absent cross margining, that a client will be assessed margin on its swaps and security-based swaps independently. An analogous concern does not exist under the EU proposal. Current market practice for end users that trade OTC derivatives on equities is to assess margin looking across the dealer’s swap and prime brokerage exposure. EMIR does not provide for this type of cross margining; the Dodd-Frank Act does.|
The Dodd-Frank Act requires the CFTC to establish position limits for 28 referenced energy, metal and agricultural exchange-traded futures (the “Referenced Contracts”) (and options thereon and economically equivalent swaps). The new CFTC rules prohibit traders from holding or controlling in excess of 25% of the estimated spot-month deliverable supply of any Referenced Contracts. The actual limits are not yet available but are subject to formulas set forth in the rule. Netting of physical-delivery contracts against cash-settled contracts will not be allowed. Bona fide hedging transactions and positions will not be counted towards a trader’s limits.
Most hedge fund transactions will not be bona fide hedging because they will not represent a substitute for a transaction in a physical marketing chain.
Position limits apply to all positions in accounts for which any person, by power of attorney or otherwise, directly or indirectly holds positions or controls trading, and requires the aggregation of positions or accounts in which a person has a 10% or greater ownership interest, subject to certain exceptions for passive investors. Persons must aggregate all accounts they hold or control having identical trading strategies. Commodity pool operators and commodity trading advisors (including those that are excluded or exempt from registration), banks, trust companies, and their separately organized affiliates, will not be required to aggregate client accounts that are controlled by CFTC-registrants who also act as independent account controllers (“IACs”), subject to satisfying specified criteria and filing an IAC notice with the CFTC. The IAC exemption requires the filing of a written notice with the CFTC and it is not applicable to spot-month positions in physical-delivery contracts. Traders must also report to the CFTC when their aggregate positions, including bona fide hedging positions, reach certain levels.
MiFID II requires trading venues which admit to trading or trade commodity derivatives to apply clear, transparent and non-discriminatory limits to the number of contracts which market participants can enter into over a specified period of time. The European Commission may also choose to adopt “delegated acts” setting out limits applicable across the EU and, in exceptional cases, national regulators may impose more restrictive limits for a period of six months.
MiFID II also gives Member State regulators the power to demand information from any person regarding the size and purpose of a derivative position. They may then require that person to reduce the size of the position. ESMA is to oversee actions taken by Member State regulators in this respect and ensure that they are taking a consistent approach. ESMA also has the power to demand that any person reduce the size of a derivative position, although to take this step it must satisfy itself that Member State regulators have not already taken sufficient action.
|Unlike in the U.S., where position limits are focused (broadly) on commodity derivatives, the EU MiFID II proposal appears to contemplate that position limits may be applied to derivatives generally. The position limit and position management powers also apply not only to physically-delivered commodity derivatives but also to cash-settled commodity derivatives.|
|Swaps Data Reporting-Post Trade||Both the CFTC (final rule issued on January 9, 2012) and SEC (no final rule issued yet) have issued regulations that would require a complete report of swaps data to be submitted to a swaps data repository as soon as practically possible, and, in any case, no later than 15 minutes, following execution. Such data will be publicly disseminated within minutes or, in some cases, 24 hours following report of such data to a data repository. The counterparty to a trade that is a registered entity (swap dealer or major swap participant) will generally be the counterparty with responsibility for reporting swaps data. Public disclosure will not be on an aggregated basis and, under the SEC proposal, identity of some counterparties may also be publicly disclosed.||
EMIR requires that all counterparties (including non-financial counterparties and CCPs, are required to ensure that the details of all concluded derivative contracts and any modification or termination of the contract, are reported to a registered or recognised trade repository no later than the working day following the conclusion, modification or termination of the relevant contract. A counterparty or a CCP which is subject to the reporting obligation may delegate the obligation, for example, to prime brokers or managers.
Trade repositories are required to publish aggregate positions by class of derivatives on fair, reasonable and non-discriminatory terms subject to necessary precaution on data protection. Where a trade repository is not available to record the details of a derivative contract, counterparties and CCPs need to ensure that the details of the derivative contracts are reported to ESMA.
|U.S. regulations, which require public dissemination of trade data on a non-aggregated basis, raise more transparency concerns than EU proposals. Note that U.S. and EU proposals both require reporting of full trade data within one day of execution. This could result in compressed time periods for negotiating trade confirmations. Current market practice is for certain trade terms to be negotiated after execution over a longer period.|
|Pre-trade Transparency||The CFTC has proposed rules that would require all transactions made available to trade on a SEF be traded through either an order book or request for quote (“RFQ”) system. A market participant must transmit a request for quotes to buy or sell a specific instrument to no less than five market participants in the trading system or platform. This raises some transparency concerns for end users. The SEC proposal would allow a participant to send a request for quote to a single participant on a SEF.||
MiFID II will extend pre-trade transparency requirements from equities only (which is the case under the existing MiFID) so as to include non-equity instruments such as bonds and derivatives.
MiFID II appears to assume the use of an order book system, with calibration to be dealt with under Level 2 measures.
|EU market participants, in particular, are concerned that MiFID II does not contemplate, at least, a phase-in approach so that derivatives could be traded through a RFQ system until there is sufficient liquidity for a central limit order book system to be used.|
|Recognition of Third Country CCPs||The Dodd-Frank Act provides that the Commissions may exempt a non-U.S. CCP from the relevant U.S. regulation if it is subject to comparable comprehensive regulation in its home country.||EMIR provides that third country CCPs can be used where the third country CCP is recognised by ESMA. Amongst the conditions for recognition is that the European Commission must adopt an implementing act determining that the CCP is established or authorised in a third country in which it is subject to effective supervision and enforcement ensuring full compliance with the prudential requirements applicable in the third country, cooperation arrangements with ESMA have been established and the third country is considered as having “legally binding requirements which are equivalent to the requirements set out under [EMIR]”; furthermore, the legal framework of that third country must provide for an “effective equivalent system for the recognition of CCPs authorised under” regimes (such as the EU’s) which are foreign to that third country.||In relation to EMIR, the reference to a third country providing for “an effective equivalent system for the recognition of CCPs authorised under third country legal regimes” was a controversial part of the negotiations for finalising the text of EMIR. Indeed a Recital to EMIR provides that, given the “very special situation of CCPs... this approach does not constitute a precedent for other legislation.” It will be interesting therefore to see whether the approach taken here will be repeated in relation to the trading obligation under MiFID II (see below).|
|Recognition of Third Country Trading Venues||It is not clear at this time what standards will apply for U.S. recognition of third country trading venues. The Dodd-Frank Act leaves essentially unaltered the Commissions’ prior regulations concerning the regulation of foreign securities and futures exchanges and does not specifically require additional regulations in respect of non-U.S. OTC derivatives trading venues.||The European Commission has proposed in MiFID II that in order for a third country trading venue to be recognized for purposes of the MiFID II derivatives trading obligation, the third country must provide “an equivalent reciprocal recognition of trading venues authorised under [the] Directive.”||As noted above, it is possible that the provision used in EMIR in relation to third country CCPs may be translated into MiFID II in relation to third country trading venues.|
|Extra-territorial Application of the Clearing and Trading Obligation||
Section 722(d) of the Dodd-Frank Act provides that the provisions enacted by Title VII of the Dodd-Frank Act regarding swaps:
“shall not apply to activities outside the United States unless those activities: (1) have a direct and significant connection with activities in, or effect on, commerce of the United States; or (2) contravene such rules or regulations as the [CFTC] may prescribe or promulgate as are necessary or appropriate to prevent the evasion of any provision of this Act...”
Section 772(b) of the Dodd-Frank Act also excludes the application of Title VII provisions concerning security-based swaps “to any person insofar as such person transacts a business in security-based swaps without the jurisdiction of the United States, unless such person transacts such business in contravention of such rules and regulations as the [SEC] may prescribe as necessary or appropriate to prevent the evasion of any provision…added by [Title VII].”
EMIR and MiFID II apply the clearing obligation and trading obligation, respectively, not only to transactions between EU counterparties, but also to transactions between two entities established in one or more third countries that would be subject to the clearing obligation if they were established in the EU, provided that “the contract has a direct, substantial and foreseeable effect within the Union or where such an obligation is necessary or appropriate to prevent the evasion of any provisions of [EMIR][MiFID II].”
EMIR provides that the European Commission must monitor and endeavour that the commitments set out in EMIR are implemented in a similar way by “international partners” which will require the European Commission to cooperate with third country authorities to ensure consistency between EMIR and what is established in such third country jurisdictions.
There is as yet no clarity on how such rules should be applied in practice on an extra-territorial basis. The complexity of the issue is highlighted in particular where a derivative contract may be between a U.S. counterparty on the one hand, and an EU counterparty on the other, and for which the reference obligation may be in a third jurisdiction. Absent guidance from the regulatory authorities, counterparties may feel unable to enter into such transactions; for example, it would not be possible to clear a single contract in two different locations.
It may be that the only workable solution is to allow the counterparties to decide which jurisdiction’s regulatory framework governs the contract, but that would only be possible if all of the relevant jurisdictions declare that each other relevant jurisdiction’s rules are consistent, even if not fully equivalent.
|Timing||Statutory effective dates have now passed (July 2011), but both the SEC and CFTC have issued various orders extending effectiveness and compliance deadlines in recognition of the delay in rulemaking. In most cases, SEC deadlines are extended until the SEC completes relevant rulemaking, while CFTC deadlines are extended until the earlier of the date the CFTC completes relevant rulemaking, or July 2012.||
EMIR was adopted by the European Parliament on 29 March 2012. It will need formally to be adopted by the EU Council, although that is expected to be a formality. It will then be published in the Official Journal of the European Union.
EMIR will be implemented only after the technical standards are developed and published. ESMA must submit these standards to the European Commission by 30 September 2012. These new standards should be fully adopted by the European Commission by the end of 2012.
The date of application of the reporting obligation and clearing obligation will be determined in the new technical standards to be developed by ESMA by 30 September 2012.
Meanwhile, political agreement on MiFID II is not expected until at least the end of 2012 and it will not take effect until the end of 2015.
|Given the tight time frame (in particular in the EU with ESMA’s advice being presented only 3 months before the end of 2012), affected firms need to prepare, if they have not already done so, for the new regulatory regime that will shape the OTC derivative markets for the years to come.|
If you have any questions regarding this update, please contact the following Sidley lawyers or your usual Sidley contact:
Matthew Dening, Partner
Ruth Frederick, Associate
Michele Navazio, Partner
Robert J. Robinson, Partner
Michele Ilene Ruiz, Partner
Michael S. Sackheim, Partner
Elizabeth M. Schubert, Partner
Nathan A. Howell, Associate
1 Please refer to our separate update on EMIR, available at http://www.sidley.com/sidleyupdates/Detail.aspx?news=5165.
2 Please refer to our separate update on MiFID II, available at http://www.sidley.com/sidleyupdates/Detail.aspx?news=5000.
Sidley’s derivatives lawyers in numerous worldwide offices advise clients on a broad range of domestic and international derivatives transactions involving swaps, commodity futures contracts and options. Our clients, located in the U.S. and outside the U.S., include commercial banks, investment banks, insurance companies, hedge funds and mutual funds and their advisers, commodity and options exchanges, clearing organizations and other participants in the OTC and exchange-traded derivatives markets. In serving our derivatives clients, our internationally-based group utilizes the extensive experience of lawyers in Sidley’s other practice areas, including tax, banking, insurance, investment funds, litigation, bankruptcy, employee benefits, securitization and financial regulatory practices. We act for our clients in a wide variety of settings, including initial transaction and product structuring, negotiation and execution; post-trade operation, modification, work-out, dispute resolution, remedies and recovery; practice before regulatory authorities; and general consultation.
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