EU drives ahead with regulating OTC derivatives by year end

5 July 2012

The European Council, the executive nationally-based arm of the EU, has officially adopted the regulation requiring financial firms to clear over-the-counter (OTC) derivatives contracts via a central clearing counterparty (CCP) and report them to trade repositories, by the end of this year.

The desire for CCP clearing and trade repositories was one of the key post-crash recommendations to have emerged after the 2008 banking crisis, but the fact that is now being legislated for means that those firms who haven’t already prepared for the new OTC trading environment must now move quickly. The major players have moved already but the revelation of the official legislative timeframe and requirements will be helpful.

The official EU regulation will apply from the end of 2012 and is aimed at increasing transparency in the OTC derivatives markets and shielding other market participants from the fall-out of a major counterparty collapse. The thankless task of unwinding Lehman Brothers trades after its collapse in 2008 without sufficient data will hopefully be avoided in the future if any such a collapse happens again. The European Parliament passed the regulation at first reading at the end of 3 July.

To be authorised, a CCP will have to hold a minimum amount of financial resources in the form of a mutualised default fund to which members of the CCP have to contribute.

Trade repositories would have to publish aggregate positions by class of derivatives under the eye of the European Securities and Markets Authority (ESMA), which will be responsible for the surveillance of trade repositories and for granting and withdrawing their registration.

ESMA will also be responsible for the identification of contracts subject to the clearing obligation, while national competent authorities will be responsible for authorisation and supervision of CCPs. CCPs from third countries will be subject to checks and balances undertaken by ESMA.

If a contract is not eligible for clearing by a CCP, the regulation requires the application of different risk management techniques, including the exchange of collateral and the holding of additional capital.

The obligation to clear OTC derivatives contracts through a CCP and report them to trade repositories applies to financial firms. Non-financial firms will only be subject to the clearing obligation, provided their OTC derivatives positions reach specified clearing thresholds, to be set by ESMA and the European Commission (EC).

The regulation also provides for multilateral trading platforms or exchanges to have open access to any CCP to clear OTC derivatives transactions, and vice versa, subject to technical and safety requirements.

By Neil Ainger

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