In September 2009, G20 Leaders agreed in Pittsburgh that all standardised over the counter ("OTC") derivatives contracts should be cleared through central counterparties ("CCPs") by the end of 2012. Separately, Basel III agreed by the Basel Committee on Banking Supervision ("BCBS") in 2010 (though subsequently revised) describes a package of amendments to the existing international capital adequacy framework, which were published by the BCBS in the aftermath of, and in reaction to, the financial crisis of 2007/8.
At a European level the clearing obligation is being addressed in the European Markets Infrastructure Regulation, commonly known as "EMIR", whereas amendments to the capital adequacy rules required by Basel III (including the regulatory capital treatment of derivatives trade exposures) are being dealt with through a package of measures known as CRD IV.
This FM Alert highlights some key issues associated with the interplay between EMIR and CRD IV on derivative transactions.
The EMIR requirements
Broadly, the mandatory clearing requirements in EMIR will require certain European financial counterparties and non-financial counterparties as well as certain counterparties based outside of the EEA as defined in EMIR ("EMIR Counterparties") to clear certain OTC derivative contracts through an European Economic Area ("EEA") CCP that is authorised by its home state regulator, or a non-EEA CCP that is registered with the European Securities and Markets Authority ("ESMA") for EMIR purposes ("Qualifying CCPs"). In order to satisfy this obligation, EMIR Counterparties will have to become a clearing member of a Qualifying CCP, or become a client of a clearing member of a Qualifying CCP, or enter into 'indirect clearing arrangements' with a client of a clearing member of a Qualifying CCP.
To support the continued solvency of Qualifying CCPs, a clearing member (and by extension its clients) will be required under EMIR to post margin at the Qualifying CCP in respect of the trades that it clears through that CCP and to contribute to the CCP's default fund. The Qualifying CCP will be permitted to draw upon the default fund in the event that any clearing member defaults on its obligations and the losses incurred by the Qualifying CCP exceed the margin provided by the defaulting clearing member. The combination of the requirements to post margin and contribute to the default fund of the Qualifying CCP under EMIR will significantly increase clearing members' and their clients' liability and costs. To understand the precise scope of this obligation clearing members should carefully review the fine print of their CCPs' rulebooks. There is therefore an incentive for EMIR Counterparties to structure some of their derivative business in a way that takes that business outside the scope of the mandatory clearing obligations under EMIR. This will allow such counterparties to clear their derivative contracts through a non-Qualifying CCP or to elect not to clear those derivative trades at all.
Under EMIR, an EEA entity is required to be authorised by its EEA home state regulator if it intends to provide clearing services as a CCP. Non-EEA CCPs are only required to be registered with ESMA if they provide clearing services to "clearing members or trading venues" established in the EEA. These Qualifying CCPs are required to comply with various requirements in EMIR including those relating to margin and default fund contributions (how these requirements will operate in practice will be determined by each CCP in accordance with its rules). Whilst EMIR will capture clearing services offered to non-EEA branches of EEA firms, it will not capture clearing services provided to their non-EEA subsidiaries.
Mitigating the impact of EMIR
European banks and investment firms that wish to remain outside of EMIR will likely have to conduct their derivative business either wholly or partially outside of the EEA. A recent consultation paper published by ESMA on the extra-territorial application of EMIR states that the clearing requirements may still apply to derivative contracts entered into between two non-EEA counterparties if those contracts have a direct, substantial and foreseeable effect in the EEA. EMIR may also apply to derivative contracts entered into between an EEA counterparty and a non-EEA counterparty unless the rules of the jurisdiction where the non-EEA counterparty is established have been declared equivalent by the European Commission. Historically, many European banks and investment firms have established non-EEA branches in order to enter into derivative transactions with non-EEA counterparties and, in some cases, those trades have been cleared through a non-EEA CCP. There is a risk that such derivative transactions would be subject to the requirements in EMIR in the absence of a decision on equivalence.
A potential solution to this problem is for European banks and investment firms to structure their non-EEA derivatives business through their non-EEA subsidiaries rather than through their non-EEA branches. Banks and investment firms would then have the choice over whether to clear those derivative contracts and who to clear through – i.e. via a Qualifying or non-Qualifying CCP (provided that those contracts do not have a direct, substantial and/or foreseeable effect in the EEA and they comply with EMIR's anti-evasion rules).
Certain amendments to the capital adequacy rules on counterparty credit risk under CRD IV clearly attempt to incentivise banks and certain investment firms that are subject to CRD IV ("CRD Firms") to clear their derivative transactions through Qualifying CCPs by introducing a nominal 2% risk weighting for certain derivative transactions (both OTC and exchange-traded) cleared through a Qualifying CCP. Less favourable capital treatment will apply to CRD Firms who enter into transactions that are cleared through non-Qualifying CCPs or are not cleared at all. A lower risk weighting is applied to transactions cleared through a Qualifying CCP to reflect the assumed lower risk of the Qualifying CCP defaulting on its obligations.
The cost tension between EMIR and CRD IV
As certain capital requirements in CRD IV may apply to 'group members' of European banks and investment firms including their non-EEA subsidiaries under the group consolidation provisions it may mean that derivatives and other transactions that non-EEA subsidiaries of EEA banks and investment firms clear through a non-Qualifying CCP (or do not clear at all) will subject the group to higher and more onerous capital requirements.
Banks and investment firms will therefore need to consider whether the benefits of clearing derivative transactions through a Qualifying CCP mitigate the costs of obtaining clearing membership (including posting margin and contributing to the Qualifying CCPs default fund).
What to do now?
The CRD IV requirements are being phased in from 1 January 2014, so it is important for CCPs to apply for authorisation or registration as soon as possible. A potential problem for CCPs based in non-EEA jurisdictions is that registration applications can only be approved if the Commission has issued a positive decision declaring the non-EEA jurisdiction's rules to be equivalent to the relevant provisions under EMIR. The registration process can take up to 180 working days. It is likely that the following jurisdictions will be assessed for the purposes of equivalence during Q4 2013: USA, Japan, Australia, Singapore, India, Hong Kong, and South Korea. The timetable for recognition of other non-EEA jurisdictions' rules by the Commission is unclear at this stage. Therefore it is critical that both clearing members and their CCPs actively engage with the relevant authorities as soon as possible and continue to monitor developments in this sphere.
Whilst EMIR and CRD IV have evolved from separate international regulatory initiatives they appear, taken together, to be pushing in the same direction (i.e. to require or encourage market participants to clear derivative contracts through Qualifying CCPs). EMIR may have had the unintended effect of driving European counterparties away from using non-EEA branches towards a local subsidiary model (where derivatives contracts are either not cleared or are cleared through a non-Qualifying non-EEA CCP), but CRD IV appears to encourage the use of Qualifying CCPs even under a local subsidiary model.
The combined effect of EMIR and CRD IV on European banks and investment firms may actually force some non-EEA CCPs who may not be required to be registered with ESMA under EMIR to 'opt-in' to the EMIR registration requirements in order to remain commercially attractive to their European clients even when those counterparties trade in derivatives through their non-EEA subsidiaries.