It has been a long time in coming but finally the European Commission has outlined its next steps in how it will be regulating the OTC derivative markets. Edmund Lakin takes a look at the latest consultation document

Key players in the derivatives industry have expressed concerns over the lack of clarity on some areas in the European Commission’s over the counter derivatives consultation.

The European Commission, in looking to regulate the OTC derivatives market, is interpreting the G20 call to have all standardised OTC derivatives contracts traded, cleared and reported to trade repositories by end-2012. In addition non-centrally cleared contracts should be subject to higher capital requirements.

The Commission’s consultation document focuses specifically on post trade infrastructure such as defining the eligibility to clear (“standardised” contracts are seen as those that are eligible to clear), requirements for central clearing houses, interoperability arrangements, and reporting to trade repositories.
The explicit focus on post-trade infrastructure may on the face of it seem to ignore part of the G20 statement because it does not seek to deal with pre-trade, but it is widely understood that this area will be dealt with under the upcoming review of the Markets in Financial Instruments Directive scheduled for 2011.

The broad range of market participants are in particular pleased that the Commission is implementing the G20 commitment, but a number of them would have preferred more clarity and more detail from the Commission.

Given the focus recently on the Wall Street Reform and Consumer Protection Act which has finally made its way to the finishing line, and recent changes to infrastructure spending within domestic Asian markets, there are concerns among market participants over regulatory arbitrage and losing business to outside of Europe.

The Commission has now come forward with the view that “standardised” contracts are those that are eligible for clearing by a CCP. In addition they recognise that not all cleared contracts are appropriate to be considered eligible to clear. The Commission is now looking to assess the risks involved with mandatory clearing and is proposing either a bottom up (CCP decision) or a top down (European authorities decision) on what is able to be cleared.
Rory Cunningham, chairman of European Association of CCP Clearing Houses, argues that “eligibility for clearing first and foremost is clearly a decision for a CCP” but “there needs to be a separate debate on mandatory”.

He raises questions as to ESMA’s role within this and how it will operate, notably how it will identify contracts and whether there may be penalties for those that trade contracts that ESMA deems to be risky.

Under US legislation The Act deems that all swaps (as referred to in the US) must be cleared, unless exempted by the relevant authorities – notably if a CCP (derivatives clearing organization - DCO) will not accept the swap for clearing. Furthermore under The Act, the burden lies with the DCO to determine what is clearable, and then submit this request to the authorities.
Exemptions for corporate end users had been a major sticking point with industry, notably the end users, and policymakers within Europe.

The current EU consultation sets out two threshold levels, the first an information threshold and the second a clearing threshold. If the clearing threshold is breached the associated company will be subject to the clearing obligation for all eligible derivatives, with the aim of capturing systemic risk.

European Association of Corporate Treasurers chairman Richard Raeburn understands that the Commission is concerned that corporate end users create systemic risk, but argues that there is “no empirical evidence for the existence of such risk”.

He argues that his members instead represent the real economy and are not the financial institutions involved in the financial crisis. Furthermore end users do not focus all their derivatives on one bank, and indeed do not create huge concentrations.

Questions on the working of the thresholds have also been raised by other market participants. Raeburn is looking to work with the Commission to make the threshold work, but sees greater utility in taking a steer from the end user exemption under “The Act” exempts mandatory clearing, with end users being defined by the nature of their primary business activity.

There is still another concern for end users in the proposed Basel III reforms, where higher capital requirements could be used to push more non-centrally cleared OTC transactions into central clearing. The risk for end users is one of liquidity, and the uncertainties over how much is required.

A large part of the consultation deals with requirements for CCPs in order to achieve robust arrangements. Commenting on the requirements, Rory Cunningham says that “some CCPs see some issues as to whether all requirements are necessary for all asset classes” in particular on segregation and portability he comments that it might be “harder in securities markets, as opposed to pure derivative markets”.

In terms of the initial capital, he understands “the drive for there to be a number there – but there are many smaller CCPs in Europe who would even find €5m too much – they have enough capital in their businesses already and have enough to survive wind downs. This is extra capital they don’t need.”

The short time frame for the consultation suggests something of the immediacy of the Commission’s desire to get a proposal out by September 2010. By limiting the scope to post trade aspects, the Commission will have time to review submissions over the summer, normally a quiet period in Brussels, and be able to present again in September.

The short time frame, and the absence of clarity on a number of areas though does raise issues as to whether there are a lack of answers in the Commission or whether it is simply holding its cards close to its chest.