EU: ESMA begins detailing central clearing of OTC derivatives

The European Securities and Markets Authority (ESMA) has launched a Discussion Paper as a first step towards preparation for the regulatory technical standards (RTS) to implement provisions of the European Markets Infrastructure Regulation (EMIR) regarding the obligation to centrally clear OTC derivatives.  The consultation will assist in developing ESMA's approach to determining those classes of OTC derivatives that need to be centrally cleared and the phase-in periods for the counterparties concerned.  Responses to the Discussion Paper are sought by 12 September 2013, and feedback received will be used to draft technical standards on the clearing obligation, on which there will be a further public consultation.  

EMIR aims to reduce the risks associated with the OTC derivatives market by improving transparency and establishing common rules for central counterparties (CCPs) and for trade repositories (TRs).  EMIR creates an obligation for most types of OTC derivative contracts to be centrally cleared, or for risk mitigation techniques such as the exchange of collateral to be applied.

EMIR applies to financial and non-financial counterparties, although the clearing obligation only applies to financial counterparties and non-financial counterparties above the clearing threshold.  Currently within the EU, some 13 CCPs provide OTC clearing for five asset classes - interest rate derivatives, credit derivatives, equity derivatives, forex and commodity derivatives.   To date, no CCPs have been authorised under EMIR, although applications are being assessed.

Notional amounts outstanding in OTC derivatives (source: BIS, December 2012)

Defining asset classes for central clearing

This Discussion Paper considers the CCP-cleared OTC derivatives and the CCPs which clear them, with the objective of identifying the key characteristics to be retained when breaking down the OTC derivative contracts within classes,  It outlines ESMA’s approach to determining:

• the characteristics of OTC derivative classes that should be subject to the clearing obligation: the initial classification of five asset classes is the starting point of the analysis of the classes of OTC derivatives to be subject to the clearing obligation, and each class will be further defined with higher granularity within those asset classes:
  • Interest rate derivatives: CCPs currently offer services to clear
    • Fixed-to-float interest rate swaps (IRS), also referred to as plain vanilla IRS
    • Float-to-float swaps, also referred to as basis swaps
    • Forward Rate Agreements (FRA)
    • Overnight Index Swaps (OIS)
    • Options
  •  Credit derivatives:  CCPs currently offer services to clear CDS on:
    • single-name corporate entities
    • sovereign entities
    • untranched indices
  • Equity derivatives: ESMA is considering classification using the following criteria:
    • Vanilla, Dividend, Volatility
    • Basket, index or single name
    • Option, Contract For Difference (CFD), Forward/Swap
    • Settlement currency, grouped by geographical zones
    • Maturity
  • Forex derivatives: ESMA focuses on: 
    • non-deliverable forwards (NDF) on emerging market currencies
    • Cash-Settled Forward (CSF)
  • Commodity derivatives: ESMA envisages a classification by base product (and then sub-product as per the ISDA taxonomy):
    • Metals
    • Energy
    • Index
    • Agriculture
    • Environmental
    • Freight
• the date(s) from which the clearing obligation takes effect, including any phase-in, the types of counterparties to which the clearing obligation should apply, and
• the minimum remaining maturity of the OTC derivative contracts to be subject to the clearing obligation.

The paper also sets out a high level analysis of the current readiness of derivative asset classes regarding the clearing obligation on the basis of some of the criteria that ESMA will take into account when defining the classes for central clearing:

• volume and liquidity
• standardisation
• availability of data
• experience in clearing
• the existence of a clearing obligation in other jurisdiction.

There is also a discussion of specific issues linked to the clearing obligation, including

• contracts concluded with covered bond issuers or with cover pools for covered bonds -  how to differentiate the derivatives of an insolvent issuer from those of the cover pool
• FX OTC derivatives - identifying where the primary risk is settlement risk rather than counterparty risk

as well as of some issues related to the procedure for the determination of the clearing obligation:

• the impact of the clearing obligation on the effectiveness of portfolio compression services
• potential risks from a clearing obligation on contracts which are no longer be appropriate for mandatory clearing 

ESMA’s procedure to define the classes that should be centrally cleared will only be initiated when a CCP is authorised under EMIR, or when ESMA has recognised CCP based outside the EU.