Clearing and Execution Intertwine

Terry Flanagan

In Europe, ESMA to determine which products are subject to mandatory clearing and execution.

The linkage between clearing and execution of OTC instruments under new legislation in the United States and Europe has become a hot topic as industry participants contemplate a new world order of derivatives regulations.

The central issue is who should make decisions on whether a given swap product should be deemed as available for trading and for clearing, and the degree to which those decisions are related.

European Market Infrastructure Regulation (EMIR), the text of which has been agreed by the European Parliament and the Council of the European Union, identifies two approaches to determine which contracts are eligible for clearing: a bottom-up approach or a top-down approach.

Under the bottom-up approach, once a competent authority has authorized a CCP to clear a type of contract, it will inform the European Securities and Markets Authority (ESMA), which in turn will decide whether a clearing obligation applies to that class of derivative in the EU.

Under the top-down approach, ESMA, in consultation with the European Systemic Risk Board) will identify types of contract that should be subject to clearing obligations but for which no CCP has yet received authorization.

Under MiFIR (Markets in Financial Instruments Regulation), once a derivative has been deemed eligible for clearing, ESMA will make a determination on whether it should be traded on regulated markets, MTFs, or organized trading facilities.

“As a matter of interest, the EU is anticipating a top-down approach, where the EC could require clearing, and thus execution, even if no CCP or SEF has listed the contract,” George Bollenbacher, financial industry consultant at Kinetix Trading Solutions, told Markets Media.

In the United States, the Commodity Futures Trading Commission has proposed a rule to define when a particular swap has been “made available to trade,” or MAT for short.

One concern is that the MAT determination may influence the determination on whether a swap should be subject to clearing.

In the view of many market participants, execution and clearing should be kept separate. Not all swaps that are required to be cleared will be available to trade solely by the creation of a cleared market. The amount of liquidity necessary for MAT is greater than that necessary to facilitate clearing of the swap.

“MAT determinations and mandatory clearing determinations should be distinct from one another because they will have different effects on the market,” according to a letter from Markit.

Swaps with even a limited amount of liquidity could potentially become subject to mandatory clearing without disrupting the market, but a mandate to trade certain less liquid swaps through a SEF requiring pre-trade transparency could effectively kill liquidity in those instruments, Markit said.

Bloomberg, which intends to register as an SEF, would like to see the execution and clearing decisions unified in the interest of efficiency, but noted that “conflating the two processes into one is not necessarily the only way to achieve greater efficiency.”

Bloomberg said that a SEF making a MAT determination should be able to incorporate by reference information and analysis already done by a derivatives clearing organization (DCO) and the CFTC as part of the mandatory clearing process.

“A SEF seeking to make a MAT determination must consider criteria that necessarily subsume some of the same factors required to be considered in the Commission’s review of swaps for mandatory clearing,” said Bloomberg.

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