Esma Backtracks As It Issues Final European Derivatives Rules

Terry Flanagan

More clarity has emerged for derivatives users in Europe after the European Securities and Markets Authority (Esma), the pan-European regulator, published its final rules for trading and clearing.

The new guidelines, which were published late last week, furnish greater detail on how firms will be affected by the European Market Infrastructure Regulation (Emir), which the European Union is rushing through to meet G20 commitments on reducing systemic risk and adding transparency to the vast but opaque global derivatives industry.

Esma has listened to industry calls to tone down its earlier proposals in its June consultation document by reducing the reporting requirements for collateral and lowering the amount of “skin in the game” by half that clearing houses will need to put up in the case of a member defaulting. However, strict definitions on which derivatives contracts will be forced through clearing have not been forthcoming, which leaves the picture somewhat clouded.

“The publication of Esma’s standards on Emir sees the EU taking its final steps towards meeting the G20 commitment on bringing OTC derivatives trading under supervision, and provides clarity to the market on the shape of the new regime,” said Steven Maijoor, chair of Esma.
“The new regulatory framework reduces the risks arising from OTC derivatives trading by improving transparency in the sector and ensuring resilient central counterparties.

“The implementation of this regime enables the EU to play its role in strengthening the global financial system through promoting stable and well-functioning financial markets, ensuring a level playing field for market participants and enhancing investor protection.”

Many market participants have been critical of how little time Esma has had to produce its final technical standards on a complex subject matter such as derivatives.

“The impact of the OTC reforms is expected, however, to be gradual, because central clearing and margin requirements will apply only to new trades, not existing positions,” said the Bank of England in a recent report on the OTC derivatives reforms and the collateral demand impact.

“It is hard to predict with accuracy what impact the regulatory change will have on the trading volumes and positions in the derivatives market. Market participants may respond, for example, by trading less, or inventing new, non-standardized but economically equivalent products to circumvent central clearing requirements.

“Growing demand for margin collateral, against a backdrop of a shrinking range of assets that are perceived as safe, creates incentives to manage collateral assets more actively.”

LCH.Clearnet, the Anglo-French clearer that the London Stock Exchange is in the process of acquiring, has also said, in a statement released last week, that it estimates that it would have to increase “its regulatory capital by approximately €300-€375 million which it intends to have in place during the first half of 2013 in order to comply with the new regulations in advance of applicable regulatory deadlines”.

The previously unregulated OTC derivatives sector, which accounts for roughly 95% of all derivatives trades, has been blamed, in some quarters, for the 2008 collapse of U.S. investment bank Lehman Brothers, a heavy user of derivatives trades, and also the subsequent global financial crisis. The U.S. and Europe are home to the main derivatives markets.

The G20’s target date for the reforms is the end of this year, but it is believed that this deadline will now be missed by at least a few months in Europe as some time will be needed to begin enforcing some elements of Esma’s technical standards such as reporting requirements and deciding which types of derivatives contracts must be centrally cleared. This, though, is small consolation for the many financial services firms who have been left with little time comply with the minutiae of the new regime.

Emir aims to drive all standardized OTC derivatives trades through central clearing with the view to reducing counterparty risk, as well as the reporting of all derivatives contracts to trade repositories, which will offer market participants a clearer view of the derivatives markets. Dodd-Frank, the similar U.S. version, is slightly ahead in the progress it is making regarding the reforms.

Derivatives users are also concerned that application of the rules will be somewhat different on either side of the Atlantic.

“In the U.S., the clearing obligation falls on everyone who trades an eligible contract, with a narrow exemption when non-financial entities enter into certain hedging transactions,” Clifford Chance, the international law firm, wrote in a report last month. “In the EU, the clearing obligation only applies to deals between financial counterparties and non-financial counterparties whose positions exceed a specific limit.”

Esma’s final technical standards have been sent to the European Commission for adoption, from which point they will then be directly applicable throughout the whole of the EU.

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