OTC Swaps Regulation: The view from ESMA

Pension funds have expressed some alarm at the cost implications of EMIR. Rodrigo Buenaventura, head of markets division, offers ESMA's perspective

IPE: How does new legislation/regulation (EMIR, MiFID II, CRD IV) meet the G20's requirements set out at the Pittsburg Summit in 2009, and fit into the broader context of market robustness?
Rodrigo Buenaventura: Recent events and market developments surrounding the financial crisis have demonstrated some areas of weakness in the financial system and have highlighted the need for certain areas of market regulation to be revised or strengthened. Whilst a number of different legislative instruments have been introduced by the EU Commission to address these weaknesses, it is worth bearing in mind that they all have slightly different purposes and objectives. Nevertheless, they should be seen as complementing one another in order to collectively meet the G20 commitments of creating a safer, more transparent and robust financial system.

The European Market Infrastructure Regulation (EMIR) focuses on increasing transparency in the over-the-counter (OTC) derivatives market and making it safer by reducing counterparty credit risk and operational risk. Regarding transparency, the new rules require that detailed information on all derivative contracts entered into by EU financial and non-financial firms are reported to trade repositories (TRs) and made accessible to supervisory authorities, and that trade repositories publish aggregate positions by class of derivatives accessible to all market participants. In order to reduce counterparty credit risk, the new rules introduce stringent requirements on prudential, organisational and conduct of business standards for central clearing counterparties (CCPs), mandatory CCP clearing for contracts that have been standardised and risk-mitigation standards for contracts not cleared by a CCP. Regarding reducing operational risk, the proposal requires the use of electronic means for the timely confirmation of the terms of OTC derivatives contracts.

The revisions of the Markets in Financial Instruments Directive (MiFID) are also aimed at increasing transparency - for example, by mandating on-exchange trading of derivatives and by imposing transparency requirements to derivatives. The proposals also create more robust and efficient market structures by taking into account technological innovations. For example, MiFID II will introduce new safeguards for algorithmic and high frequency trading activities. There will also be a stricter framework and stronger supervision of commodity derivative markets, as well as stricter requirements for portfolio management, investment advice and the offer of complex financial products such as structured products.

IPE: A temporary exemption from EMIR was granted to pension funds in February. However, pension representatives argue that the introduction of other directives such as the Capital Requirements Directive (CRD IV), the EU implementation of Basel III, remove the advantage or go against the spirit of the exemption by increasing the cost of bilateral OTC derivative transactions for pension fund counterparties. How do you respond to this argument?
RB: Requiring such entities to clear OTC derivative contracts centrally would lead them to have to divest a significant proportion of their assets for cash in order for them to meet the on-going margin requirements of CCPs. A suitable technical solution for the transfer of non-cash collateral as variation margins should be developed to address this problem and if one has not been found by this deadline, then the exemption may be extended by the EU Commission by two years, and then by a further year until an alternative solution is found.

In relation to the interaction between EMIR and CRD IV, we believe that the two proposals complement one another and are fully consistent from the point of view of their objectives and proposed solutions. Both have the same starting point: the financial crisis exposed the fact that the risks associated with OTC derivatives were not backed by sufficient capital or collateral. EMIR tackles the issue mainly from the point of view of clearing and collateral. In particular, it requires firms that are active in the OTC derivatives market either to clear those derivatives through a CCP or to hold collateral to back the risks associated with the derivatives that are not cleared through a CCP. For pension funds the exemption is temporary and the aim remains clearing. CRD IV tackles the issue from the point of view of capital by stipulating what the appropriate amount of capital should be in case of banks and investment firms to mitigate the risks stemming from OTC derivatives. However, if those institutions hold collateral, then the capital they need to hold could
be proportionately lower.

ESMA, the European Banking Association (EBA) and the European Insurance and Occupational Pensions Association (EIOPA) are working together to develop draft technical standards related to bilateral collateralisation. We have received comments from stakeholders following the publication of our discussion paper and will take into account the work of the Basel Committee/IOSCO international working group developing principles on collateral. We will then issue a consultation where we will set our proposal for technical standards related to bilateral collateralisation. It is extremely important that stakeholders share their analysis and point of view, on our proposed draft technical standards. We particularly invite stakeholders to share relevant data to support their arguments or proposals.

IPE: At the International Capital Markets Association (ICMA) conference in Milan in May, ESMA said that international convergence and co-operation between Europe and the US in terms of new regulations was necessary. How is ESMA looking to implement a level playing field between the US Dodd Frank Act and Europe's EMIR?
RB: It is worth pointing out that the G20 commitments are being implemented in Europe through different legislative routes. The purpose of EMIR is to strengthen proposals in relation to OTC derivatives, CCP requirements and reporting to TRs, but there are also MiFID II and CRD4 to consider. In the US, the G20 commitments are solely being implemented through the Dodd Frank Act.

We are working closely with the US and other third-country supervisors and try as much as possible to prevent loopholes which would lead to regulatory arbitrage. We understand that in order to have a safe and efficient derivatives market, we need to have clear rules that complement each other on a cross-border basis. ESMA is in favour of a mutual recognition process in order to avoid the burden of double requirements being placed on market participants. When a third country has implemented equivalent rules, we should be able to rely on such rules. Indeed, we should avoid both ‘underlap' and overlap.

Dialogue is of paramount importance in this respect and we are continuing to have discussions with third country supervisors.

IPE: What are ESMA's plans for the next 12 months in terms of derivatives market regulation?
RB: Following EMIR's entry into force and the endorsement of the technical standards by the Commission, ESMA will move into the implementation phase. ESMA has been given a number of direct responsibilities, including identifying and publishing in a public register of derivative contracts and classes of derivatives that are eligible for central clearing, recognising third country CCPs and also the registration and supervision of TRs. There are also a number of guidelines that will need to be developed by ESMA to assist market participants in the implementation of EMIR. As part of the on-going review of a number of EMIR provisions, the data that will be collected via trade repositories will be very useful in reviewing the clearing thresholds.

Rodrigo Buenaventura is head of the markets division at ESMA, an independent EU authority that works to foster supervisory convergence in the fields of banking, insurance and occupational pensions


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