Last week, the European Commission (EC) adopted Regulatory Technical Standards (RTS) that provide a clearing mandate for certain interest rate OTC derivatives. The RTS have been subject to significant discussion and come in the wake of Dodd-Frank’s fifth anniversary and nearly three years after the Commodity Futures Trading Commission (CFTC) adopted similar requirements in the United States. This post discusses the mandate and specific areas of concern for buy-side market participants.
Do you have to clear?
The RTS divide market participants into four categories:
Category 1 = Financial Counterparties (FCs) and Non-Financial Counterparties[1] (NFCs) that are clearing members of central counterparties (CCPs) for purposes of the OTC derivatives subject to the clearing mandate.
Category 2 = FCs and Alternative Investment Funds not otherwise considered FCs (AIFs)[2] with a month-end average exposure of non-centrally cleared derivatives above EUR 8 billion for each month following publication of the RTS, excluding the month of publication.
Category 3 = FCs and AIFs with a month-end average exposure below EUR 8 billion.
Category 4 = Counterparties that are “NFC plus”* and do not otherwise meet the requirements of Categories 1, 2 or 3.
Because buy-side participants generally are not clearing members of CCPs, Categories 2 and 3 will be particularly important to the buy-side. It is important to note that the EUR 8 billion threshold includes OTC derivatives beyond those certain interest rate swaps and forwards covered by the clearing mandate. In addition, the average exposure calculation should be performed at the fund level for UCITS and AIFs. Therefore, fund managers of UCITS and AIFs will have to perform the requisite calculations on a fund-by-fund basis to determine whether a fund falls into Category 2 or 3.
*NFCs that engage in certain OTC derivatives contracts above a particular threshold are considered NFC plus and are subject to the clearing mandate. NFCs that engage in an amount below the threshold are “NFC minus” and are not subject to the clearing mandate. Commercial end users and other non-fund buy-side participants will generally qualify as NFC minus if such participant has non-hedge OTC derivatives exposure below the particular threshold.
What do you have to clear?
The four classes of interest rate OTC derivatives include: fixed-to-floating swaps; basis swaps; forward rate agreements; and overnight index swaps. The specifications are nearly identical to those previously adopted by the CFTC in Regulation 50.4, with two differences. First, the forward rate agreement class does not include JPY-based products. Such products were included by the CFTC. Second, the overnight index swap class extends to maturities up to three years. CFTC Regulation 50.4 only covers swaps with maturities of two years are less.
When do you have to start clearing?
The RTS provide for staggered effective dates by category, as more fully described below. It is important to note that in the case of a transaction between two counterparties that fall into different categories, the later date applies to the transaction.
Category 1 = 6 months after “entry into force” of the RTS, which means twenty days following publication of the RTS.
Category 2 = 12 months after entry into force.
Category 3 = 18 months after entry into force.
Category 4 = 3 years after entry into force.
Therefore, the difference between falling above or below the EUR 8 billion threshold discussed above means a particular fund may have an additional 6 months of time before it must begin centrally clearing its interest rate swaps. Since the threshold calculation is to be performed at a fund level, this may introduce operational complexity for fund managers if particular UCITS or AIF funds fall under Category 2, while others do not.
What is frontloading?
Frontloading refers to the provisions under EMIR that require certain trades executed after the first EMIR authorization of a CCP (March 18, 2014) but prior to the effective date of clearing mandate to be subsequently submitted for clearing. This frontloading concept caused much uncertainty and was the topic of extensive discussion from industry groups. Fortunately, the EC addressed much of the industry’s concerns by setting the remaining maturity thresholds for a significant portion of previously-executed trades high enough so that the frontloading obligation will not apply. However, Category 2 buy-side participants may still have a frontloading obligation for trades entered into during the period of five months after entry into force of the RTS but before the 12-month effective date.
What else should you know?
It is important to note that the clearing obligations may affect U.S.-based funds as well, to the extent a fund trades with a EU-based counterparty. Buy-side participants should consider how this will impact their business operations. For example, a U.S.-based mutual fund may execute an interest rate swap with an EU counterparty that is subject to both the CFTC’s and EC’s clearing mandate. In this context, the location of the clearing CCP presents a unique problem.
The CFTC and EC are still at a standstill over the EC’s recognition of U.S.-based CCPs as “equivalent” to those CCPs authorized under EMIR.[3] While the CFTC has not imposed a geographical locus on its clearing mandate (i.e., multiple foreign-based clearinghouses are registered with the CFTC as derivatives clearing organization (DCO) at which the clearing mandate may be satisfied), EMIR requires the OTC derivatives subject to the clearing mandate under the RTS to be cleared at either a CCP that is either authorized or recognized as equivalent under EMIR. In order to be authorized under EMIR, a CCP must be organized in the EU. Therefore, in the absence of “equivalence” for the United States, the CCPs at which a cross-border trade can clear will be limited. The CCP will have to be both authorized under EMIR and registered with the CFTC as a DCO, which at this time is limited to LCH.Clearnet Ltd for interest rate swaps.
A fund that clears its interest rate swaps exclusively in the United States may have certain of its trades cleared at a CCP at which the fund has very few or no other positions. This will reduce the availability of offsetting positions and may result in an overall increased amount of margin posted to CCPs. Buy-side participants should consult with their business personnel and legal counsel to determine the best course of action.
The text of the RTS can be found here.
Annex I to the RTS sets forth the specifications of the classes of OTC derivatives required to be cleared and can be found here.
Good day. Good clearing. DR2.
Footnotes:
[1] Each term defined in Article 2(8) of the European Market Infrastructure Regulation 648/2012 (EMIR).
[2] Defined in Art 4(1)(a) of Directive 2011/61/EU. Certain AIFs do not meet the definition of FC and are considered NFCs. NFC status notwithstanding, the EC determined that such AIFs with sufficient operational capacity regarding OTC derivatives should be included in the same category as AIFs that are FCs.
[3] To date, the EC has adopted equivalence decisions for Australia, Hong Kong, Japan and Singapore. The transitional period for equivalence was recently extended again by the EC and is currently set to expire on December 15, 2015.