More than three years after the entry into force of the European Market Infrastructure Regulation (“EMIR”) and the regulatory technical standards of 19 December 2012 with respect to, inter alia, indirect clearing arrangements, indirect clearing is again at the centre of attention. 

More than three years after the entry into force of the European Market Infrastructure Regulation (“EMIR”) and the regulatory technical standards of 19 December 2012 with respect to, inter alia, indirect clearing arrangements, indirect clearing is again at the centre of attention. 

The reason for this is not just the fact that the first clearing obligation of G4 interest rate swaps for Category 1 counterparties will now very soon be upon us, but also because on 5 November 2015 ESMA published a consultation paper on indirect clearing regulations, both in the context of EMIR and MiFIR.  Once clearing of OTC derivatives through central counterparties (“CCPs”) will be a reality, some market participants will only be able to clear their trades and access CCPs through an indirect clearing arrangement. It is for that reason that any indirect clearing set-up in the OTC space needs to have the desired effect but also that any indirect clearing regulation works for exchange traded derivatives and does not negatively impact on an already long standing practice of indirect clearing in that area.

In this article I will discuss the proposed regulation against the background of critical noises which have already been expressed on several occasions in the past prior to this consultation by the market against the existing indirect clearing regulation in the context of EMIR and the draft regulatory technical standards which have been prepared in the context of MiFIR. The deadline for responses on the consultation was 17 December 2015 and I will therefore also provide a brief overview of the main positions expressed by the responding main market associations on behalf of their members.

Indirect clearing of OTC derivatives

The concept of indirect clearing has been part of the level 1 text of EMIR since its inception. According to article 4(3) EMIR a counterparty to an OTC derivatives transaction of a class which has been made subject to mandatory clearing, will have to clear such transaction as clearing member of a CCP or as client of a clearing member. In view of the capital and risk management requirements to which clearing members of a CCP are subject (see the EMIR conduct of business rules in articles 37(1), 37(3) and 37(6) EMIR and the prudential requirements in articles 42, 43(3), 45 and 48 EMIR), part of the market will necessarily have to clear either as client of a clearing member or through an indirect clearing arrangement as client of a client of a clearing member. Such indirect clearing arrangement consists of contractual arrangements between a CCP, a clearing member, the client of a clearing member and the indirect client pursuant to which the client of a clearing member can provide clearing services to the indirect client. According to EMIR such indirect clearing arrangement may not increase the counterparty credit risk of the indirect client and such arrangement needs to secure that the assets and positions of the indirect client are protected in a similar way as set out in articles 39 and 48 EMIR in relation to the client of a clearing member. After initial discussions in the market, shortly after EMIR entered into force, on whether clearing members should be under an obligation to offer indirect clearing arrangements resulted in a general acceptance that this should not be the case, discussions now focus on how this equivalent level of protection can be offered to indirect clients.

Indirect clearing of exchange traded derivatives

In the context of exchange traded derivatives the concept of indirect clearing is already a well- established one and any further regulation on indirect clearing as required by article 30 MiFIR will to some extent have to respect the status quo and not unnecessarily undermine that existing market. Also, it will have to respect and reflect the differences that exist between the markets of OTC derivatives and exchange traded derivatives. Or, as the 5 November 2015 consultation paper states as the purpose of the consultation: ‘to consult on the draft requirements that could address both the problems affecting the development of indirect clearing arrangements for OTC derivatives and the problems raised in relation to indirect clearing arrangements for ETD, as the issues encountered are essentially the same for ETD and OTC derivatives (although some nuances exist between the two)’. This concern on whether a uniform indirect clearing regulation will sufficiently reflect the differences between different derivatives markets (OTC and ETD) has already been extensively highlighted by FIA Europe in the context of discussions on both the Discussion Paper MiFID II/MiFIR of 22 May 2014 (ESMA/2014/548) and the Consultation Paper MiFID II/ MiFIR of 19 December 2014 (ESMA/2014/1570). This was also the reason for ESMA to exclude from the final draft regulatory technical standards for MiFID II/MiFIR which it sent to the European Commission on 28 September 2015, the draft regulatory technical standards for indirect clearing arrangements for exchange traded derivatives as it wanted to make those subject to a consolidated consultation procedure, together with the already existing regulatory technical standards for indirect clearing under EMIR.

Articles 39 and 48 EMIR and indirect clearing.

As indicated above, an indirect clearing arrangement with a clearing member should not increase counterparty credit risk and should ensure that the assets and positions of the counterparty benefit from protection with equivalent effect to that referred to in article 39 (Segregation and portability) and article 48 (Default procedures) of EMIR. Essentially this means that an indirect client which for clearing its trades will be dependent on an indirect clearing arrangement, may not end up in a worse position than a direct client would be and an indirect clearing regulation should reflect that. What does this mean in practice?

Article 39(4) EMIR requires a clearing member to keep separate records and accounts that enable it to distinguish both in accounts held with the CCP and in its own accounts its assets and positions from the assets and positions held for the account of its clients at the CCP level. Transferred to an indirect clearing arrangement this would mean that a client of a clearing member would have to offer similar services to its clients (being the clearing member’s indirect clients). From an accounts perspective this would mean that the direct client would equally have to offer its clients the choice between omnibus client segregation and individual client segregation but also that the CCP would have to create such arrangements in its accounts administration to enable the client to make a segregation at the level of the CCP between its assets and positions and the assets and positions of its clients (i.e. indirect clients). This segregation in the accounts structure at the level of the CCP, the clearing member and, in case of indirect clearing, the client seeks to ensure that in the event of a default at the level of the clearing member, a client will be able to port its assets and positions to a replacement, back-up clearing member within the porting window before any such positions get liquidated in the absence of portability. In an indirect clearing structure this should equally be possible in case of a default at the level of the direct client. If upon liquidation of the positions any balance remains due by the CCP to the direct client, the CCP will return such balance to it if the CCP is familiar with such client’s identity. In an indirect clearing scenario the CCP and/or clearing member will have to refund any such balance to the indirect client, outside of a direct client’s insolvency by way of a ‘leapfrog’ payment. However, such ‘leapfrog’ payments may prove to be very challenging and potentially not bankruptcy-proof if contested by a direct client’s trustee in bankruptcy. The fact that these indirect clearing relationships will typically involve many different jurisdictions and therefore many different insolvency regimes will considerably add to the challenge of being able to make such ‘leapfrog’ payments. At the time the 19 December 2012 regulatory technical standards on, inter alia, indirect clearing arrangements, were put in place ESMA may still have thought that EMIR would prevail over any ‘conflicting laws, regulation and administrative provisions of the Member States’ (see footnote 34 of the ESMA Consultation Paper, Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories, 25 June 2012 | ESMA/2012/379), however the reality is often a different one and any indirect clearing regulation will have to take that reality into account. These concerns and others in relation to indirect clearing, have already been highlighted in the context of the EMIR Review in August 2015 but it should probably be assumed that a response from the regulator on these specific points will now be covered in the context of this consolidated public consultation, rather than in the report from the European Commission on the EMIR Review.

The consultation of 5 November 2015.

With the public consultation ESMA is looking to both (i) amend the existing regulatory technical standards of 19 December 2012 to the extent deemed necessary following the consultation and (ii) adapt the existing draft RTS on indirect clearing arrangements under MiFIR. In doing so the consultation paper closely follows the topics which were already the subject of consultation in the context of EMIR and MiFIR in 2014: (i) the structure and segregation of accounts; (ii) adequate default management procedures (including necessary ‘porting’ and ‘leapfrog’ payments); and (iii) how indirect clearing arrangements should be implemented for chains which go beyond what is usual in the world of OTC derivatives. The latter would be the case in scenarios where an indirect client offers clearing services to another indirect client which itself acts as direct client for further indirect clients, not unusual in the exchange traded derivatives space. Such chains could potentially be unlimited and the requirement to guarantee that they should not increase counterparty risk but, instead, provide equivalent levels of protection which articles 39 and 48 EMIR provide to direct clients is obviously a challenging one.

What would such indirect clearing arrangements mean for all those parties involved in an indirect clearing chain? For CCPs that they will have access to all the information on assets and positions of each indirect client in the chain to make adequate margin calls. For clearing members to establish adequate procedures of default management covering both the possibilities of porting of trades as well as liquidation of positions in the absence of portability. In this context the consultation paper however refers for the first time to an ‘obligations of means’ rather than an ‘obligation of results’. For a direct client this means that it needs to provide the clearing member with all the necessary information for it to properly identify and monitor any risks that come with indirect clearing. These obligations of a direct client equally apply to indirect clients where they clear for underlying indirect clients as if they were a direct client themselves. What becomes very clear though is that the longer the indirect clearing chain is, the more important it will be that there is an adequate flow of information, right through and up the clearing chain, with all involved parties being fully aware of their responsibilities.

Market feedback on the consultation.

Both ISDA and FIA Europe have responded to the consultation and their feedback very much reflects feedback that they have expressed on previous occasions. In the context of exchange traded derivatives FIA Europe has repeated its concern for the impact of any regulation on the existing, well established, market and has promoted a limitation of the proposed regulations to shorter chains given the operational complexities and risks for longer, cross-border chains. ISDA has again highlighted how local insolvency regulations may very well undermine the propagated ‘leapfrog’ payments by a clearing member to an indirect client in a direct client’s insolvency and that it takes more to successfully establish such insolvency ring-fencing than a mere contractual obligation. Equally, the proposed regulation for longer indirect clearing chains would only realistically work if there is a proper information stream throughout the clearing chain by all involved parties in the chain. However, in the absence of clear contractual obligations at each level between the relevant parties involved it is questionable how this would ever work.

What is new in the market feedback is that it is unclear what it means in the context of porting and leapfrog payments that parties have an ‘obligation of means’ instead of an ‘obligation of results’. What does it require for such obligation to be met?

Conclusion.

It is clear that establishing a regulation for indirect clearing that works for the markets it seeks to regulate – the market for exchange traded derivatives and the market for OTC derivatives – is much more challenging than anticipated. It is disappointing to see that where most of the topics which come up when discussing the concept of indirect clearing have already been highlighted by the market on previous occasions, the current draft RTS does not seem to have taken any of those issues at heart. With the clearing obligation now only months away from us the need for the regulator to take these concerns seriously has never been bigger. One central question which should be at the forefront is whether it makes any sense to have one single set of rules for indirect clearing to serve markets which are different to start with.

This article was first published in edition 6 of Rocket, our magazine. Download available Rocket editions here, and save your up to date address in your profile to to indicate your interest in receiving a printed copy of the magazine. Copies are also available to purchase and subscribe to via the shop.

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