Some Recent Regulatory Developments in the Derivatives Space

In this article, I will provide a snapshot of some derivatives related regulatory developments, which may be of interest to the reading audience of Rocket. It is to some extent
February 15, 2017 - Editor

In this article, I will provide a snapshot of some derivatives related regulatory developments, which may be of interest to the reading audience of Rocket. It is to some extent a random selection of topics, all of which have however been, or are currently, the centre of attention of the relevant regulators and the derivatives industry, either as a result of the introduction of new regulations or through the publication of consultation papers. Given that this article seeks to focus on some main regulatory highlights, the level of detail provided will necessarily be limited. However, a further in-depth analysis of any of the topics discussed below may follow in a future article.

In this article, I will provide a snapshot of some derivatives related regulatory developments, which may be of interest to the reading audience. It is to some extent a random selection of topics, all of which have however been, or are currently, the centre of attention of the relevant regulators and the derivatives industry, either as a result of the introduction of new regulations or through the publication of consultation papers. Given that this article seeks to focus on some main regulatory highlights, the level of detail provided will necessarily be limited. However, a further in-depth analysis of any of the topics discussed below may follow in a future article.

Some Recent Regulatory Developments in the Derivatives Space

I will first provide a hopefully helpful summary of discussions on the development of recovery and resolution frameworks for central counterparties (CCPs). Since the introduction of mandatory central clearing of over-the-counter derivatives, CCPs have become the new systemically important market participants. They concentrate risk and, if not properly managed, could become major sources of financial instability. The publication in August 2016 by the Committee on Payment and Market Infrastructures and the Board of the International Organisation of Securities Commissions (CPMI-IOSCO) of a consultative report called “Resilience and Recovery of Central Counterparties (CCPs): Further guidance on the PFMI”, as well as a discussion note by the Financial Stability Board (FSB), equally in August 2016, titled “Essential Aspects of CCP Resolution Planning” have reignited a discussion which has gone back to 2001. The reports are the fruits of a joint work-plan established by CPMI-IOSCO and the FSB in April 2015 to coordinate their actions with a view to enhancing resilience, recovery and resolvability of CCPs.

On 13 July 2016, ESMA launched a consultation on proposals to delay the application of the clearing obligation for FCs and AIFs with a limited volume of derivatives activity, which is somewhat linked to the continuing discussions on a workable indirect clearing offering in the OTC space. I will discuss the background of the consultation and ISDA’s feedback on behalf of the market.

Finally, a very brief update on the status of the EU Margin Rules now that the date of their entry into force is very close upon us.


Part 1: CCP Recovery & Continuity

With mandatory clearing of certain classes of OTC derivatives now well and truly upon us, CCPs have become increasingly important for the overall safety and soundness of the financial industry, given the central role they play and the potential effects their risk management can have on the economic cycle. This realisation is properly reflected in two recent discussion/consultation papers by CPMI-IOSCO and FSB that specifically focus on aspects of CCP resolution planning and that are in a way the culmination of a coordinated work-plan to enhance resilience, recovery and resolvability of CCPs.


A little bit of history

The discussion on safe and efficient CCPs goes a long way back and was originally conducted in a wider context of financial market infrastructures (FMIs), in addition to CCPs also covering central securities depositories, securities settlement systems and trade repositories. In January 2001, the Committee on Payment and Settlement Systems (CPSS) published “Core Principles for Systemically Important Payment Systems (CPSIPS)”, which provided 10 principles for the safe and efficient design and operation of systemically important payment systems. This was followed by the publication by CPSS and IOSCO in November 2001 of “Recommendations for securities settlement systems (RSSS)” which identified 19 recommendations for promoting the safety and efficiency of securities settlement systems that captured the full set of institutional arrangements for confirmation, clearance, and settlement of securities trades and safekeeping of securities.

In November 2004, the CPSS and the Technical Committee of IOSCO published the “Recommendations for central counterparties (RCCP)”, 15 recommendations addressing the major types of risks faced by CCPs, with a methodology for assessing a CCP’s observance of each recommendation. This was then followed in January 2009 by the CPSS and the Technical Committee of IOSCO establishing a working group, which produced guidance on the application of these recommendations to CCPs that clear OTC derivatives and published a consultative report , titled “Guidance on the application of 2004 CPSS-IOSCO recommendations for central counterparties to OTC derivatives CCPs”.

The CPSS and the Technical Committee of IOSCO launched a comprehensive review of all three above mentioned sets of standards for FMIs (the CPSIPS, the RSSS and the RCCP) with a view to harmonising and strengthening the three sets of standards. This resulted in the April 2012 report of the CPSS and the Technical Committee of IOSCO with a unified set of principles for FMIs (PFMI), which are defined as multilateral systems among participating institutions, including the operator of the system, used for the purposes of clearing, settling, or recording payments, securities, derivatives, or other financial transactions.  Such FMIs would include all systemically important payment systems such as CSDs, SSSs, CCPs and TRs.

Developments continued in October 2014 when CPMI-IOSCO published its report “Recovery of Financial Market Infrastructures” to provide guidance for FMIs and authorities on the development of recovery plans. The report was meant to provide supplemental guidance on, and a menu of tools for, the observance of the PFMI as the disorderly failure of such FMIs could lead to severe systemic disruptions.  The report considered recovery tools that fall into five categories: (1) tools to allocate uncovered losses caused by participant default; (2) tools to address uncovered liquidity shortfalls; (3) tools to replenish financial resources; (4) tools for a central counterparty (CCP) to re-establish a matched book; and (5) tools to allocate losses not related to participant default. The CPMI-IOSCO report was consistent with a paper that the FSB published, equally in October 2014, on the Key Attributes of Effective Resolution Regimes for Financial Institutions. That paper set out the core elements that the FSB considers necessary for an effective resolution regime and that should allow authorities to resolve financial institutions in an orderly manner without taxpayer exposure to loss from solvency support, while protecting vital economic functions through mechanisms which make it possible for shareholders and unsecured creditors to absorb losses in a manner that respects the hierarchy of claims in liquidation.

In April 2015, the FSB and CPMI-IOSCO agreed on a joint work-plan to coordinate their actions to enhance resilience, recovery and resolvability of CCPs. Under this work-plan, the FSB agreed to “consider the need for, and develop as appropriate, standards or guidance for CCP resolution planning, resolution strategies and resolution tools, including cross-border coordination and recognition of resolution actions, which should build on the Key Attributes. Such standards or guidance should aim to ensure that any CCP can be successfully resolved without resorting to a government ‘bailout’, and without resulting in contagion to other parts of the financial system”.

An earlier paper by ISDA from August 2013...

ISDA’s involvement

ISDA has also been involved in the discussions on this topic and in January 2015 published the “CCP Default Management, Recovery and Continuity: A Proposed Recovery Framework”, in which ISDA proposes a recovery framework, as well as tools to re-establish a matched book, for cases when the default of one, or more clearing members threatens the viability of a CCP. The proposed recovery framework is consistent with the recommendations contained in the October 2014 CPMI-IOSCO report. The paper only focuses on losses caused by a CCP participant default and does not expand upon other types of losses envisioned in the CPMI-IOSCO report such as those related to liquidity shortfalls. In the report ISDA expresses as its view that recovery and continuity of a systemically significant or critical CCP clearing service is likely to be less disruptive and less costly to the financial market, as well as to the broad range of market participants that utilize cleared OTC derivatives to manage and hedge risk exposure. As such, the recovery of a clearing service is generally preferable to its closure, particularly in times of severe market distress where the need for market participants to manage and hedge exposure is likely to increase. It is therefore critical that measures to prepare for a default of one or more clearing members are employed and that the CCP’s default management strategy incorporates recovery measures that are both comprehensive and effective.

A comprehensive recovery framework should in ISDA’s view comprise the following elements:

  1. Recovery measures (portfolio auction of a defaulted clearing member’s portfolio; limited cash calls to solvent clearing members to increase default resources; loss-allocation mechanisms in the form of a pro-rata reduction in unpaid payment obligations of the CCP; partial contract tear-up to assist the CCP in re-establishing a matched book).
  2. Recovery measures should be clearly defined in the clearing service’s rule book with a view to providing adequate transparency and predictability.
  3. Appropriateness of utilising recovery measures beyond pre-funded resources. If those resources have been exhausted further measures to increase them through cash calls or measures involving loss allocation to clearing participants should only be considered if the default management process is determined to be effective and based on consultation with an impartial authority.
  4. Segregated, limited recourse, clearing services if the CCP offers several clearing services to prevent contagion across clearing services.
  5. If a default management process is unsuccessful in re-establishing a matched book and the continuation of the service is likely to exacerbate systemic risk, then the CCP is faced with having to consider closure of the clearing service, i.e. full contract tear-up. At this point the resolution authority will be evaluating which course of action is most effective.
  6. A CCP should be obligated to fully compensate clearing participants if recovery measures involve loss allocation or partial contract tear-up. This ensures that the application of these tools is consistent with the principle of “No Creditor Worse Off” (NCWO).

The above ISDA Paper followed an earlier paper by ISDA from August 2013 (“CCP Loss Allocation at the End of the Waterfall”) in which it highlighted the difference for the purposes of robust recovery and continuity mechanisms between Default Losses and so-called Non Default Losses where the CCP is potentially insolvent but its clearing participants may all remain solvent and other recovery/resolution measures should be undertaken. These losses should accrue first through the CCP ownership and control structure, i.e. should be borne first by the holders of the CCP’s equity and debt.

Building on from here, the FSB published in August 2016 the progress report (“Essential Aspects of CCP Resolution Planning”) on which it requested market feedback by 17 October 2016, with a view to providing more granular guidance by early 2017. At the same time CPMI-IOSCO published a consultative report (“Resilience and recovery of central counterparties (CCPs): Further guidance on the PFMI”). The FSB progress report is seeking comments on aspects of CCP resolution that are considered core to the design of effective resolution strategies, covering such topics as: objectives of CCP resolution; resolution strategies; timing of entry into resolution; adequacy of financial resources in resolution; tools to return to a matched book; allocation of losses in resolution; non-default losses; application of the “No Creditor Worse Off” (NCWO) safeguard; equity exchange in resolution; cross-border cooperation; and cross-border effectiveness of resolution actions.

The CPMI-IOSCO report is seeking comments on guidance for use by CCPs on certain principles and key considerations in the PFMI (see above) relating to financial risk management for CCPs. This guidance that is being consulted upon is not intended to create additional standards for CCPs beyond those already set out in the PFMI, but is rather intended to create additional granularity on how the CPMI-IOSCO intend the PFMI to be implemented by CCPs. Most of the guidance in the report relates to governance, credit, margin and liquidity. A number of market associations1 submitted their response to the CPMI-IOSCO report on 18 October 2016, followed on 21 October by a response to the FSB consultation. At the time of submission of this article for publication the market response had not yet been properly digested but may be the topic of a future publication.

The most recent development in this area is a draft regulation, which the EU is working on and that is expected to be published in November 2016, aimed at managing the financial collapse of clearing houses in a way that does not jeopardise the smooth working of markets. The draft EU law allegedly sets out how regulators should deal with a failing or a collapsed clearing house in a way that shields tax payers without disrupting markets. As the systemic importance of a CCP failure cannot be determined with full certainty in advance, the proposed framework should in principle apply to all CCPs, irrespective of their size and complexity, according to the draft regulation, with costs and losses from a failing clearing house to be imposed as far as possible on the CCP’s owners and creditors and not the tax payer. With these new EU regulations in the making the discussion on CCP recovery and resolution is set to be heating up over the immediate future and will undoubtedly get a lot more attention in this magazine.

ESMA consultation on proposal to amend the phase-in period of the clearing obligation for financial counterparties with a limited volume of activity.

On 13 July 2016, ESMA launched a consultation on proposals to delay the application of the clearing obligation for FCs and AIFs with a limited volume of derivatives activity. One of the reasons mentioned in the consultation for the proposed delay is the difficulty, which especially smaller market participants experience in obtaining access to CCP clearing, where becoming a clearing member or getting access to a CCP through client clearing or establishing an indirect clearing relationship is not always a feasible option. The proposal, which applies to all derivatives classes that have been made subject to the clearing obligation to date, seeks to extend the phase-in period for the Category 3 counterparties with an additional two years. Under the existing regulations the clearing obligation for these Category 3 counterparties would start on 21 June 2017 for the OTC interest rate swaps denominated in the G4 currencies, on 9 February 2018 for European Index CDS and on 9 February 2018 for the EEA currency interest rate swaps.

ISDA has supported the proposal in its response to the consultation of 5 September and indicated that by adding two years to the compliance deadlines of the small and less systemically important financial counterparties in all three existing clearing obligation RTS, the overall objective of the clearing obligation to reduce systemic risk would not be compromised. However, ISDA has highlighted in its response that the need for this extension is to some extent caused by the fact that in some cases banks need to hold extra capital against the collateral received from counterparties which can ultimately make the cost of transacting in derivatives more expensive. It would therefore be crucial and beneficial for the access to clearing that the European transposition of the BCBS Leverage Ratio includes amendments that will help facilitate the ability of clearing members to offer client clearing services and that the design of the Leverage Ratio will appropriately recognise the risk reducing effect of posted collateral, the more so as indirect clearing offerings for OTC derivatives is still shrouded in complex operational and legal arrangements, especially in a cross-border context, and will require further regulatory guidance. Equally, national competent authorities and ESMA may have to explore other ways to address clearing access with the European Commission in the context of the upcoming EMIR Review. The arguments for a delayed implementation of the clearing obligation for Category 3 counterparties do, in ISDA’s view, equally apply to Category 4 counterparties and should therefore justify an extension of the compliance deadline for that category as well.

The arguments for a delayed implementation...

Part 2: Margin on Uncleared OTC derivatives in Europe

(Draft Regulatory Technical Standards on risk mitigation techniques for OTC derivatives not cleared by a central counterparty under Article 11(15) of Regulation (EU) No 648/2012)

With the European legislative process with respect to the draft EU Margin Rules now getting very close to completion, there follows below an overview of how we got to where we are and what the next weeks/months will have in store:

  • On 8 March 2016, the European Banking Authority (EBA), the European Insurance and Occupational Pensions Authority (EIOPA) and the European Securities and Markets Authority (ESMA), jointly referred to as the European Supervisory Authorities (ESAs), submitted for endorsement to the European Commission the final draft regulatory technical standards (RTS) under Article 11(15) of Regulation (EU) No 648/2012. This followed a discussion paper and two consultation papers on 6 March 2012, 14 April 2014 and 10 June 2015, respectively;
  • On 28 July 2016, the European Commission sent a letter to the ESAs informing them of its intention to endorse with amendments this draft RTS and submitted to the ESAs a modified version of the RTS. On the same date, the European Commission also informed the ESAs of certain further amendments regarding the dates of application of the RTS;
  • Those notifications from the European Commission opened a period of six weeks during which the ESAs could amend their draft RTS on the basis of the European Commission’s proposed amendments and resubmit it to the European Commission in the form of a formal opinion, which is what the ESAs did on 8 September 2016. The ESAs rejected the amendments proposed by the European Commission and provided the reasoning behind such a decision with some other changes being of a non-substantive nature;
  • This was followed on 4 October 2016 by the European Commission adopting  the draft regulatory standards submitted by the ESAs with amendments and notifying the European Parliament and the European Council, which initiated the scrutiny period for both to raise objections against the draft RTS;
  • Potentially in response to the European Commission’s Vice President’s request by letter of 4 October 2016 for support for an early confirmation of the draft RTS by the European Parliament to ensure the EU would follow as much as possible the international timeline for the margin rules, there has been an acceleration in the legislative process with an expectation (at the time of submission of this contribution for publication) of an endorsement of the RTS by the European Parliament during the 24-27 October 2016 session and the European Council of Ministers on 8 or 11 November 2016;
  • The above timeline could result in a publication of the RTS in the Official Journal of the EU around 18 November 2016, with an entry into force by 8 December and a first effective date under Article 36(1) of the RTS of 8 January 2017 for the Phase-1 Dealers. ISDA is currently involved in an advocacy exercise with the EU institutions to ensure that the scrutiny period for the RTS does not end before the end of the week beginning 21 November 2016 with a view to having the effective date for Initial Margin and Variation Margin for the Phase-1 Dealers not fall before mid-January 2017. This is because of financial institutions’ end-of-year ‘code freeze’, which would stand in the way of any system changes in the period immediately prior to, and post completion of the processing of, their financial year end. The latter would not have any impact on the effective date of the draft RTS for the remainder of the market (the non-Phase-1 Dealers) for which 1 March 2017 would still be the first effective date for Variation Margin. Note, this article was written prior to the revised dates being finalised.



1          FIA, ISDA, gfma, afme, asifma, sifma, IIF and The Clearing House.

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