EC finalises OTC rules, leaves key technical items to Esma

The European Commission today formally published and adopted long-awaited legislation on clearing and reporting obligations for over-the-counter derivatives – bringing further relief to corporate hedgers – but market observers say the most contentious issues remain unresolved.

"It's even more high-level than we expected and by draft legislative standards, it isn't terribly comprehensive. The EC has clearly listened to the feedback that has been given by the industry, but there's an awful lot in there that's still not answered," says one industry lobbyist.

The 62-page text sets out rules on key issues such as how the eligibility of different contract types for clearing should be determined, how non-financial entities should be treated under the new framework, and how central counterparties (CCPs) should be operated and regulated. But it will be left to the European Securities and Markets Authority (Esma) – a new pan-European regulatory authority due to become operational at the start of 2011 – to determine much of the detail of those rules.

For example, on the crucial question of which OTC derivatives should be mandated for clearing, the EC says any authority that authorises a CCP to clear a certain contract type should immediately notify Esma of that decision, and Esma must then decide, within six months, whether the clearing mandate should be extended.

In addition, Esma will have the power – in consultation with another new body, the European Systemic Risk Board – to identify classes of derivatives that should be cleared but for which no CCP has yet received authorisation. Giving that kind of power to two nascent authorities has left some market participants uncomfortable.

It's even more high-level than we expected and by draft legislative standards, it isn't terribly comprehensive. The EC has clearly listened to the feedback that has been given by the industry, but there's an awful lot in there that's still not answered.

"It's not absolutely clear how this would work. If Esma enforces clearing for a product that no CCP has said it wants to clear, we'd certainly have concerns if the CCP had reservations about the safety of clearing that product. The EC understandably doesn't want to leave clearing entirely to industry discretion, but this is an area of uncertainty," says one industry association official.

Another crucial issue is the treatment of non-financial entities that use derivatives to hedge their commercial risks – corporates, in other words, which have lobbied feverishly to be exempted from any clearing requirements because of the collateral costs associated with using a CCP.

In the industry consultation that preceded today's legislation, the EC proposed two thresholds, including a quantitative clearing threshold which, if exceeded by a corporate end-user, would necessitate the clearing of all derivatives traded by that corporate. The clearing threshold remains in place in the legislation but, under pressure from corporate lobbying, the text concedes that "contracts entered into by a non-financial counterparty that are objectively measurable as directly linked to the commercial activity of that counterparty shall not be taken into account".

Even though lobbyists would prefer to have seen the elimination of the clearing threshold altogether, that extra language has been seen as a victory for corporates as they will need only to prove they are hedging commercial activity to avoid CCPs altogether.

"We do view this as a favourable outcome, because there seems to be much more overt recognition of hedges that are used for managing commercial risk. We argued against the introduction of a clearing threshold, as we felt it would be difficult to make work. They have kept it, but it's clear they don't intend it to catch conventional corporate risk mitigation," says Richard Raeburn, chairman of the European Association of Corporate Treasurers in London.

With the EC's endorsement, the legislative text now passes to the European Parliament and European Union member states for consideration, with the aim of full adoption by the end of 2012. Although it has already taken the EC more than a year to finalise the initial text, lobbyists expect more work ahead as the draft is debated and adjusted by parliamentarians.

"We wouldn't yet say we've won the battle, because there is still a lot of detail to be resolved, especially at the level of Esma. We need to make sure the detail that now needs to be fleshed out continues to promote sensible outcomes. In particular, it's important that Esma consults broadly and not just with the financial sector," says Raeburn.

Michel Barnier, the EC's commissioner for internal market and services, was triumphant about the adoption of the legislation today, insisting the absence of proper regulation of OTC derivatives had contributed to the financial crisis and no financial market can afford to remain "a Wild West territory".

"You cannot understate or overstate the importance of derivatives. We know they take place in a very non-transparent way and we want the light to shine on people who are not used to that. That is what we will do – not just light but also transparency – and as far as these derivatives are concerned, a great effort must be made for standardisation, clearing and registration," said Barnier at a press conference in Brussels.

This article first appeared on Risk.net