The law outlines procedures for mandating clearing for some derivatives, and how central counterparty clearing houses will be regulated. But market participants said further clarification would be needed.

Progress will be slow. While four new regulatory bodies will be operational from January 1, the rest of the Commission’s proposals – even if they are rubber-stamped into law – will not come into force until July 2012.

Nuts and bolts

The approach to deciding what will be cleared mirrors that proposed in the EC’s June consultation paper. There will be two methods: bottom-up and top-down.

The bottom-up approach would involve a CCP deciding to clear a contract, and having this approved by a national authority. The authority must then inform the new European Securities Markets Authority (Esma), which will decide whether a clearing obligation should apply to all such contracts in the EU.

In the top-down approach, Esma and the European Systemic Risk Board, its macro-prudential counterpart, would decide which contracts should be subject to mandatory clearing. Unsurprisingly, it was this suggestion which drew most chatter from the market. Clearing houses want the right to choose what they clear, while many trading participants resent the idea of being forced to use central counterparties (CCPs).

Firms cannot avoid a central clearing requirement by deciding not to participate in a CCP. Those that fail to meet a CCP’s participation requirements or do not wish to be clearing members must access CCPs through other clearing members.

In addition, CCPs must not limit their links to execution venues with which they have a relationship or which are part of the same group. A CCP authorised to clear eligible derivatives will have to clear those contracts on a non-discriminatory basis, irrespective of the execution venue.

So far as interoperability goes, the bill effectively obliges clearing houses to open their doors to trades from all sources, but allows exchanges to keep their doors shut – insisting users clear at only one clearing house.

National authorities will remain responsible for authorising and supervising CCPs, but Esma will also play a part in authorising them, and will draft technical standards for them. CCPs in countries outside the EU will have to meet the conditions set by Esma.

Esma will also be responsible for the surveillance of trade repositories and for granting or withdrawing their registration.

One market participant thought Esma would be a far more powerful organ than the present Committee of European Securities Regulators – adding that, with respect to the UK, this could be a problem: “There is this concern in the UK, of Esma trying to manoeuvre things, and the Bank of England having to cede power. The right corridors haven’t been opened to engage on that yet.”

… but plenty to worry about

Clearing houses should keep the right to have a final say on what contracts they clear, contrary to the thrust of draft EU legislation, according to leaders of the European futures market.

The Futures and Options Association and its affiliate, the European Industry Council spoke out against provisions that will allow regulators to force clearing houses to accept some trades. Roger Liddell, CEO of LCH.Clearnet, sits on the EIC.

The FOA and EIC, who believe centrally clearing derivatives could be more expensive than trading them over the counter in some cases, have previously warned that increased costs from clearing should not be allowed to become so large that they outweigh the benefits of using derivatives to hedge risk.

Lobbying efforts on behalf of corporate derivatives users have borne fruit. The bill contains an exemption from the clearing requirement for non-financial users. But industrial firms holding derivatives positions above a certain information threshold would have to have their trades centrally cleared and report transactions to a trade repository. And the FOA has criticised the fact that financial firms, such as fund managers, will not have be exempt when they use derivatives to hedge risks.

Standards will be drawn up by the European Securities Markets Authority, the European Systemic Risk Board and other relevant authorities. The move towards clearing and reporting echoes that in the US, where the Depository Trust and Clearing Corporation launched an equity derivatives trade repository last month.

Anthony Belchambers, the FOA’s chief executive, warned that the final act could look very different from the bill. “In general, the text of the regulation is in line with expectations,” he said, “but it has to be reviewed by the European Parliament, where there is a heady and very differentiated mix of political views and priorities. I hope that pragmatism and proportionality, rather than populism, will be the outcome.”

“We need to educate MEPs on the subject of OTC derivatives,” agreed a market source. “Most of them don’t know anything about it, and even more of them don’t care.”

Other concerns centre on collateral requirements – something one source said would not just affect products newly mandated for clearing. “There will be much more collateral required for CCPs,” he stated, “but also much tougher requirements for any stuff that’s not cleared. The question is: is there enough collateral in the world to support this?”