Recovery and resolution of central counterparties

The European Market Infrastructure Regulation (EMIR)¹, which requires standardised over-the-counter (OTC) derivatives to be cleared through a central counterparty (CCP), was intended by European legislators as, among other things, a response to the financial crisis. These CCPs need authorisation and are subject to regulatory requirements. Trading in standardised OTC derivatives has become safer, because the risk of contagion is reduced. Yet the central counterparties may themselves expand to such an extent that this could give rise to systemic risks. If such a central counterparty were to default, financial stability could be adversely affected.

In order to counter these risks adequately, the European Commission published a proposal for a regulation for the recovery and resolution of central counterparties in November 2016. The new regulatory framework will primarily implement the international recommendations on the recovery of central counterparties made by the Committee on Payments and Market Infrastructures of the International Organization of Securities Commissions (CPMI-IOSCO) and those on their resolution made by the Financial Stability Board (FSB). The European Commission's proposed regulation is to ensure that the central counterparty's functions that are critical for the financial market are maintained even in the event of recovery or resolution. The negotiations at the European level to finalise the regulation began in February 2017.

The proposed regulation firstly contains rules on recovery and resolution actions that allow open positions to be closed and uncovered losses to be settled, which could otherwise occur if clearing members default (default losses). Secondly, rules are being proposed under which recovery and resolution actions can also be used to settle losses that arise from the central counterparty's operations (non-default losses).

Review of EMIR

In addition, the European Commission published a report on EMIR which assesses comments made by market participants on the implementation of the regulation. At the same time, the Commission held out the prospect of measures intended to simplify the existing requirements, especially for so-called non-financial counterparties (i.e. undertakings other than banks, insurance undertakings or fund companies), making the process more efficient and reducing disproportionately high costs and negative factors.

The report deals with different aspects of EMIR. For example, it raises the question of whether thresholds above which more stringent legal requirements apply to non-financial counterparties are appropriate. Another issue is whether it will be necessary every time for the two parties involved to submit one data record each when reporting such derivative transactions to the trade repository. A number of factors make it difficult, especially for smaller undertakings subject to the clearing obligation, to gain access to a central counterparty in order to meet this obligation. One reason may be, for example, that, due to their small size, these undertakings are forced to involve a clearing member. These clearing members are banks which are subject to the Capital Requirements Regulation (CRR).² The CRR specifies relatively high capital requirements for these types of services, with the result that the provision of these services is not profitable, especially if the customer base includes small customers only. With regard to the supervision of central counterparties, the Commission is considering additional transparency requirements in order to avoid procyclical effects in the provision of collateral to a central counterparty and thus to prevent clearing via central counterparties from adding to the pressure on banks in crisis situations.

The EMIR review had begun in 2015 with a consultation process initiated by the Commission. Once the initial discussions with the member states have been conducted, the first legislative proposals are expected in the first half of 2017.

Collateralisation requirement for contracts not cleared by a central counterparty

The delegated regulation on risk-mitigation techniques for non-standardised OTC derivatives³ entered into force on 4 January 2017.⁴ The underlying regulatory technical standard had been developed jointly by the three European Supervisory Authorities (ESAs).

European regulations

As early as 2012, the EU had specified in EMIR minimum requirements for risk management and transparency in OTC derivatives transactions. For example, Article 11(3) of EMIR requires risk management procedures that prescribe the timely, accurate and appropriate exchange of collateral for OTC derivative contracts not cleared through a central counterparty (CCP).

The delegated regulation provides more details on this requirement and in this process also takes guidance from the principles of the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) in order to ensure a maximum of international harmonisation and consistency. Firstly, it contains requirements for a risk management process that allows the timely, accurate and appropriate exchange of collateral. Secondly, it governs the processes that the counterparties and competent authorities have to take into account when exempting intragroup transactions from the collateralisation requirement and lays down the criteria to be met in this regard.

Types of collateral

The EU has opted for variation margins and initial margins as collateralisation instruments. The variation margin is used to balance continual fluctuations in value of the derivatives contracts on a regular basis. The initial margin, by contrast, is used to cover current and future fluctuations in value expected between the last time margin was collected and the sale of the position. Counterparties can use a standardised approach or an internal model to calculate the initial margin. The delegated regulation contains requirements for these models as well as for the timing of when the collateral has to be provided.

The regulation also defines the assets eligible as collateral and contains rules on how to measure these assets and on the associated haircuts. Moreover, it describes the requirements for segregating initial margins. Another requirement is that the counterparty accepting collateral must not re-pledge or otherwise reuse initial margins it has collected as collateral. Additionally, concentration limits on initial margins collected are to ensure that there is an adequate selection of individual issuers, types of issuers and asset classes.

Scope of application

The requirements apply to financial counterparties, including, among others, banks and insurance undertakings, and non-financial counterparties exceeding the clearing threshold referred to in Article 10 of EMIR. In order to maintain proportionality, the delegated regulation defines certain thresholds at the group level below which certain requirements do not apply. It also includes product exemptions.

What is more, the competent supervisory authority can, under certain circumstances, exempt OTC derivatives from the collateralisation requirement, if both counterparties belong to the same group.⁵

Start of the collateralisation requirement

Market participants with a nominal volume of non-centrally cleared OTC derivatives in excess of €3 billion have been obliged to exchange the initial and variation margin since 4 February 2017. Thanks to the gradual phase-in of the regulations, counterparties with lower volumes had more time to prepare for their application. They have been subject to the variation margin requirement since 1 March 2017. There will be another four steps, starting on 1 September 2017, to phase in the requirement to exchange initial margins.

Outlook

In 2016, a joint BCBS and IOSCO working group (monitoring group) dealt with the issue of what problems could arise during national implementation of the global collateralisation standards. If the group identifies serious inconsistencies in the implementation, it can propose amendments to the global standards in the medium term.

Consistent application must also be ensured at the European level. To this end, the three European Supervisory Authorities are planning to draw up and publish questions and answers relating to the delegated regulation.

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