New legislation for over-the-counter derivatives from the European Commission next year will include a central counterparty directive. But what are the implications of the new law? Writer Frances Maguire

The European Commission (EC) has outlined how it will start the process of drafting legislation to regulate over-the-counter (OTC) derivatives next year. The proposals are in line with the objective outlined in the G-20 meeting of September 25, 2009, calling for all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties (CCPs) by the end of 2012 at the latest.

In view of the CCPs' systemic importance, the EC intends to propose legislation governing their activities so as to eliminate any discrepancies among national legislations and ensure safety, soundness and proper governance. The CCP directive, expected mid-2010, is likely to also include legislation on trade repositories, making it mandatory for all OTC transactions to be reported, to enable supervisors to get a complete overview of where the risks are in the system.

Information on trades made on-exchange or cleared through a CCP can be provided to regulators directly by these entities. The EC will propose legislation governing trade repositories as well as new reporting obligations on market participants.

So far, the only piece of legislation in Europe covering the safety and soundness of CCPs is the Settlement Finality Directive (SFD). While essential, as it covers the effects of a default of a CCP participant from spreading to other participants, the EC argues that the SFD is a crisis-management instrument, not a broad instrument covering all aspects of CCPs' activities, so insufficient to ensure their safety and soundness.

As the CCPs provide services for several asset classes, the forthcoming legislative proposal on CCPs will cover the same range of financial instruments as the Markets in Financial Instruments Directive (MiFID), so as to achieve consistency across the value chain and avoid loopholes. MiFID will also be amended to enhance transaction and position reporting, to be developed in conjunction with CCPs and trade repositories.

According to the EC: "Harmonising pre- and post-trade transparency requirements for the publication of trades and associated prices and volumes across the various organised venues needs to be carefully considered, also in the case of OTC markets. It will be key to avoid loopholes in the framework of trading venues, and to ensure derivatives are fully covered. This will be addressed within the review of MiFID in 2010."

Revision approach

Florence Fontan, head of public affairs at BNP Paribas Securities Services, says that the EC has outlined a plan and various actions it intends to take in order to structure the OTC derivatives. "In this context, the intent is the revision of the MiFID and Market Abuse directives, a new version of the capital requirements currently being discussed for the Basel II Directive, and finally, a CCP directive."

For those OTC contracts not considered standardised, or too illiquid for centralised clearing, the Capital Requirements Directive, covering bi-laterally traded OTC derivatives, will be amended by the third quarter to mandate firms supplying initial and variation margins and substantially differentiate capital charges between centrally cleared and bilaterally cleared contracts.

The EC will propose legislation requiring financial firms to post initial margin, specific to counterparty characteristics, and variation margin, to reflect the change in the value of a contract. Non-centrally cleared contracts will be subject to higher capital requirements. This would strengthen the incentive for market participants to put a wider range of products onto central clearing.

"The intention is to move OTC contracts to a CCP and the intention is to have a proposal for a CCP directive to submit to the council for June 2010. This directive is going to be much broader as it is going to tackle all the elements of the OTC products and markets that cannot fit into the Capital Requirements, Market Abuse and MiFID directives. This is going to be a very significant and detailed directive on CCPs and what they are looking at is more of a market infrastructure directive, so tackling central securities depositories (CSDs) and also trade repositories - the equivalent of CSDs, but for OTC contracts," says Ms Fontan.

The third and final phase of the self-regulatory code of conduct is to build interoperability links between the CCPs, and although there have been about 50 outstanding interoperability requests, only one is live and only a handful are close to going live. Legislation had been threatened if this crucial step was not undertaken by the industry and despite the flurry of agreements in recent months, the additional legislation is coming.

Ms Fontan believes the code of conduct has brought everything it can bring to the market. The principle of the CCP directive is to ensure the safety of the system based on sound and safe market infrastructure. "If they want to structure the OTC market to put more through the CCPs, they need to make sure that the CCPs are sound, that this is an improvement on the bilateral trading of today. So the priority is safety and they also want to define the conditions for interoperability because the proposals for interoperability currently being discussed create additional risk," she says.

Clearing links

LCH.Clearnet, which operates a clearing link with the Swiss CCP SIX X-clear for trades executed on the London Stock Exchange, is awaiting regulatory approval for four more interoperability agreements, following concerns from the regulators, in particular, about inter-CCP margin requirements. LCH hopes to offer an alternative CCP for Chi-X Europe, Nasdaq OMX Europe and BATS Europe, which clear through the European Multilateral Clearing Facility, and Turquoise and NYSE Arca Europe, which clear through EuroCCP. However, it is not thought that the CCP directive will replace or override the code of conduct and that interoperability links will still be expected despite the technical difficulties the industry is having in getting them off the ground.

Rory Cunningham, chairman of the European Association of Central Counterparty Clearing Houses and director of strategy and development at LCH.Clearnet, says: "It is not thought that the CCP directive will legislate for interoperability, in that it is not expected to make it mandatory, but the directive is likely to set down risk-management rules that must be in place if CCPs interoperate. The code of conduct has a wider scope as it covers the trading venues and CSDs, and also has provisions on price transparency and accounting separation at all levels - and it is unlikely that the legislation will replace any of these provisions."

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