The ESMA OTC Derivatives End User Exclusion

ESMA has released a Consultation Paper on the draft technical standards for trade repositories, OTC clearing and CCPs.

Discussion of non-financial counterparty exclusions begins on page 14.

OTC contracts that protect non-financial counterparties against risks "directly related to their commercial activities and treasury financing activities" are entirely excluded from a CCP clearing obligation.  OTC derivatives that do not protect against "directly related" risks but do not exceed clearing thresholds are also exempt from the clearing obligation.

To be "directly related" and therefore excluded from theshold computation, OTC derivatives contracts of a non-financial counterparty must be "objectively measurable as reducing risks directly related to its commercial activity or treasury financing activity or that of its group." There are two alternative tests for exclusion.  The first test is whether the OTC derivatives contract of the non-financial counterparty "individually, or in combination with other derivatives contracts", reduces "the potential change in the value of assets, services, inputs, products, commodities, liabilities that it owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs in the ordinary course of its business, or the potential change in the value of assets, services, inputs, products, commodities or liabilities referred to above, resulting from fluctuation of interest rates, inflation or foreign exchang rates."  The second test is whether the OTC derivatives contract qualifies for accounting treatment of a hedging contract under IFRS principles endorsed by the European Commission.  The rules are clear that whether the contracts consitute hedging under local GAAP rules is the standard, although ESMA expects most local GAAP treatment to meet the proposed definition.

If OTC derivatives contracts are not excluded, they count toward thresholds for clearing.  Clearing thresholds are set by notional amount and by asset class, with 5 asset classes defined: credit, equity, interest rates, foreign exchange, and commodity & others.  Breaching the threhold for any one asset class subjects the non-financial counterparty to a clearing obligation for all derivatives for all asset classes thereafter.  The notional amount thresholds will be phased-in, and periodically reviewed.

Non-financial counterparties will have to confirm OTC derivatives contracts by the end of the second business day following the trade day.

Portfolio reconciliation must be daily if counterparties have more than 500 contracts between them, weekly if between 300 and 500 contracts, and monthly for less than 300 contracts.

Portfolio compression is mandated for all counterparties with more than 500 non-centrally cleared contracts to be done at least twice a year.

Capital treatment will be addressed in a separate set of regulations on Basel III and CVAs.  There is still a significant likelihood that exclusion from clearing will result in a requirement of higher bilateral margin and contract re-pricing to include the CVA.

Much more in there, but this hits the high points.

Hurtling Towards Harmonisation

I spent most of yesterday reading the Financial Stability Board's OTC Derivatives Markets Reforms Third Progress Report on Implementation.  Thrilling stuff if you were desperately awaiting your next installment of regulatory waffle on harmonisation of global regulation and infrastructure for derivatives.

What struck me most powerfully about this report was the weakness of the policy agenda ("improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse" and motherhood and applie pie) and the absoluteness of the policy prescriptions ("[A]ll jurisdictions and markets need to agressively push ahead to achieve full implementation of market changes by end-2012 to meet the G20 commitments in as many reform areas as possible.").  After all, the global financial crisis was not caused by derivatives.  The financial crisis was caused by abusive securitisation of debt (mostly RMBS) which was impelled by preferential capital treatment under the Basel Capital Accords.

Why all?
Why agressively?
Why full implementation?
Why the deadline of end-2012?

I have been troubled by harmonisation of global regulations as an absolute objective for my entire career.  The Basel Capital Accords always struck me as dangerously simplistic in ignoring the national differences in banking systems.  Perhaps I am alone in thinking that different countries that have made different choices about legal principles and economic interest and market structure could reasonably hold different views about regulatory policy, priorities and practices.

A country like Britain whose banks are mostly giant global behemoths of nearly unmanageable size and complexity has a very different risk profile to countries like Russia or Saudi Arabia where most wealth is generated from resource extraction and the priority is protecting investments and ensuring market access.  Derivatives in London are used mostly for speculative trading and market making by intermediaries.  Derivatives in a resource economy will be mostly used for hedging and trade management.  And yet both are being subjected to absolute rules and absolute infrastructure requirements without regard to native interest or the different risk characteristics presented by empircal market practice and experience.

The report recognises that some countries are asserting native interests in requiring local clearing arrangements (e.g. Japan), but does not explore the policy rationale or recognise legitimate methods for protecting native interests.  Instead any variation from the desired consistency with the orthodox interpretation of requirements is treated as threatening the fabric of international markets (unless the US or central banks are doing it).

There is no recognition in the report of the risks of unintended consequences from implementing these reforms, even though much is being aired in the industry as the deadlines near.  Operational complexity will be massively increased for all market participants by parallel implementation of Legal Entity Identifiers and mandatory trading and clearing reforms.  Liquidity risks are growing daily as the shortage of quality collateral tightens amid downgrades and immobilisations.  Clearing houses are competing on lower margin requirements and taking lower quality assets, increasing the risks of a clearing house failure with massive systemic disruption and/or public bailouts.  Markets are suffering from declining liquidity, high volatility and impaired price discovery as end-users and institutional investors decide to sit on the sidelines to see what sort of markets emerge from the reforms.  Lawyers are struggling with renegotiating and redocumenting literally millions of bilateral agreements with varying terms and constraints into the new standardised construct.  And all of this is happening at a time when banks are undercapitalised, more encumbered than ever, stressed and struggling with both markets and regulators.

Why is "one size fits all" regulatory diktat a bad guiding principle for Communism but an excellent guiding principle for global capitalism?  Wouldn't we be more likely to discover what good public policy looks like if we allowed countries to take different views on market regulation and then compared empirical experience?  Both Denmark and Greece apply all Basle Capital Accord and EU directives, but they have very different financial markets with very different risk profiles.  They certainly have had very different experiences.  Shouldn't we ask what Denmark is doing right that Greece is doing wrong and learn from that, even if it is contrary to prevailing orthodoxy?

More generally, is a global financial system that insists on adherence to orthodoxy a strong system or a weak system?  If the policies are conceived and implemented in error - as the Basel Capital Accords may yet prove to be, no matter how many regulatory careers are built on them - then the adherence to orthodoxy weakens the entire construct and exposes everyone to severe systemic risk.

Given the massive cock ups revealed in the past five years, I'd rather have a period where different countries were free to experiment in legislating and regulating their financial systems than a rush to orthodoxy dictated by the same geniuses who caused the massive cock ups in the first place.  But I guess that's why I'm not a regulator anymore.

Initial Margin: Theory and Practice

The news that the CME CCP will be accepting corporate bonds and that LCH-Clearnet will accept RMBS for initial margin has me thinking about the dangers of demutualisation of clearing houses.  Managements of shareholder owned clearing houses are keen to compete for market share and volume to increase revenues, bonuses and profits (not necessarily in that order).  The interests of their members (and of central banks and taxpayers who may be asked for bailouts) may require more prudence than managements might prefer.

No where is the tension more obvious than in the scope of assets accepted for initial margin.  It is worth remembering that clearing houses only take very short term risk.  One day risk is normal for exchange traded derivatives.  A default will be determined, positions liquidated and final settlement of initial and variation margin made on the same day.  Several days to several weeks risk might be more sensible for OTC derivatives which are less liquid and more difficult to price quickly among a small cadre of dealing firms.

The initial margin the clearing house takes from each member is intended to cover the liquidation costs to the clearing house of disposing of the member's open positions at the time of a default.  As markets come under stress when members default, and members default when markets come under stress, it is quite likely that the clearing house will be closing out positions and liquidating initial margin assets into stressed markets.  The assets taken as initial margin should be of a quality that they are cash equivalent - traded in liquid markets where they can be disposed of for cash as and when the clearing house needs it.

For that reason it has been best practice for clearing houses to only take cash and very liquid government securities as initial margin.  Cash and government securities tend to be counter-cyclical assets in stressed markets, gaining value from their superior credit quality, liquidity and price transparency.  Corporate bonds and RMBS may be valuable assets, but we have seen that prices collapse and market liquidity evaporates under stress conditions.  They are pro-cyclical assets, and the very act of CCP liquidation will further stress already stressed markets against the CCP realising the value it might have projected before the default.

I'm sure that the risk committees at the CCPs are aware of all this, and that there are prudential limits and generous haircuts on the use of either corporate bonds or RMBS as initial margin in their rules.  It still makes me nervous that pro-cyclical assets will be eligible as initial margin.  Rules will tend to be relaxed and exceptions become more normative as markets become complacent and competition intensifies.

The IMF is projecting a huge shortfall in quality, liquid assets driven by record balance sheet encumbrance of banks forced to secured lending markets, immobilisation of collateral assets in margin and CCPs, and downgrading of assets which were once thought quality but now are looking worse and worse.  If clearing houses begin to compete on the scope of accepted initial margin, that will increase the risks already concentrated in the CCPs.

Members who must backstop the capital and default guarantee fund of each clearing house should be paying attention.  So should the central banks that will have to backstop liquidity for a CCP.  And so should treasuries - and behind them taxpayers - who may end up having to recapitalise or bailout a troubled CCP.

There was a reason that market infrastructure was run on mutual principles of membership for most of the last three hundred years.  It concentrated minds on risk management for the longer term - over the business cycle rather than the bonus cycle.

Extra-Territorial Implications of Dodd-Frank - Part 1

Excellent podcast on the extra-territoriality of Dodd-Frank as it applies to trading, reporting and clearing of OTC derivatives, provided by Julie Schieffer of DerivSource, with Donna Parisi of Shearman & Sterling and John Williams of Allen & Overy.  Below is a summary of the key points, many of which are relevant to choices that clearing houses and CCPs must make in designing their operations, rules and compliance strategies.

Many of the issues for non-US clearing houses and CCPs are similar to those I addressed back in 1996 when I secured for Clearstream, then Cedel, the first exemption from US clearing agency registration which allowed it to clear and settle US Treasuries in Luxembourg.  At a little over two years, it was the fastest SEC determination on a CA-1 Clearing Agency application or exemption application in SEC history. Gaining an exemption from US clearing agency registration is no trivial undertaking, especially when the principles and conditions for such exemptions remain undefined.

• The task of ensuring compliance with US regulations is daunting as many rules remain undefined, and harmonisation of US requirements with those which may apply in Europe and Asia may be problematic for both compliance and commercial reasons.
• The market infrastructure has not yet been built and the interpretation of laws remain uncertain, yet businesses must make decisions on how and where they will contract their derivatives business.
• Title VII of Dodd-Frank defines CFTC and SEC jurisdiction in Section 722, but provides a safe harbour for business without a “direct” US connection or in evasion of US regulation, but there is little guidance on how these provisions would be interpreted in practice.
• Section 725 gives CFTC authority to exempt a clearing house from registration as a Derivatives Clearing Organisation if it can demonstrate that it is subject to an analogous foreign regime, and 752 encourages international harmonisation, but there has been no exemption and the CFTC has not provided guidance on how it might be applied. 
•  Legal extra-territoriality and operational extra-territoriality need to be addressed separately.  Each clearing house operates under a legal regime.  Both ICE Clear and LCH-Clearnet registrations with the CFTC have elected to register as DCOs with the CFTC going forward, so do not provide precedent for the scope or conditions of any exemption.
• Whether brokers need to register as Futures Commission Merchants is also an issue.  CFTC has required DCOs outside the US to change rules to require that clearing members outside the US that handle US clients must register as FCMs with the CFTC.  If a clearing house is not a DCO the CFTC may grant an exemption from clearing member registration as FCMs, but the issue remains unclear.  Exemption authority is not well defined, and may depend on how terms are defined within the regulations.  Needs to be a solution to allow US customers to deal with a foreign clearing member where that clearing member is mandated by foreign law to be domiciled and registered elsewhere.
• Inconsistent and sometimes contrary regulations will require some lead time as well as guidance to resolve.
•  No matter where you are doing business in the world, if you are doing business with a US customer then your business will be subject to Dodd-Frank requirements.  A non-US affiliate of a US person will probably not be subject to the requirements (e.g., a London affiliate of a US bank or corporate).  Branches may raise a more difficult question as branches are typically not treated as separate entities of a bank, so a non-US branch of a US bank may be treated as a US person.  SEC and CFTC interpretations on US persons remain inconsistent.
•  What level of US investor participation in an off-shore fund will trigger treating the off-shore fund as a US person?  Similarly, it may make a difference if there is a US-based investment advisor managing the off-shore fund.
•  The nature of the underlying contract may also have an impact, if the underlying is a US corporate or a US-exchange-traded contract.  The CFTC may be reluctant to carve these out from US jurisdiction.  “contacts and effects” test in 722 of Dodd-Frank may be inconsistent with the US Supreme Court pre-Dodd-Frank decision in the Morrison case which limited extra-territorial scope.
• In addition to CFTC and SEC, Dodd-Frank recognises prudential regulators for the purpose of determining adequate margin and capital.  Institutions subject to Federal Reserve oversight may benefit from a regulator which is more comfortable recognising home country rules on prudential supervision, but this then raises competitive issues for non-banks subject to more restrictive SEC or CFTC regimes.
• It takes quite a long time to sort out the answers to cross-border regulation, and the gaps are often filled by market practice rather than new rules.  Transactional certainty may remain elusive for a long time, which will chill international activity and makes for poor public policy.  Law firms and swap dealers will have to coordinate to fill in the gaps while the agencies deliberate the final rules.
• In the Lehman insolvency, we found great reluctance to cede local interests in times of extreme stress.  There will be various pools of client margin in different pools in different countries leading to lower efficiency and more risk. 
•  Systems and infrastructure should focus in the medium term on cross-margining and netting to reduce margin inefficiencies and provide greater certainty on close-out positions in resolutions.