Paola Lucantoni Financial Market Law and Regulation

a very technical and detailed legislation, aiming at preventing gold plating and based on three main types of instruments, (i) main EU Regulation n° 648 of July 4 th 2012 called EMIR (European Market Infrastructure Regulation), «on over-the-counter derivatives, central counterparties and trade repositories», which entered into force on August 17 th 2012; (ii) three Implementing Regulations n° 1247, 1248, and 1249, published in the OJEC on December 21 st 2012;

(iii) and six Regulatory Technical Standards developed by ESMA (the European Securities and Markets Authority), EBA (European Banking Authority), or jointly by ESMA, EBA and EIOPA (European Insurance and Occupational Pensions Authority), in order to fulfil the obligations imposed by EMIR, which were adopted by the European Commission as delegated implementing regulations – in particular n°. 148/2013, 149/2013, 150/2013, 151/2013, 152/2013, and 153/20

The legislation under consideration covers three main areas, namely (i) the CCPs (Central Counterparties) clearing obligation for specific categories of financial OCT derivatives, traded by non-financial counterparties qualifying based on the amount of derivatives traded, pursuant to Article 10, Reg. n° 648/2012; (ii) bilateral risk mitigation obligation for OTC Derivatives contracts not cleared by a CCP, provided for by Article 11, Reg. N° 648/2012;

(ii) the reporting obligation to Trade Repositories (TRs) of any information concerning OCT derivatives trading, pursuant to Article 10, Reg. n° 648/2012

Otc derivatives held high level of responsibility in the financial crisis Focus on: the law that governed the otc derivatives’ trade and post-trade activities before the crisis the additional requirements that the new legal frameworks involve a comparison of the new north-American and European regulations

history Derivatives have been employed for hundreds of years (4000 bC, in Mesopotamia, future trading on commodities) Since 1970 the volume of derivatives has grown at a staggering rate Derivatives trading boomed and lead to the creation on the CBOE (Chicago Board Options Exchange)

In 2011, the global market for derivatives amounted to a notional amount of $650 trillion, a value which dwarfs the world GDP of $58.26 trillion (Source: World Bank, World Development Indicators, 2009) note that the notional amount does not reflect the actual exposure of the market participants. A same asset passed from one party to another will double the the notional amount without actually increasing the global amount of “bets” on the market

ETD versus OTC Derivatives are separated into two categories: (I) exchange-traded derivatives ETD (II) over-the-counter derivatives OTC. ETDs are the derivatives contracts which are traded using a public exchange, whereas OTC derivatives are contracts traded directly between two parties.

ETD ETDs are standardised, relatively liquid contracts, which are based on the most common underlyings and come with pre-defined variable

ETD: the advantage being centrally settled through a clearinghouse, which concentrates cash-flows by acting as a compulsory counterparty to each part of the contract Through a system of margins that the clearinghouses require from the parties, the risk that they bear is much reduced as a result, the counterparty default risk of ETDs is minimal

OTC are not standardised and offer a high level of customisation trading OTC derivatives offers a wider variety of underlyings under more tailored terms and conditions In terms of volume, OTC derivatives represent an overwhelming majority of the global derivatives trading, accounting for approximately 90 per cent of this colossal market

Role of OTC Derivatives in the crisis Financial derivatives have been under heavy scrutiny since the late 2000’s financial crisis. But the financial crisis did not start due to financial derivatives The spark that set off the crisis was the mortgage crisis, which, in turn, led to the meltdown of many major lending and investment institutions, such as Bear Stearns and Washington Mutual.

CDS: the role in the crisis At the heart of the blame on derivatives are credit default swaps (CDSs), a product that pays out in case of loan default The legitimacy of these assets lies in the fact that debt holders might want to mitigate their risk, and, therefore, buy a CDS related to their holding the access to CDSs allowed a relative spreading of the risk across various actors (e.g. hedge funds) willing to take on risk

domino effect A large amount of the CDS- trading was purely speculative; some investors bet on the failure of market loans The large volume of assets traded and interconnectedness of the various financial companies led to what is called “systemic risk”, or the so-called “domino effect”. Too big to fail: AIG bailout, cost around $182 billion

Analysing derivatives’ role in the crisis One of the main problems in the days of the financial crisis was the dramatic lack of transparency and liquidity in the market. Market participants did not have access to their peers’ risk exposures, and could, therefore, not properly assess the stability of their counterparties This was partly due to the inherent characteristics of OTC derivatives, inter alia, the fact that they do not have to be dealt with through a clearinghouse, and that no centralised public record of the companies’ exposures existed.

Bilateral clearing/lack of global information Most of the CDSs contracts were not cleared through CCPs, but cleared bilaterally, explaining partially why both the regulator and market participants under- estimated the counterparty’s credit risk Due to the absence of information, financial institutions found it difficult to select reliable counterparties and the markets froze.

conclusion In conclusion, financial derivatives were not the cause of the financial crisis, but their existence allowed institutions to over-expose themselves, both in terms of volume and in terms of interconnectedness. High levels of speculation and a lack of transparency led the financial world close to a meltdown. Changes in the infrastructure and legislation will try to prevent this event from happening again in the future.

Costs and benefits Benefits add value to social welfare (lenders can extend more credit without having to increase their prudential capital by acquiring CDSs, and, therefore, using more of their capital for its useful pro-cyclical purpose) Costs the costs arising from the opacity of the market and the asymmetry of information the systemic risk stemming from the use of these products

opaque markets the relation between the dealers and their clients (end-users) is based on unequal grounds due to a common lack of transparency on the pricing of OTC derivatives their misuse, which can lead to sub-optimal levels of risk-taking, such as over-investment and over- leveraging. The structure of derivatives allows for an investor (or speculator) to bear a large position while requiring little capital Result: higher systemic risk in the financial markets,

CCPS ␣ an entity that interposes itself between the counterparties to trades, acting as the buyer to every seller and the seller to every buyer ␣ CCPs reduce their own risk by requiring initial margins and margins calls based on daily variations of the value of the derivatives The role CCPs hold for OTC derivatives is very similar to the role of clearinghouses for ETDs

EMIR (european market infrastructure regulation) Clearing – CCPs (have to be authorised by their national competent authorities) Reporting – Trade repositories (centralised registries which preserve various information about the running OTC derivatives contracts) Risk mitigation – bilateral clearing

Clearing Two approaches to define which contract should be cleared Bottom up approach: CCPs can select contracts they would accept too clear; CCPs have an obligation to inform the ESMA which in turn can decide to apply a clearing obligation on this type of contract across the member States. Top down approach: ESMA and European Systemic Board can determine which currently uncleared derivatives contract should be subject to compulsory clearing.

Clearing non-financial market participants enjoy an exemption from the clearing obligation. Nevertheless, if their exposures reach a threshold, defined by the EMSA, and the companies are a systemic risk to the financial markets, the exemption will not be granted

Financial Counterparties (FC) And Non- Financial Counterparties (NFC). Financial counterparties are listed in Article 2, Paragraph 1, n° 8), Regulation n° 648/2012; in particular, as specified in recital 25 of Regulation n° 648/2012, they include investment firms, credit institutions, insurance and reassurance undertaking, UCITS, institutions for occupational retirement provision, and alternative investment fund managers. In fact, these are entities that are authorised to perform collective and personal asset management.

Defining “non-financial counterparties” referred to in Article 2, Paragraph, 1, n° 9 of Regulation n° 648/2012, is more complex. Under the aforesaid Article, non- financial counterparty means “an undertaking established in the Union other than the entities referred to in points (1) and (8)”, that is, an undertaking other than financial counterparties, CCPs, TRs, and other than trading venue managers

the European legislator established that non-financial counterparties that are subject to the clearing obligation only include those non-financial counterparties selected through a twofold filter, namely (i) their exceeding a clearing threshold calculated based on the notional value of OCT derivatives positions;

(ii) and by excluding from the calculation all risk- hedging financial derivatives (hedging test). As a matter of fact, the European legislator aimed at extending surveillance and transparency also to OCT derivatives trade performed by non-financial counterparties that – due to the quantity and purpose of their positions in OCT derivatives contracts – do not meet risk hedging needs functionally related to their core business.

Bilateral Risk-Mitigation Techniques for Non-CCP- Cleared OTC Derivative Contracts The overall EMIR framework does not provide for a clearing obligation through central counterparties for all OTC derivative contracts. In fact, it regulates specifically OTC derivatives whose features make them more suitable for bilateral clearing.

To mitigate counterparty credit risk, market participants that are not subject to the clearing obligation should have risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral. (Recital 24 Reg. n° 648/2012). In rafting regulatory technical standards specifying the ways for timely and accurate Exchange of collateral for the management of risks related to OTC derivatives not eligible for compensation, ESMA considered the results of counterparty and systemic risk analyses. (Art. 11, Regulation n° 648/2012).

following obligations: 1) timely confirmation of the contract terms; 2) portfolio reconciliation; 3) portfolio compression; 4) dispute settlement

timely confirmation of the contract’s terms. Pursuant to Article 12 of Delegated Regulation n° 149/2013, an OTC derivative contract which is not cleared by a CCP shall be confirmed, where available, via electronic means, or even by fax, paper or manually processed , “as soon as possible”. Confirmation is only required when the parties have reached an agreement on all the terms of the relevant contract.

Portfolio reconciliation is another obligation for financial and non-financial counterparties. Under Article 11, § 2, Regulation n° 648/2012, they shall mark-to-market on a daily basis the value of outstanding OTC derivative contracts. The seeming objectivity of the mechanism is however challenged by the provision itself, as Paragraph 2 also reads: «Where market conditions prevent marking-to-market, reliable and prudent marking-to- model shall be used ».

portfolio compression analyse the possibility to conduct a portfolio compression exercise in order to reduce their counterparty credit risk and engage in such a portfolio compression exercise.

settlement of disputes In order achieve timely resolution, dispute settlement procedures should envisage a special process for disputes that are not resolved «within 5 business days» (Art. 15, § 1, par. b), Delegated Regulation n° 149/2013). The monitoring of disputes is entrusted to financial counterparties, which shall report the competent national authority all disputes relating to any value higher than 15 million Euros and “outstanding for at least 15 business days

Only financial counterparties and qualifying non- financial counterparties are subject to obligations pertaining to (i) mark-to-market, and (ii) the exchange of collateral.

mark-to-market Pursuant to Article 11, § 2 of Regulation n° 648/2012, Financial counterparties and non-financial counterparties referred to in Article 10 shall mark-to- market on a daily basis the value of outstanding contracts. Where market conditions prevent marking- to-market, reliable and prudent marking-to- model shall be used.

exchange of collateral In fact, the collateral exchange system hinges on an exchange between the counterparties of both an initial margin – for the coverage of potential future exposure to a counterparty that could arise from future changes in the mark-to-market value of the contract or in the counterparty’s default risk – and variation margin, allowing assessing over time the changes in the contract risk conditions.