Central clearing of OTC interest rate derivative contracts—all change?

Central clearing of OTC interest rate derivative contracts—all change?

The European Commission recently adopted new rules regarding central clearing of certain over-the-counter (OTC) interest rate derivative contracts. Brett Hillis, partner at Reed Smith, along with Joanna T Williams, counsel, and Jennifer Schwalbenberg, associate at the firm, explain the new requirements.

Original news

Commission sets out new derivatives rules, LNB News 06/08/2015 116

New rules adopted by the European Commission will make it mandatory for certain OTC interest rate derivative contracts to be cleared through central counterparties (CCPs). Commitments made by world leaders at the 2009 G-20 Pittsburgh Summit made central clearing a vital part of the response to the financial crisis, with the aim of improving transparency and mitigating risks.

What is the background to the new Commission rules?

The European Market Infrastructure Regulation (EU) 648/2012 (EMIR) introduces the obligation to clear certain standard types of OTC derivatives through central counterparties that comply with EMIR standards (CCPs). This obligation does not apply when dealing with non-financial counterparties below the clearing threshold (NFC-) or non-EU parties that would be NFC- if established in the EU.

The new rules are the result of the ‘bottom-up’ approach (as described in EMIR, art 5(2)) to determine which classes of OTC derivatives are considered suitable for mandatory clearing. When a national competent authority (NCA) authorises a CCP to clear a class of derivatives under EMIR, it must notify the European Securities and Markets Authority (ESMA). ESMA must assess whether those classes are suitable for mandatory clearing and develop draft regulatory technical standards (RTS) specifying:

  • the class of OTC derivatives that should be subject to the clearing obligation
  • the date from which the obligation takes effect, including phase-in and the categories of counterparties to which the obligation applies, and
  • the minimum remaining maturity of the OTC derivative contracts subject to frontloading

The first EU CCPs were authorised by NCAs in Q1 2014 to clear several classes of interest rate derivatives (and, subsequently, certain classes of credit, equity, commodity and FX derivatives). Since then ESMA has been through a process of assessment and consultation on each such class. On 6 August 2015, the Commission adopted the first RTS on interest rate OTC derivatives. From this date the Council and the European Parliament have a maximum three month objection period to consider the RTS, which they can extend for another three months. Once they both signal their non-objection, the RTS will be published in the Official Journal

What are the main requirements set out in the rules?

This first set of rules applies to interest rate swaps denominated in euro, pounds sterling, Japanese yen or US dollars that have specific features, including the index used as a reference for the derivative, its maturity, and the notional type. The main areas covered are phase-in, frontloading and the treatment of intra-group trades.

The clearing obligation will be phased in based on four categories of counterparty, with the clock starting to run from entry into force of the RTS:

  • category 1 (existing clearing members on an EMIR CCP for the relevant class of trade) six months
  • category 2 (non-category 1 FCs and alternative investment fund (AIF) NFC+s with a group aggregate month-end average notional amount of OTC derivatives of =€8bln) 12 months
  • category 3 (non-category 1 or 2 FCs and AIF NFC+s) 18 months, and
  • category 4 (other NFC+s) 3 years

For contracts between counterparties in different categories, it will apply from the later date.

Frontloading only applies to FCs in categories 1 and 2 (by two and five months after entry into force of the RTS, respectively). For it to apply trades entered into from the date the RTS comes into force must have a remaining maturity of six months or more on the relevant clearing obligation start date.

The rules also give more detail around the limited exemptions from the clearing obligations, including the intra-group exemption. For trades between EU and third country group entities, there is a three year transitional period where they can use the exemption without having a positive equivalence ruling. This will still require an application to the EU entity’s NCA.

What should firms do as a result of the new rules?

Firms should engage with clients now to make sure they are aware of what the final rules look like and see where they are in their preparations for mandatory clearing. They should periodically check for additional guidance published by ESMA, the Commission and NCAs on the clearing obligation, implementation timeline (and make sure they are on relevant mailing lists to receive updates) and keep on the lookout for RTS covering other classes of derivatives.

What advice should firms be giving to their clients?

Firms should advise their clients that they need to work out whether they are caught by the clearing obligation and, if so, begin to prepare as soon as possible. Preparations should include:

  • classifying themselves as category 1, 2 ,3 or 4
  • identifying which counterparties they enter into the relevant classes of OTC derivatives with
  • of those counterparties, find out which category each of them falls into (which is likely to involve counterparty engagement)
  • make any necessary amendments to trading documentation (eg provide for frontloading, if relevant)
  • establish the necessary clearing relationships for each product to be cleared
  • ensure access to sufficient clearing eligible collateral for CCP margin requirements, and
  • put in place procedures to monitor for additional clearing obligations coming into force

Interviewed by Alex Heshmaty.

The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor

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