Alongside the supervisory framework for CCPs and the reporting system for derivatives transactions, the clearing obligation forms the third pillar of the European Market Infrastructure Regulation (EMIR), the "Magna Carta" of derivatives markets. This is a good opportunity to take a look back at the rocky road that led us to where we are today, to explain the convoluted provisions of the regulation and to warn about some implementation hurdles on the way ahead.

When, in September 2009, G20 leaders agreed that all over-the-counter derivatives (OTC derivatives) transactions were to be cleared through central counterparties, the starting date they envisaged was the end of 2012. No fewer than three years were supposed to pass before EMIR was to enter into force. The regulation merely acts as a framework describing the procedures, conditions, contents and limits of the clearing obligation largely in abstract terms. Details were not provided until a delegated regulation came into force on 14 March 2013. The European Securities and Markets Authority (ESMA) addressed a number of further issues of interpretation and implementation in a document which, although not legally binding, does practically point the way ahead and has now expanded to almost 100 pages.

Difficult process

This is because it was necessary to clarify further details, in particular the distinction between OTC and exchange traded derivatives (ETD), calculation modalities of the group-wide portfolio size, including netting and hedging, the classification of counterparties and the conditions for exempting intragroup transactions.

This proved difficult: the project was plagued by delays due to intensive lobbying from the affected companies and associations as well as conflicting views, often aired in public, of the European Commission, ESMA and the European Parliament. On 1 October 2014 ESMA took the first step, following comprehensive public consultations on various aspects of the clearing obligation. An unusually sharp exchange of opinions followed between the European Commission and ESMA, which on 6 March of this year adopted the final draft regulation. A gauge of how many issues still needed solving may be the fact that the Commission took another five months to ponder the draft, even though it always accompanies ESMA practically every step of the way.

Now the ball is in the Council's and Parliament's court; they have been looking at the draft these past weeks. It is regarded as unlikely that the Parliament will make use of its right to a three-month deliberation period. Barring any further unexpected twists, the regulation may be published in the Official Journal of the European Union before the year is out and come into force 20 days later. However, the clearing obligation will only come into full force in the next three years.

Scope

The material scope was largely undisputed from the beginning: first, single-currency interest rate swaps in euros, US dollars, pounds sterling and Japanese yen with variable or constant, but not conditional nominal amounts on one of the standard indices (LIBOR, EURIBOR, EONIA and FedFunds) without optionality will be subject to the clearing obligation. The contracts excluded on the basis of that definition are largely regarded by ESMA to be not liquid enough to justify a clearing obligation in the long run. However, efforts are being made to subject interest rate swaps in smaller Scandinavian and Eastern European currencies to central clearing in a second attempt.

The principle is succinct: all interest rate swaps listed in the annex to the regulation are to be cleared centrally. Two lines of the regulation are taken up by this principle. The remaining four pages are devoted to provisions concerning three areas of exemption. They concern contracts with covered bond issuers, less sophisticated or risky market participants and intragroup derivatives involving a third country.

Contracts with covered bond issuers

The draft regulation exempts from the clearing obligation certain contracts which are entered into by covered bond issuers – in Germany, for instance, the issuers of Pfandbriefe – for their cover pool. The conditions were subject to long negotiations, since the market practice and legal frameworks concerning covered bonds vary from country to country. A German Pfandbrief or Danish realkreditobligationer have little in common with an Irish asset-covered security. There was some concern, notably from Irish commentators, that the exception described in EMIR might encourage the funds industry to engage in arbitrage practices.

According to the compromise solution reached, contracts can be exempted only when used to hedge against interest rate or currency mismatches between the cover pool and the covered bonds issued; this will also apply to future bilateral margining of uncleared derivatives. In functional terms, this is comparable to the classic hedging transactions of non-financial counterparties. The primary reason for the exemption is the fact that, contrary to the usual practice, the counterparty initially has no termination right when its counterparty, the cover pool, becomes insolvent, but its claims against the cover pool are to be honoured as much as the claims of the holders of "normal" Pfandbriefe. Such an asymmetrical termination right is included in many jurisdictions to protect Pfandbrief creditors, because otherwise the intended protection against market price risks would end at the very moment when – due to the issuer’s insolvency – it becomes vital.

Another condition is that the contracts be registered under the corresponding national provisions for covered bonds. In addition, the exemption only applies when the counterparty to the derivative concluded with cover pools in principle ranks at least pari-passu with the covered bond holders in case of insolvency. This principle in particular would be undermined in central clearing as the margins paid out of the cover pool would be taken away from Pfandbrief creditors. Moreover, due to its highly restricted composition, the cover pool usually does not have sufficient liquidity to provide margins from liquid assets in the long term.

Lastly, the exemption from the clearing obligation requires that the covered issuance be hedged to the extent of at least 102%. This condition can also be found in many national provisions for covered bonds. For the purposes of practical implementation, the issuer needs to inform the counterparty of the conditions for being exempted from the clearing obligation.

Phase-in periods according to sophistication

The second exception provides for a later introduction of the clearing obligation, according to the market participants' sophistication (see graph). To this end, market participants are divided into various categories. The idea is to make the conditions economically reasonable: for smaller, particularly non-financial counterparties, the preparations for central clearing tend to be a greater burden than for large banks that are already clearing members for contracts under the clearing obligation.

The categorisation of a market participant has an impact on the following: firstly, how long the phase-in period is, following which the participant needs to transfer a concluded interest rate swap contract, which in principle is subject to the clearing obligation, to a CCP for central clearing immediately upon conclusion. Depending on the category, the phase-in period is set as six, twelve, 18 or 36 months.

Secondly, the categorisation determines if and when interest rate swap contracts entered into during the phase-in period, and thus not cleared centrally, nevertheless are to be cleared at a later date (frontloading). Frontloading is to apply to large companies only. It is to begin two or five months after the regulation comes into force. EMIR's original schedule was slightly different, though: frontloading of interest rate swaps cleared by Eurex Clearing AG, for instance, should have come into effect as early as mid-April 2014. However, neither the content nor the scope of the clearing obligation had been defined then. This uncertainty would have made pricing and contractual arrangements for OTC derivatives rather cumbersome. In order to avoid that, the lawmakers largely gave up the concept of frontloading.

Clearing obligation: timing

Clearing obligation: timing

BaFin

Market participants: four categories

1. Clearing members (typically large banks)
2. Financial companies without clearing membership, derivatives portfolio of over EUR 8 billion
3. Smaller financial companies, derivatives portfolio of under EUR 8 billion
4. Non-financial companies without clearing membership

Category 1 comprises financial and non-financial counterparties which on the date of entry into force of the regulation are clearing members for at least one of the classes of derivatives, of a CCP compliant with EMIR. Those considering such clearing membership should take note of this date – too much haste might prove expensive. Such incentive issues seem unavoidable in larger regulatory projects. The categorisation is indivisible: a company in category 1 keeps this category for all interest rate derivatives subject to the clearing obligation. Consequently, such a company may need to obtain access to clearing for further products subject to this obligation within the six-month phase-in period.

The second category includes financial counterparties and certain equivalent alternative investment funds whose aggregate group average of outstanding gross notional amount of non-centrally cleared derivatives is above EUR 8 billion. The calculation is based on the average of the first three months after the publication of the regulation in the Official Journal. Correctly determining this volume may be a complex process, in particular as it requires taking into account all consolidated companies worldwide, even, in ESMA's view, if the group management is domiciled in a third country. The calculation must take into account all derivatives, including those traded on-exchange, and potentially even if they are cleared through a CCP outside the EU which is not recognised by ESMA. As category 2 companies need the three months to learn whether they might actually fall into category 3, the regulation gives them three more months than their larger counterparts from category 1 until the start of frontloading.

Companies from the third category are spared frontloading. This category differs from the second one only by the aggregated portfolio volume, which stays clear of the EUR 8 billion threshold. However, as noted earlier, this privilege comes at a price. Investing in the business processes needed to determine the aggregate volume is not in vain for yet another reason, though: this figure will be used in the future regulation on bilateral margining of non-centrally cleared derivatives to determine categorisation and so decide again on the length of transitional periods.

Last but not least, category 4 encompasses all companies that do not belong to any of the other categories. This applies only to non-financial counterparties that carry out major volumes of OTC derivative trades, making them subject to the clearing obligation. Thanks to a bold intervention by the European Parliament in early 2013, they benefit from a three-year transitional period during which they do not need to clear any contracts centrally. No frontloading is provided for either. Whether or not these contracts will need to be collateralised bilaterally, however, is another matter.

If the counterparties of a contract belong to different categories, the category of the "smaller" one is taken into account, as its protection would otherwise be undermined. Anyone intending to enter into an interest rate swap contract which in principle is subject to the clearing obligation has to be aware of what category both they and the other party belong to.

Intragroup contracts

The third exception can be seen as an innovation both in legal and supervisory terms: the Commission has proposed that the intragroup transactions exemption under EMIR be extended by up to three years to all intragroup contracts involving a company domiciled in the EU, regardless of the domicile of the other party. By contrast, EMIR's regulatory model provides for an exemption from the clearing obligation only in the case of contracts whose counterparties are domiciled in the EU and equivalent third countries. This equivalence would not be required any more under the Commission's proposal. Globally active groups thus would – as long as they fulfilled the other requirements, most notably by having a centralised risk management – be able to have all their intragroup derivatives transactions exempted from the clearing obligation for three years, even if the non-European counterparty found itself in a regulatory no-man's land. Apart from that, notification procedures and material criteria were taken almost word for word from EMIR.

From the legal perspective, this measure was admittedly only successful thanks to the European Commission's creativity in simply prescribing a new phase-in deadline for these special contracts. The lawmakers’ motive is clear: the Commission has not been able to declare any third country equivalent in the field of the clearing obligation yet, meaning that the intragroup exemption under EMIR would run dry for the time being. However, the Commission is likely to take some third-country equivalence decisions soon, so that the market participants would have to take all the necessary steps to prepare for central clearing only for a short interim period. This would have been all but impossible to justify. In the case of the US, another hurdle is that the Commission has not yet classified the US supervisory law as equivalent for CCPs, meaning that the clearing obligation could only be fulfilled by clearing houses domiciled in the EU. The consequences, particularly for the business processes of large banks, would have been significant to say the least. However, whether all this justifies giving companies carte blanche to carry out intragroup transactions with subsidiaries in the remotest parts of the globe is a political question and one the Council and Parliament will need to answer in the coming weeks.

Possible practical problems

How is the clearing obligation to be fulfilled in practice? Only those central counterparties that have either been authorised under EMIR to clear derivatives subject to the clearing obligation by a national supervisory authority in the EU, or recognised by ESMA, in the case of third-country CCPs, will be suitable. All interest rate swaps that will be subject to the clearing obligation in the future are cleared by clearing houses domiciled in the EU. The way to technical implementation is thus paved for large banks and their clients with a non-clearing member status.

The situation is less clear for smaller financial institutions and non-financial counterparties which for various reasons are dependent on access to clearing through intermediaries (indirect clearing). The conditions for such services, in particular in terms of account segregation, are so demanding that indirect clearing has not been offered to a large extent so far. It remains to be seen whether this situation will have improved by the time the regulation comes into force.

Outlook

Even though the clearing obligation for interest rate swaps seems to have reached its last leg, a lot is still going on in the area: as already mentioned, further interest rate swaps denominated in smaller currencies may become subject to the clearing obligation soon. The same applies to credit default swaps (CDS).

The current review of EMIR might change the conditions of the clearing obligation, too. ESMA is currently voicing its thoughts about a revision of the criteria for determining non-financial counterparties subject to the clearing obligation.

Last but not least, relaxing the requirements of indirect clearing services is being discussed in the course of the review of the second Markets in Financial Instruments Directive (MiFID II). The finishing straight – if there even is such a thing – is still a long way off.