Derivatives after the crash

Author: | Published: 18 Mar 2015
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Rosali Pretorious and Tom Harkus of Dentons consider the key objectives of Emir and their impact on the buy-side’s use of OTC derivatives

Since the G20 summit in Pittsburgh in 2009, regulators across the globe have been pushing counterparties away from bilateral, over-the-counter (OTC) markets and on to clearing houses exchanges and trading venues.

The market's opinion of derivatives changed after the collapse of Lehman Brothers and the chaos that followed. In particular, the web of bilateral derivative contracts appeared impossible to untangle. Regulators were left in the dark and lacked the regulatory tools to intervene.

On July 27 2012 the EU published the Regulation on OTC derivatives, central counterparties (CCP) and trade repositories, commonly known as Emir (European Market Infrastructure Regulation). The key objectives of Emir are to: (i) transfer risk away from counterparties by obliging the systemically important counterparties to clear standardised OTC derivatives; (ii) reduce risks by imposing risk-mitigation requirements on the most important participants in the non-cleared OTC derivatives market; and, (iii) improve transparency in the derivatives markets by obliging all counterparties to report the details of their trades to trade repositories who in turn could provide regulators with information on trends and look for market abuse.

Each of these deserves an analysis before a brief consideration of other regulations impacting on the buy-side's use of derivatives. The main focus of this article will be on clearing, as this is the major change brought by Emir.

European clearing model

US clearing model


In their simplest form, cleared OTC derivatives are those that counterparties negotiate bilaterally but, rather than those two counterparties having one contract, a CCP is buyer to the seller and seller to the buyer. The CCP's position is flat, but the parties only face CCP credit risk. Clearing members, which the CPP approves, interface between the CCP and the counterparties.

In the UK (and continental Europe) the market uses a principal-to-principal model. The clients transact with the clearing members, who in turn enter into a back-to-back transaction with the CCP. There can also be a chain of indirect clients beneath the counterparties. On US designated clearing organisations (DCOs), clearing members, authorised as futures commissions merchants act as agents and the transaction is between the clearing member's clients and the CCPs directly.

Article 4 of Emir requires certain counterparties to clear eligible OTC derivatives. This obligation catches financial counterparties and those non-financial counterparties (NFCs) that exceed the threshold set out in article 10 of Emir (the clearing threshold) where they trade with each other. Where only one party is outside the EU, it is necessary to ask what classification that counterparty would have if it were established in the EU. Where both counterparties are outside the EU, Emir only applies if the OTC derivative has a 'direct, substantial and foreseeable effect' within the EU or to prevent parties evading Emir. Subject to certain details, the former includes where one party has a guarantee from an EU financial counterparty or where the parties contract through branches in the EU.

Undertakings for Collective Investment in Transferable Securities (Ucits) and Alternative Investment Funds (AIFs) whose manager is registered or authorised under Ucits IV or the Alternative Investment Fund Managers Directive (AIFMD) fall within the definition of financial counterparties under Emir. However, if its manager is not authorised or registered under the AIFMD, then an EU AIF will be classified as a NFC. Non-EU AIFs would need to consider what their classification would be if they were established in the EU.

"A CCP failure would have an even bigger systemic impact than when Lehman Brothers entered administration"

However, those counterparties are only required to clear OTC derivatives that the European Securities and Markets Authority (Esma) has mandated for clearing. Esma will stagger the first wave of regulatory technical standards (RTS) that mandate specific types of OTC derivatives for clearing. They occur at different stages and they include: interest rates; credit; foreign exchange; equity; and commodity.

At present, Esma and the European Commission (EC) are finalising these draft RTS. On January 29 2015, Esma published a memorandum in response to a letter from the EC to Esma of December 18 2014. The letter raised issues with: (i) postponing the start date of frontloading; (ii) clarity, for investment funds, that the OTC threshold should be calculated for each individual fund rather than across the group of funds; and (iii) excluding non-EU intragroup transactions from the scope of clearing.

Frontloading is the requirement to clear eligible transactions entered into after a CCP has been authorised to clear that type of OTC derivative, but before the clearing obligation is effective (article 4(1)(b)(ii) Emir). However, Esma and the EC agree that the start date is too uncertain, which will cause issues such as how to price those trades. As drafted, the proposed RTS will effectively: (i) postpone the start of the frontloading obligation for Category 1 and Category 2 counterparties (see table) for two months and five months, respectively, after the EU publishes the final RTS; and (ii) remove the frontloading obligation for Category 3 and Category 4 counterparties.

Excluding non-EU intragroup transactions, however, is a more problematic issue. Under article 3 of Emir, non-EU intragroup transactions can only be excluded if the EC has made an equivalence decision under article 13(2) for the relevant third country. To date, the EC has not made any of these equivalence decisions. Esma and the EC have mooted various solutions, such as excluding all intra-group transactions. What the answer will be is not clear: the market is waiting to see how Esma and the EC resolve the issue.

As proposed, the clearing obligation will begin at different times for different counterparties. Interestingly, AIFs that are NFCs receive special treatment. They are treated as financial counterparties in the RTS for interest rate derivatives (which we expect to be the template for other asset classes once published). The counterparty categories are as follows:

Client categories in the draft RTS

Category 1 – Clearing members of authorised CCPs – clearing mandatory from six months from publication of RTS

Clearing CCPs that are authorised to clear one or more of the mandated OTC derivatives on a European authorised CCP.

Category 2 – Other financial counterparties and NFC AIFs above the OTC Threshold – clearing mandatory from 12 months from publication of RTS

These include:

  • financial counterparties that do not fall into category 1; and
  • The OTC threshold covers counterparties whose aggregate month-end average notional amount of OTC derivatives as of dates to be determined exceeds €8 billion ($9.1 billion). This corresponds to the ultimate threshold set under the proposed regulations for posting collateral for uncleared OTC derivatives. The OTC threshold was not included in the consultation paper.

and, in both cases, on the condition that they exceed the OTC threshold.

Category 3 – Other financial counterparties and NFC AIFs below the OTC threshold – clearing mandatory from 18 months from publication of RTS

This covers the financial counterparties and AIFs that do not fall into category 1 or 2. Categories 2 and 3 are an extra distinction from those included in the consultation paper. Category 2 counterparties must clear mandated OTC derivatives six months earlier than envisaged in the first consultation paper.

Category 4 – Other NFCs above the clearing threshold: clearing mandatory from three years from publication of RTS

NFCs that exceed the clearing threshold and that do not fall into any other category.

The OTC threshold covers counterparties whose aggregate month-end average notional amount of OTC derivatives as of dates to be determined exceeds €8 billion ($9.1 billion). This corresponds to the ultimate threshold set under the proposed regulations for posting collateral for uncleared OTC derivatives. The OTC threshold was not included in the consultation paper.

Pension funds

Although they are financial counterparties, occupational pension schemes have an exemption from clearing enshrined in article 89 of Emir. This is due to expire on August 16 2015. Clearing members and CCPs only accept variation margin in the form of cash. As pension funds are often cash poor, many are unlikely to be able to meet calls to post variation margin.

The EC recommended an extension of this exemption for a further two years (until August 2017). The EC simultaneously published a report into solutions to this problem. One proposal it included was to borrow the cash from cash-rich corporates. However, our reading of the report suggests the EC sees collateral transformation by CCPs, backed-up by central banks, as the main solution. To work this would first need buy-in from CCPs and central banks.


CCPs and clearing members have various obligations imposed on them under Emir. One of these is for the CCP to segregate collateral held to enable the clearing member to distinguish between positions and assets held for its clients and those held for itself. Articles 39(2) and 39(3) of Emir oblige CCPs to offer both 'individual client segregation' and 'omnibus client segregation' as a minimum. Individual client segregation means segregating each client's account. Omnibus segregation means separating clients' assets and positions from the clearing member's own account, but commingling them with other clients' assets and positions is allowed. Clients whose assets and positions are held in an omnibus account can be a select group of clients, such as a group of affiliated companies. In practice, this is often used by fund managers for a number of house funds. CCPs are busy developing further models such as custody accounts, which potentially offer a higher level of protection. It is important that clients take care when selecting an account type. In particular, if opting for an omnibus account, the client must be prepared to cover shortfalls from other clients in that account.

Typical default waterfall for an EU?CCP


CCPs must also ensure clients can, on the default of the clearing member, transfer its positions and assets to another clearing member, rather than close out its transactions. Theoretically, this will enable the market to avoid the events that followed Lehman Brothers' collapse. For this to work in practice, clients should have clearing agreements in place with another clearing member to port their transactions to. Each CCP sets its own porting window and the maximum times are generally between 24 hours and five days depending on several factors, including the account type that holds the assets. As negotiating clearing documents typically takes much longer than this, not to mention the on-boarding process, the market recognises the need for clients to have at least two clearing members for this to have a realistic chance of working. This adds more cost to clients, in particular to smaller counterparties who do not have the volume of transactions to split their book across two clearing members.


To enable porting, the UK had to amend its insolvency law. As the assets for margin requirements are transferred to clearing members with full title, removing them from an insolvent estate would have fallen foul of the anti-deprivation rule. The same principles apply to what is known as leapfrogging. Under the back-to-back transaction, clearing members post the same or equivalent assets to the CCPs as they receive from clients. If a clearing member defaults and the client does not port, the client can take the assets out of the account of the clearing member before they are transferred to the insolvent estate.

CCPs too big to fail?

These protections are useful but what happens if a CCP defaults? Emir concentrates risk in CCPs. A CCP failure would have an even bigger systemic impact than when Lehman Brothers entered administration. CCPs may be too big to fail, but they do have some safeguards to avoid clearing members and their clients suffering a loss.

A default loss waterfall applies to CCPs when a clearing member defaults (see diagram). However, the law changed on February 1 2014 and then again on May 1 2014. Since then, CCPs in the UK must have in place loss-allocation rules setting out in detail how they would allocate losses to ensure business continuity. These recovery plans cover all losses, not just those caused by clearing members defaulting. The Bank of England expects these plans to change over time. It is considering whether UK CCPs need to make any more changes to bring them in line with the recently published CPMI-IOSCO (Committee on Payment and Market Infrastructures-International Organization of Securities Commissions) guidance on recovery of financial market infrastructures.

If recovery is impossible, the regulators are keen to keep the CCPs running without taxpayers footing the bill. In 2014, the Bank of England put in place a domestic resolution regime for UK CCPs, where the Bank of England will act as resolution authority. It can transfer the CCP's property to a private sector purchaser or to a bridge CCP owned by the Bank of England. It can also transfer the ownership of a CCP to any person. Again, the Bank of England is keen to develop its resolution regime. Next year, we expect to see the European legislative proposal on CCP recovery and resolution framework for financial institutions other than banks and this would provide the platform to do so.


There are various agreements between clients and clearing members to document how transactions are cleared. Clearing members have traditionally used agreements bespoke to each CCP. The International Swaps and Derivatives Association (ISDA) and the Futures and Options Association (FOA) developed, with clearing member and client input, an industry standard addendum that sits with the ISDA master agreement. They also developed a module that works with the FOA's standard exchange traded derivatives clearing agreement. The ISDA and the FOA have also published legal opinions for clearing members and clients, which cover various points when using the addendum including close-out netting.

The documents take time to negotiate and require careful consideration. Clients must first decide which account type they wish to opt for with the CCP. Under omnibus and individual client segregation, there are further options for clients to choose from. Clients of investment managers, asset managers and others who act as agents for their clients will look to their managers to guide them. Managers may find it difficult to persuade their clients to share in the risk of the other clients within an omnibus account. However, an omnibus account is a practical and cost-effective solution, especially where each principal is not trading high volumes.

Indirect clearing

Where clearing members will not accept a client as a direct client, another solution is necessary. Known as indirect clearing, this is where there is at least one indirect client beneath the direct client. The market has not embraced this model for OTC clearing. As well as economic viability, there are many legal issues that need to be addressed, such as porting and leapfrogging if the parties are established in different EU jurisdictions. Further, unlike with direct clearing, Emir does not require clearing members to offer indirect clearing along with the segregated account types for the ultimate client. Many of these issues and several others are being ironed out by the industry. However, it is difficult to see this tension being resolved quickly and easily.

Risk mitigation for non-cleared derivatives

Despite the delays, much of the OTC derivatives market is already cleared. Many reports show the increase in cleared OTC derivatives and the correlated decline in uncleared OTC derivatives. However, any reports that the market for uncleared OTC derivatives is dead may be greatly exaggerated.

One G20 commitment was for all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by the end of 2012 at the latest. Clearly this deadline has slipped.

Emir introduced risk mitigation requirements for non-cleared OTC derivatives. These include: (i) reconciling portfolios at intervals dependent on the volume of transactions; (ii) agreeing dispute resolution procedures between counterparties; (iii) compressing portfolios where there are equal and opposite transactions; (iv) the timely process of agreeing written confirmations; and (v) the timely, accurate and appropriately segregated exchange of collateral.

Exchange of collateral

These risk-mitigation techniques are in force, except for exchanging collateral, which is supposed to be in effect from December 1 2015. From this date, certain financial counterparties and NFCs above the clearing threshold must exchange variation margin with each other. Esma intends to phase in the requirements to exchange initial margin over four years. Initially this requirement will only impact where both counterparties' (at group level) gross aggregate notional amount of non-cleared transactions is at least €3 trillion. Over time, the rules will apply to more counterparties as the threshold reduces. The final reduction is due to take place on December 1 2019 and would lower the threshold to £8 billion (the OTC threshold). Esma indicated it may postpone this timetable to enable counterparties to put the necessary documents and systems in place.

Transaction reporting

Regulators now want an overview of the market. To do this Emir requires all counterparties to report details of their transactions, whether cleared or not, to trade repositories. In practice, most buy-side firms delegate this obligation to their dealers, clearing members or exchanges. The ISDA and the FOA negotiated and published a template delegated reporting agreement for this purpose.

"AIf recovery is impossible, the regulators are keen to keep the CCPs running without taxpayers footing the bill"

Just as the market overcame this hurdle, a new reporting obligation appeared on the horizon. From January 3 2017, the Markets in Financial Instruments Directive will be replaced with what is known as MiFID II. MiFID II poses a new challenge by introducing a separate reporting requirement to all derivative contracts on firms carrying out MiFID business. The amount of detail is more onerous than under Emir. Further, participants have noted that the reporting fields are designed with securities primarily in mind. Only derivatives linked to equity or bonds are currently reportable.

For the asset management industry, the burden of MiFID II reporting is likely to be shouldered mainly by banks and trading venues. As with Emir, asset managers and other buy-side counterparties who are caught may seek to rely on their dealers or trading venues to report on their behalf. However, the contractual documentation will need to reflect this.

Other developments

Emir does not exist in a vacuum and it is worth noting other regulations that affect the use of derivative transactions in the asset management industry.

For investment funds, Ucits IV restricts the use of OTC derivatives. The proposals for Ucits V and VI have been delayed. Once revisited, they may amend these restrictions to take into account the changing landscape of derivatives trading.

Similarly, the AIFMD introduced leverage reporting requirements and enabled competent authorities to impose leverage restrictions on managers. The constraints on reporting net positions, rather than gross positions, caused some concern in the investment fund industry, as this can have a significant impact on the leverage reported. It is something that the regulators may revisit, in particular in light of the changes introduced by Emir.

The industry has also taken its own steps. ISDA published its Resolution Stay Protocol on November 12 2014. Many of the word's leading banks have signed up to it. By doing so, the adhering parties opt into special resolution regimes in order give regulators time to facilitate an orderly resolution of a troubled bank. Finally, the Bank Recovery and Resolution Directive will play a major part in strengthening the financial service infrastructure. Bail-in and the resolution fund will add new protections to try to avoid repeating the events of the recent financial crisis.

Future regulation


Rosali Pretorius

T +44 20 7246 7181

Tom Harkus

T +44 20 7246 7280

1 Fleet Place

The fundamental shift in how parties trade OTC derivatives and the safeguards for systemically important counterparties means some of the existing rules for the buy-side are becoming outdated. In the not too distant future we expect Esma and the EC to revisit regulations such as Ucits and the AIFMD. We also think there may be consolidation of overlapping rules such as transaction reporting under MiFID II and Emir.

In the short term, however, the regulators have enough to deal with. For example, they need to make indirect clearing viable, find a solution for pension funds to post variation margin and also deal with the cross-border issues that threaten to derail the prolonged timetable to implement mandatory clearing.

For the buy side, the immediate challenge is to find a solution that works and negotiate the agreements in time without tripping up over the details.