On 15 September 2010 the European Commission published a formal legislative proposal on new regulation on over the counter (OTC) derivatives, central counterparties (CCPs) and trade repositories, known as the European Market Infrastructure Regulation (Emir).
The timing was symbolic, coming exactly two years after Lehman’s collapse, but the proposed regulation is no mere gesture: Emir is in effect a political and regulatory solution to some of the systemic risks uncovered by the failure of Lehman.
OTC derivatives were posing a regulatory problem in that those deals had traditionally been negotiated and executed on a bilateral basis, which increased the risks of individual counterparties to any particular trade and which did not provide sufficient visibility of any exposure.
The G20 has addressed this risk by imposing mandatory central clearing of standard derivatives contracts. The proposed Emir, due to take effect in 2012, authorises CCPs or clearing houses to sit between buyers and sellers – which in turn affects the financial institutions that broker the deals, and their clients.
Bank of America Merrill Lynch (BAML) associate general counsel Janet Wood is one of a handful of bank lawyers in London who is wrestling with the implications of the new regulatory proposals, and is leading much of her organisation’s thinking in London on this. Wood has spent much of her working life as a derivatives lawyer – first in private practice at Clifford Chance, then at futures brokerage Carr Futures and Enron – and has been at BAML since 2004.
The issues are manifold and fascinating, she says, and banks as potential clearing members have a crucial part to play in the debate.
“Thirty years ago there was no International Swaps and Derivatives Association master agreement and people created their own forms of documentation – and then over time the documentation became more harmonised,” she explains. “The same process will apply to the OTC cleared market. Now people are trying to develop optimal legal structures and documentation taking account of different jurisdictions and different client needs.”
Emir raises a whole set of issues that have not been fully decided, not least the range of derivatives that will be subject to clearing; it covers all derivatives products with some exceptions for foreign exchange transactions, and the planned European Securities and Markets Authority (ESMA) will be responsible for determining which products will be subject to mandatory clearing. “In terms of a list of specific contracts which will be subject to mandatory clearing, that has not been published yet,” notes Wood.
Furthermore, the regulation of CCPs requires standardisation of a whole host of rules on margin, financial resources, risk settlement and organisational issues. Here, the legal relationship between the clearing house, the financial institution or clearing member, and the client comes into play.
“Clearing houses are established in different jurisdictions, and the way in which they operate and the structures they create are slightly different, so that’s an interesting challenge for us as clients of theirs,” says Wood. “All the clearing houses solve these problems in slightly different ways.”
The European approach to clearing has traditionally seen CCPs anxious to make sure they owe obligations only to those that they have vetted, creating an inner circle of appropriate institutions as clearing members.
Wood says: “Among other things, the clearing house has relied on the creditworthiness of the membership, so clearing houses have had to be careful about who to admit as a member.”
Indeed, criteria for membership of the clearing house is one of the first macro-issues banks are dealing with, raising a familiar set of post-Basel issues.
“You need enough members to make it a functioning liquid market, but it’s a balancing act,” comments Wood.
Apart from the membership criteria, potential clearing members will need to give consideration to a number of issues, particularly in relation to a default fund, adds Wood.
The key questions for clearing members here are what are their obligations to contribute to a default fund, whether there are obligations to repeatedly top up the default fund, and if so, how often.
“Clearing houses are investigating ways of mitigating the counterparty default risk which they are now assuming, and different clearing houses are investigating different ways of replenishing their default funds,” says Wood.
There is also some debate over whether the fund would be pooled across products or whether there would be a separate default fund for each product – and whether a clearing member would therefore be obliged to contribute to this fund in relation to asset classes in which it does not trade.
With bilateral structures soon to be a thing of the past, examining the default waterfall – the order in which losses are applied and the contributions by clients, other clearing members and the clearing house itself – is crucial.
“Therefore,” says Wood, “banks are asking what their obligations might be in terms of voluntary or mandatory position auctions, or allocation of trades in the event of another member default.”
However, Wood is not simply investigating the risk from the point of view of the clearing member but engaging with clients over their own risks and obligations. Here again, she raises pertinent questions. Clients will want to know how their margin is protected throughout the process, from sending the margin to the relevant clearing member to the margin being held with the clearing house.
They may also want to know whether cash margin benefits from client money protection, and what is the clearing house default management process. For example, are client trades transferred to another clearing member, and what is the process and timing for this?
With so much still unresolved, and with the implementation of Emir still more than a year away, there will continue to be enormous debate in the financial institution sector over the establishment and regulation of central counterparties.
There is no template as yet, but in-house lawyers in the banks will be central to determining the way – and fundamental to the regulatory push – to lessen systemic risk.
“It’s a really, really interesting debate, and this is a fascinating time to be working in this market,” concludes Wood.