sifma otc derivatives clearing 11:00-12:30 focus on...

OTC Derivatives ClearingFocus on Europe

MT

SIFMA2 May 201311:00-12:30

© 2013 Thomas Murray Ltd.

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AGENDA

Theory

� Regulation – EMIR and ESMA

� Mandatory Clearing

� Mandatory Trade Reporting

� European Asset Safety Solutions

Questions (posted on GoToWebinar)

Practice

� Some differences between the USA and Europe

� Selecting a clearing broker

� Selecting a CCP

� Selecting a Trade Repository

Questions (posted on GoToWebinar)

Wrap Up


Regulation


Regulatory requirements in Europe

Regulation

EMIR

� The European version of Dodd Frank, but much more focused – just market infrastructure.

� Regulation, not Directive (remember when we were threatened with a Directive for infrastructure?)

� Separate from the CSD Regulations (coming), although watch out for the conflicts.

� Issued on 4 July 2012. Only 59 pages plus nine supplements. Subject to Level 2 by ESMA and EBA

� Adopted by the EU on 16 August 2012 and entered into force on 15 March 2013

Missed opportunities

� Relies on competition between CCPs

� Decouples CCPs and Trade Repositories

� No T2S solution for TRs

� Possibly puts Europe at a competitive disadvantage to the USA.



Regulation

ESMA

� Responsible for Level 2 of EMIR

� Final Report dated 27 September 2012 (but draft technical standards). Further updates at end of December 2012. The

impact assessment notes that a number of CCPs fall short of the capital requirements.

� Still considerable work outstanding – authorisation of trade repositories and CCP plus determining asset classes

subject to mandatory clearing.

CCPs

• Recognition of third country CCPs (but nothing about qualifying CCPs)

• Margins: confidence interval (99.5%), look back period (1 year), liquidation period (2 days)

• Default fund: Largest clearing member in default (or 2+3>1). Extreme but plausible conditions

• No concept of systemically important FMU. SIFIs at national level.

• Currently working on Recovery & Resolution Plans

• Default waterfall: 25% SIG separately identified. Top up within 1 month.

• Investment policy: government debt, 95% of cash has to be collateralised. Versus PRC.



Regulation

EBA

� Responsible for setting the capital requirements for CCPs

� Not a global requirement, so creates much opportunity for regulatory arbitrage.

� Straight forward requirements based on revenues and expenses of CCP; may be enhanced in the future.

A CCP shall hold capital, including retained earnings and reserves, which shall be at all times more than or equal

to the sum of:

� (a) the CCP’s capital requirements for winding down or restructuring its activities calculated per Article 3;

� (b) the CCP’s capital requirements for operational and legal risks calculated in accordance with Article 4;

� (c) the CCP’s capital requirements for credit, counterparty and market risks calculated in accordance with Article 5;

� (d) the CCP’s capital requirements for business risk calculated in accordance with Article 6.

LCH.Clearnet estimates it will require additional capital of €300-375 million

Eurex will put in an additional €150 million

EuroCCP and EMCF have combined


Regulatory Timeline


Mandatory Clearing


Is it Mandatory?

Contracts to be cleared

� The five asset classes, but FX Forwards and FX Swaps are uncertain – they are excluded from mandatory clearing in

the USA.

� ESMA para 27: No CCP will be forced to clear contracts that it is not able to manage and the clearing obligation will

actually enter into force following the bottom-up approach.

� There are currently no CCPs clearing FX Forwards.

LCH ForexClear only covers NDFs.

CME do SEK/NOK cash settled forwards (CSFs using WM/R 4pm London Fix) and NDFs only. Working to solve the

CLS settlement issue to provide clearing of deliverable FX.

ICE Clear Europe has plans for FX Forwards (but exempt in US so might not).

� There are very few European CCPs clearing Interest Rate Swaps:

LCH SwapClear

CME Clearing Europe (no open interest)

Eurex OTC Clear (low volumes)

Nasdaq OMX (SEK only).

Mandatory Clearing


Exemptions

USA vs. Europe

� USA excludes FX forwards and swaps – ESMA not yet announced

� EMIR provides pension fund exemptions, USA does not

� Wider overall exemptions in the USA, EMIR captures every Financial Counterparty.

EMIR

� Out of scope Article 1: European central banks and public sector entities.

� Pension funds – until August 2015. Due to variation margin issues for LDI funds.

ESMA

� Financial counterparties are all caught – no exemptions or thresholds.

� Exemptions are not product related, “mandatory clearing” is.

� If you are an NFC, take all your mandatory OTC positions, remove any hedging activity and see if you still exceed the

thresholds. If so, then you are subject to mandatory clearing across all products (even if hedging).

Mandatory Clearing


Exemptions

NFCs have exemptions re Thresholds and Hedging

Thresholds

ESMA considered that the clearing thresholds used to determine which NFCs should be subject to the clearing obligation

should be set per asset class. For the purpose of the clearing thresholds, 5 asset classes were considered:

� credit derivative €1 billion

� equity derivatives €1 billion

� interest rate €3 billion

� foreign exchange €3 billion

� commodity and others €3 billion

Mandatory Clearing


Exemptions

NFCs have exemptions re Thresholds and Hedging

Hedging

• EMIR recognises that non-financial counterparties (NFCs) use OTC derivatives to protect themselves against

commercial risks directly linked to their commercial activities or treasury financing activities. As a result, these OTC

derivative contracts that protect the NFCs against risks directly related to their commercial activities and treasury

financing activities as well as those that, for different purposes, do not exceed the clearing thresholds are not subject to

the clearing obligation.

• However, it is well established that when the clearing thresholds would be exceeded, the clearing obligation would

apply to all future OTC derivatives concluded by the NFC after it has exceeded the clearing thresholds, no matter

which purpose they have.

Mandatory Clearing


Mandatory Trade Reporting


Trade Reporting

EMIR Counterparty Categories

Four Categories

1. Financial Counterparties: FC

• Banks

• Insurance companies

• Investment firms

• UCITS

• Pension funds

• AIFs

2. “Systemically important” Non-Financial Counterparty: NFC+

• NFCs that enter into “ non-hedging” activities in derivatives above the clearing threshold

3. Not “systemically important” Non Financial Counterparty: NFC-

• NFCs that enter into derivatives positions for “hedging” activities only

4. Third country (non-EU) entities: 3rd CE …. reporting not required


Reporting focus: EU risk exposure includes financial and non-financial counterparties, but under EMIR counterparties

outside the EU do not have to report to a TR

Reportable asset classes: All derivatives (ETD & OTC): Equity, Commodity, FX, Interest Rates & Credits

Reportable transactions: Confirmations, modifications, terminations, novations, compression & collateral changes, as

well as mark to market or mark to model at trade or portfolio level

Reportable portfolio: all transactions dating from 16 August 2012

Two-side reporting: all EU counterparties responsible

Timing: near-time no later than trade date +1

Counterparty identification: a compliant unique identifier (currently CICI the CFTC interim compliant identifier to be

replaced by LEIs at some future date.)

Comprehensive Reporting Requirement

Trade Reporting


EMIR Reporting exceeds MIFID Requirements

Trade Reporting

Product Scope Reporting Content

MiFID Reporting EMIR Reporting

Cash Equities

Cash Bonds

Equity Derivatives

Debt Derivatives

FX Derivatives

Commodity Derivatives

MiFID Reporting EMIR Reporting

Reportable Asset Classes:

• All listed derivatives

• All OTC derivatives: Equity,

Commodity, FX, Interest Rates

& Credit

Reportable Data fields:

• Counterparty details (26 fields)

• Contract details (59 fields)

• Collateral & valuation details

• Unique identifiers – UTI, UPI,LEI

Inte

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Iden

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Trade Reporting

The reporting requirement came into force on 16 August 2012

Full implementation starts September 2013. Subject to the authorization of a trade repository, the timetable

is as follows:

• Reporting of credit and interest rate derivatives contracts to TRs – 23 September 2013

• Reporting of all other asset class derivatives contracts to TRs – 1 January 2014

• Back reporting of derivative contracts outstanding on 16 August 2012 (and still outstanding on

reporting start date) – within 90 days of the reporting start date for that asset class

• Back reporting of derivatives entered into before, on or after 16 August 2012 that are no longer

outstanding on reporting start date – theoretically reportable within three years of the reporting start

date for that particular asset class

Staggered Implementation


European Asset Safety Solutions


What’s at risk

Asset Safety

CCP risk

� Initial margins – look back , confidence level and close out

period. What do they cover. What don’t they cover.

� Default fund. How calculated. What does it cover. What it

doesn’t cover.

� Differences between initial margin, variation margin and

default fund.

� Importance of the waterfall

� Fellow Customer Risk (CFTC) or Double Default (ESMA)

The whole value chain is FOP, not DvP

Basel III

� Places requirements on banks (and brokers) that have exposures to CCPs (there’s nothing about client protection).

� Distinguishes between qualifying and non-qualifying CCPs.

� Sets out hypothetical capital for a CCP (driven by its own contribution to the default fund (SIG)).

� Differences in default fund parameters in terms of number of clients covered against default.


Segregation Models – Futures Model

Principal or Agency

CFTC Part 190

Any loss in the customer omnibus 4d account is shared pro-rata (fellow customer risk – called double default risk in Europe)

Basel III.

115. Where a client is not protected from losses in the case that the clearing member and another client of the clearing member jointly

default or become jointly insolvent, but all other conditions in the preceding paragraph are met, a risk weight of 4% will apply to the client’s

exposure to the clearing member.

Asset Safety


Segregation Models – LSOC

(The CFTC Complete Legal Segregation Model)

Basel III

110. Where the clearing member offers clearing services to clients, the 2% risk weight applies to the clearing member’s trade exposure to

the CCP, provided that they are subject to individual segregation: 114.(a)

Margin excess: EMIR Article 39 (6) provides the same level of protection for any excess margins.

LCH.Swapclear: Deed of assignment

Asset Safety


Questions so far


Some differences between

the USA and Europe


Significant differences

USA vs. Europe

• Principles vs Rules base approach

• Extraterritoriality and substituted compliance

• Trade reporting of ETD required under EMIR, not under Dodd Frank

• Qualifying CCP (temporary exemptions, etc.)

• Default fund coverage

• CCP and clearing broker capital requirements

• Top down (USA) vs. bottom up (Europe) approach to mandatory clearing

• Possible differences in asset classes subject to mandatory clearing (not known until ESMA announces

European contracts subject to mandatory clearing).


Selecting a Clearing Broker


Considerations


� Existing ETD broker may not be suitable

� Existing global custodian may not be suitable

� Credentials: commitment to business more important than asset safety and credit rating?

� Client base & Pipeline

� Back loading bandwidth

� Collateral transformation & liquidity swaps

� Margin modelling and collateral optimisation

� Currency deadlines

� Affirmation platforms and trade reporting (Bloomberg VCON, MarkitWire)

� Fees – ticket fee plus capital utilisation charge based on initial margin (maybe maintenance charge and a CCP fee).

Watch out for minimum monthly. Back loading and compression fees.

You also need a backup provider if you are to achieve portability


Back Loading

� Possible benefits from position offsets and close outs across different bi-lateral counterparties, as well as a

simplification in administration if there is just one source/database of trades & positions

� Once back-loaded the portfolio will be offered the protection of the clearing house in line with other cleared trades

� Can be an operationally intensive exercise, with each CCP offering a slightly different back-loading approach

� Initial margin will need to be funded once back loaded

� Back loading achieving netting effects resulting in lower initial margins

� LCH currently offering a 50% discount on back loading – clearing broker should pass on this discount



Compression

� There are two ways in which clients can reduce the size of their portfolio, the first is netting and the second is trade

compression

� Compression services offered by the individual CCPs in the form of offsetting contracts whereby IRS and CDS trades

with matching economic details can be compressed

� Generally automated at CCP as required for bi-lateral trades of more than 500 (e.g. SGX-DC)

� Requires clearing broker support to optimise inputs

� Typically either automated compression or selective compression can be offered:

� Automated compression occurs on an overnight cycle, contracts where all attributes match will be collapsed and

reported the following morning on start of day confirmation reports.

� Selective compression is where an account can be updated intra-day to automatically compress in the overnight

run (following the same process as automated compression), and then switched back the following day to

prevent further compression. Selective compression gives flexibility to control when the account compresses.



Clearing Broker RFP

Credentials

Asset Safety

Memberships

Clients

Functionality

Margining

Reporting

Systems

Fees

Legal Documents

Overview Document

RFP process very similar to custody selection:

� Client profile (detailed portfolio is key to margin modelling)

� Derivative specific RFP questionnaire (see left)

� Long list to usual suspects

� Scoring and analysis

� Selection of short list

� Star Chamber

� Negotiation

� Transition

Full service or DIY option



Fees

� Standard rate cards made up of:

Transaction fee

Basis point fee re initial margin

Maintenance fee

CCP fees

� Some clearing brokers will impose a minimum fee

� Those with small portfolios should seriously consider transforming the portfolio into futures and incurring the basis risk.

� Depends upon portfolio. If long dated then maintenance fee is appropriate. If high turnover then transaction fee will

drive the costs.

� The more business you can show the better the terms.



Selecting a CCP


Client Clearing CCP Landscape

Selecting a CCP

OTC products currently cleared by CCP

Rates CDS

CME Group � �

ICE Clear Credit �

LCH SwapClear �

Eurex OTC

Clearing October 2012

Client Clearing new products

Rates CDS

NASDAQ OMXMarch 2013

SEK only

CME Europe March 2013

ICE Clear

EuropeQ1 2013

LCH SA Q2 2013

Given that IRS and CDS will almost certainly be subject to mandatory clearing, there are only a few CCPs to choose from.

LCH SwapClear is dominant in IRS. There is stiff competition in the CDS space.


CCP Risk Assessments

Thomas Murray programme

� In conjunction with major clearing members

� Detailed questionnaire (not self assessment)

� Covering the following risks:

Counterparty, Treasury & Liquidity, Asset Safety,

Financial, Operational

� Plus appraisal of:

Governance & Transparency, Legal & Regulation.

� Detailed data and benchmarking.

Selecting a CCP


Selecting a Trade Repository


� Under EMIR the trade repository has to be established in the EU, but there is no obligation under the rules for any entity

to set up a trade repository

� EMIR allows foreign trade repositories to fulfil the role (provided professional secrecy exists) and there is mutual access

to information. So reporting trades to GTR in New York will be possible.

� Exchange venues can either be a TR for their own trades or can report them elsewhere.

� The fee structure for trade repositories is not final (subject to a recent ESMA consultation). EMIR expects the

commercial sector to provide the solution, but the commercial case is not clear …. Volumes may decline

� Presumably there will be competition for OTC derivatives but only IRS is likely to be commercially attractive.

� Reporting responsibility for one-off bi-lateral OTC derivatives remains open. Will these have to go direct to ESMA?

Selecting a Trade Repository

Trade Repositories


• ESMA began accepting applications in mid-March. June is the earliest expected date for notification of approval.

* Nasdaq OMX have announced an EMIR trade reporting service … but not a repository

** Harmony TR Connect offered by Traiana provides connectivity to multiple trade repositories.

Current applications with ESMA

Trade Repositories

Trade Repository Instruments Location

CME All asset classes London

DTCC (UK & Netherlands) All asset classes UK entity; European data centre

ICE Trade Vault Europe Commodities, credit,

interest rates, & FX

London

RegisTR All asset classes Madrid

UnaVista All asset classes LSE Group


.

Choosing a reporting approach

Trade Repositories

Reporting

Choice

Asset Manager Counterparty Comments

Independent Common

Counterparty AM

Common

Counterparty SD

The TR(s) must match common data

elements

Partial Delegation

(PD)

Counterparty AM Common (both)

Counterparty SD

Will this work for all counterparties? Is

the CCP offering this?

Full Delegation

(FD)

No responsibility Common (both)

Counterparty SD

Counterparty AM

Do you want to allow all Counterparties

control over you CP data?

Third Party Agent submits

FD or PD

Common

Counterparty SD

Offers control but AM can’t delegate the

liability

• Middleware platforms can be used with any of the scenarios


Summing Up

Implementation guide

Define your business strategy

• Asset classes

• Major counterparties

• Operational platform

Select Clearing Broker(s)

• Establish terms & complete legal documentation

• Identify reporting approach

Evaluate CCP offerings

Monitor current regulatory deadlines and jurisdictions (don’t forget Switzerland is different)

Engage with industry groups to learn best practices and emerging experience

Leverage standards to lower costs of compliance … e.g. CCS

Don’t wait …. Lessons from USA - New arrangements require testing all round …. CCPs, portfolio reconciliation, reporting


Questions remaining


QUESTIONS?

If you have any additional questions, please contact us:

Janet Wynn

[email protected]

646-628-1392

Tim Reucroft

[email protected]

+44 20 8600 2306