The EU and the Commodity Futures Trading Commission (CFTC) reached a landmark agreement on regulating cross-border derivatives on 11 July 2013. This agreement, summarised in a statement called the Path Forward, is an important milestone that allows the US to complete its cross-border rules and for the EU to proceed with its cross-border proposals.
The bulk of the announcement details CFTC policy views and proposals (see our Regulatory Brief here). While the Path Forward indicates that there is more compromise and negotiation to be done to reach harmonisation on several issues, in particular transaction reporting and central counterparty (CCP) initial margin requirements, the EU and US regulators stated a clear intent to continue this collaboration with a view to achieving mutual recognition of the two regimes.
In the US, CFTC relief will be provided under a system of “substituted compliance” allowing an entity to comply with a third country rule. “Jurisdictions and regulators should be able to defer to each other when it is justified by the quality of their respective regulation and enforcement regimes”, said Gary Gensler, Chairman of the CTFC. In the EU, an entity subject to a requirement in a third country will be able to opt to follow either EMIR rules or the relevant third country rule if the EU has recognised the rule as equivalent.
The announcement did not contain any firm European Market and Securities Authority (ESMA) equivalence determination decisions, but some critical insights. While it is likely that ESMA will deem US non-centrally cleared operational risk obligations and clearing obligations to be equivalent, transaction reporting rules and CCP initial margin rules are two areas that the announcement identifies as areas of discrepancy. There will be continued work in these areas. ESMA is due to provide the European Commission (Commission) its advice on equivalence determinations for the US and Japan by 1 September, with determinations for Hong Kong, Switzerland, Singapore and Australia due by 1 October.
The announcement says that the EU will consider whether risks posed by any entity guaranteed by an EU ‘person’ remain unmitigated with a view to ensuring that the guaranteed entities are required to operate under derivatives rules in a G20 jurisdiction. Therefore we expect that the ESMA cross-border consultation will propose that any such entities located outside the EU will be subject to EMIR requirements under the cross-border proposals (pending associated equivalence assessments). The announcement also says that ESMA is considering whether the activities of EU branches of third country firms also pose unmitigated risks which suggest that these could also be brought into EMIR’s scope.
The agreement is hugely important. The closely linked US and EU derivatives markets represent the bulk of the world’s over-the-counter derivatives markets; the Bank for International Settlements estimated recently that these markets comprise 88% of global trading in the heavily traded interest rate derivative market. In recognition that many derivative counterparties will be subject to both countries’ new derivatives regulatory regimes, the EU and US are working to iron out duplications, inconsistencies and possible conflicts between the rules so that compliance with one set of derivative requirements will satisfy compliance obligations with a reciprocal rule under the other regime. This approach will help firms to avoid conflicts of law, inconsistencies and legal uncertainty created by cross-border transactions.
In terms of next steps, ESMA is expected to publish its first cross-border rule proposals for public consultation this month, providing a brief consultation period over the summer closing on or around 1 September. ESMA must then deliver its final proposals for EMIR cross-border rules to the EC by 25 September 2013. The EMIR cross border rules will then be reviewed and endorsed by EU legislators in a process we expect to run about six months, with resulting rules likely to come into effect in early Q2 2014.
Additionally, ESMA must deliver its advice on EMIR third country equivalence determinations to the EC this autumn. ESMA is due to deliver its advice on the equivalence of US and Japanese derivatives rules applicable to counterparties, CCPs and TRs by 1 September, with advice on derivative counterparty rules to follow by 1 October for Australia, Canada, Hong Kong and Switzerland. ESMA will also assess CCP and TR legal regimes for some of these and other jurisdictions by 1 October. See the EC’s updated mandate on EMIR equivalence for the schedule.
We estimate that the legislation to pass the first equivalence determinations into law will also likely come into effect during Q2 2014.
From Monday some European fund managers will start complying with the Alternative Fund Managers Directive (AIFMD), a package of reforms directed primarily at hedge funds and private equity funds. In reality, most will take advantage of the one-year transition period and hold out on becoming authorised (and thus under the scope of the Directive) until 2014.
Whether fund managers start complying with AIFMD from 22 July 2013 or 2014, significant work is needed to gear-up for compliance and embed the necessary operational changes. AIFMD is a beast of a Directive and is likely to shape a firm’s line of operations, their relationships with service providers, custody frameworks, remuneration policies and marketing approaches – to name a few areas. Implementing a number of the requirements, such as appointing an ‘AIFMD-ready’ depositary, is likely to be extremely time consuming process.
Some of the larger alternative asset managers have been preparing for six months or more, making their foresight an advantage when raising money from investors. But, more recently, all asset managers falling within the scope of the Directive have started to analyse what they’ll need to do in order to comply.
Even at this late stage, preparing for the Directive efficiently will give managers the flexibility to comply in the way that will bring greatest benefit to their business, including:
Alternative fund managers face the daunting prospect of being subject to a pan-EU regulatory regime for the first time. There are good ways and bad ways of approaching this large task which reaches to the heart of how some managers conduct their businesses. By preparing as effectively as possible, managers can analyse the changes they need to make in the context of their strategic goals, giving them competitive advantages at a time when regulation may well open up new opportunity.
A financial system can’t work without a lender of last resort, some safety nets and backstops. Despite the best intentions of regulators, from time to time banks will fail and require financial support, potentially from the public purse.
Generally, countries can use a combination of mechanisms to deal with ailing banks, such as a deposit insurance agency, a rainy day fund paid by bank dues, or an understanding that big banks will bail-out their smaller peers in times of distress. However, at the Eurozone level, the plans foresee a common financial fund permitting direct financial intervention in order to break the destructive sovereign/bank feedback loop.
On 10 July, the Commission proposed a Single Resolution Mechanism (SRM) for the banking union. We are still waiting on the final text of the proposals expected in a few days (a preliminary version of legislative proposals can be found here) but there is now sufficient information to get a reasonable picture of how resolution might work under the new regime.
Under proposals, much of the responsibility would rest with the Single Resolution Board (Board), a new entity consisting of representatives from the European Central Bank (ECB), the Commission and the relevant national supervisors. The Board will have a different configuration for each bank, as it must be designed to reflect the specific risks of each bank. They would be tasked with planning the resolution of a bank which the ECB has signalled is in trouble. Working with national supervisors, the Board would have wide-ranging powers to analyse and define the approach for resolving a bank. However for legal reasons, the Commission would have the final say on whether, and when, to place a bank into resolution, what tools should be used and funds injected.
National resolution authorities will be tasked with executing the resolution plan in line with national company and insolvency law. Should a national resolution authority not comply with the Commission’s decision, the Board would have the power to directly address executive orders to a troubled bank.
The Board would have a pot of money at its disposal, the Single Resolution Fund, which would be used to support banks which have entered the resolution and restructuring process. It would be funded by contributions from the banking sector, replacing the national resolution funds of the euro area Member States.
The proposal would not explicitly ascribe any new role to the European Stability Mechanism (ESM). However, rules on how national or European public funds could be used in cases of bank resolution are to be laid down by the draft Bank Recovery and Resolution Directive, which is still under negotiation. So the potential for using ESM to retrospectively bail-out banks in Spain, Portugal or Ireland is still a possibility (albeit a very small one).