Including updates on OTC Derivatives, the Financial Conglomerate Directive and short selling


ESRB advises on the use of OTC Derivatives for non-financial firms and Collateral in EMIR

The European Systemic Risk Board (ESRB) adopted advice on the use of over-the-counter (OTC) derivatives by non-financial corporations and the eligibility of collateral for CCPs on 29 August 2012. Both papers were accompanied by macroprudential stances which considered the systemic risk implications of the ESRB’s recommendations. The European Securities and Markets Authority (ESMA) requested the ESRB’s input as part of its consultation on Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories (EMIR) which was published on 25 June 2012.

Non-financial firms are exempt from certain clearing obligations under EMIR. The exemption applies if positions relating to ‘speculative trading’ remain under certain thresholds (i.e. do not meet the definitions for commercial or treasury financial activity). When non-financial counterparty positions exceed the clearing threshold, the draft RTS outlines that the firm must:
  • notify ESMA and the national supervisors immediately
  • meet the clearing obligation on all OTC derivative contracts if the rolling average position over the following 30 working days continues to exceed the threshold
  • clear all relevant contracts within four months of becoming subject to the clearing obligation.
These exemptions are designed to give firms leeway to hedge business risk without being subject to additional requirements while ensuring that speculative, investment or trading activities by non-financial firms are cleared through central counterparties (CCPs). However, the design of such a regime is complicated, particularly the methodology for calculating the thresholds. The ESRB notes that derivatives held in the context of hedging commercial and treasury activities are not risk free, and allowing a certain proportion of these transactions to go “un-cleared” has systemic implications.

The ESRB believes that the clearing thresholds of non-financial corporations should be based on macroprudential principles. The integrity and stability of each market could be undermined if a sizable portion of transactions are not cleared by participants. So as a starting point, it believes that non-financial firms should clear the majority of their OTC derivatives through CCPs.

ESRB believes that the total amount of derivatives held by a non-financial corporation, irrespective of their intended use, should be considered as the basis of calculating the threshold. Therefore, the definition of clearing thresholds should be based on gross market values. ESRB is proposing methodology for calculating thresholds using a two-step approach. The approach is designed to ensure the risks arising from non-financial firms holding derivatives are appropriately considered.

It believes the definition of commercial and treasury activities should be as detailed and objective as possible to ensure speculative trading by non-financial firms is not exempt from clearing. The aim is to leave no discretion for different interpretations or arbitrage. ESRB welcomes the detailed definitions of commercial and treasury financing activities ESMA set-out in the draft RTS. However, it underlines that commercial activities of non-financial firms should refer to specific items in their balance sheet, and more specifically, to their core business (stock, payables, property etc). The concepts of capital/operational expenditure should be introduced in the definition of commercial activities in line with those adopted by the International Financial Reporting Standards. ESRB also suggests that treasury financing activities should be defined using the cash flow statement of the non-financial firm.

In the second paper, ESRB proposes a number of requirements on CCPs to ensure a high degree of certainty over the transferability and value of CCP collateral. It suggests that CCPs should only accept securities that are listed and publicly traded. The practice of using financial instruments issued by a clearing member and posting it as collateral by another member should either be limited or subject to higher haircuts. On the latter, the haircut should be designed in a way that minimises sudden and large increases in times of market stress (i.e. mitigate their pro-cyclicality). CCPs should also reduce their reliance on CRA ratings and start building their own internal risk models.

It is obvious that considerable preparation is still required for the European mandatory clearing regime, as we approach the “end of 2012”deadline. Analysing the impact of regulations from a macroprudential stance is a very useful contribution, helping us to better understand the impact of reforms.


ESAs consult on calculating capital at the conglomerate level

The European Supervisory Authorities (ESAs) published a Joint Consultation Paper on Draft Regulatory Technical Standards on the uniform conditions of application of the calculation methods under Article 6.2 of the Financial Conglomerates Directive (FiCOD) on 31 August 2012. Under FiCOD, entities in a financial conglomerate must ensure that the capital available at the conglomerate level is at least equal to its capital adequacy requirements.

The current text of CRR/CRD IV requires the ESAs to harmonise the three methods used to calculate the supplementary capital adequacy requirements at the level of the conglomerate:
  1. accounting consolidation- calculated on the basis on the consolidate position of the group
  2. deduction and aggregation method- based on the accounts of solo entities
  3. combination of methods - combination of method 1 & 2, where the use of either method alone would not be appropriate.
The draft RTS sets out uniform specifications across these three methods, in particular the transferability and availability of own funds and the coverage of deficit at financial conglomerate level. The draft RTS also specifies that multiple gearing and intra-group creation of own funds must be excluded when determining the capital available at the conglomerate level.

The consultation closes on 5 October 2012.


FSA prepares UK regime for the Short Selling Directive

The FSA published a consultation paper, Short selling regulation –Handbook changes (CP12/21), outlining the proposed changes to the FSA Handbook needed to implement the EU Short Selling Regulation (SSR) (EU 236/2012) which takes effect from 1 November 2012. This paper highlights those areas where Member State discretion still is applied (even though as a Regulation, SSR is automatically binding on Member States).

The consultation paper outlines the FSA’s approach when deciding whether to impose a temporary prohibition or restriction on short selling. The FSA intends to consider each case on its merits and to adopt a two part test under which it would intervene only if both:
  • the price fall in a financial instrument is, or may become, disorderly
  • the FSA believes that the restriction would prevent further disorderly decline in the price of the financial instrument.
What constitutes a “disorderly failure” will be based on a host of criteria such as the size of the fall, the nature of the price movements and the relative volumes of trading in the financial instrument on UK and other markets.

The consultation closes on 20 September 2012. The FSA will finalise any changes to the Handbook in light of responses and issue a policy statement probably in October.

In a separate development, ESMA issued a Statement - Short Selling Regulation Update, on 30 August 2012. The statement alerts market participants to ESMA’s forthcoming consultation on the market making and authorised primary dealer exemption notification under the SSR. The consultation should be published in mid-September and will outline the procedure to be followed by firms and regulators in dealing with notifications of intention to use the exemption.