On February 10, 2016, United States Commodity Futures Trading Commission (“CFTC”) Chairman Timothy Massad and European Commissioner for Financial Stability, Financial Services and Capital Markets Union Jonathan Hill announced an agreement (the “Agreement”) between their respective agencies for a common approach regarding the regulatory requirements for central clearing counterparties (“CCPs”) under the rules and regulations of their respective jurisdictions. The Agreement had long been sought by many market participants, and the absence of an agreement had created an impediment to cross-border clearing. When the Agreement is fully implemented, it will facilitate market participants in one jurisdiction choosing to clear through a CCP in either jurisdiction.
In the United States, CCPs are generally required to be registered with the CFTC as derivative clearing organizations (“DCOs”) and are subject to regulation as such. CCPs subject to the European Union (“EU”) regulatory regime (“EU CCPs”) must be authorized by the European Securities and Markets Authority (“ESMA”) under the European Market Infrastructure Regulation (“EMIR”). Importantly, in order to clear transactions for market participants that are based in the EU, non-EU CCPs must be recognized as equivalent by ESMA. Prior to any such recognition by ESMA, the European Commission must adopt an implementing act determining that the legal and supervisory arrangements in that non-EU jurisdiction impose legally binding requirements that are equivalent to the requirements in EMIR.
As part of the Agreement, the European Commission intends to propose an implementing act making an equivalence determination with respect to the CFTC’s rules for DCOs. As a result of this act, ESMA would be permitted to recognize DCOs as “equivalent”, such that DCOs can continue to serve market participants in the EU while complying with CFTC regulations for DCOs.1 In addition, a DCO determined to be “equivalent” by ESMA will be a “qualifying CCP” for purposes of the EU Capital Requirements Directive IV (“CRD IV”) and the EU Capital Requirement Regulations (“CRR”).2 As part of the Agreement, the CFTC and European Commission agreed that ESMA would determine that a DCO is “equivalent” only if the DCO’s rules provide that:
- for a clearing member’s proprietary positions (meaning positions held in the clearing member’s house account) in exchange-traded derivatives (i.e., futures and options on futures), the DCO must collect an amount of initial margin that assumes a hypothetical two-day liquidation period;
- the DCO’s initial margin models specifically include measures to mitigate the risk of procyclicality;3 and
- the DCO must maintain “cover 2” default resources (i.e., default resources that are sufficient to cover the default of its two clearing members to which the DCO has the largest exposure).
The specifics of these requirements should be set forth in the ESMA recognition decisions for each DCO. Importantly, these conditions will not apply to exchange-traded derivatives in agricultural commodities traded in the U.S. Requiring CFTC-registered DCOs to implement these rule requirements would represent a change from the current CFTC requirements for DCOs because, under CFTC rules:
- DCOs are required to collect initial margin from clearing members assuming a hypothetical one-day liquidation period on futures contracts (and options thereon);4
- although DCOs may include measures in the initial margin models to mitigate procyclicality risks, they are not specifically required to do so under the CFTC’s rules; and
- currently, DCOs that are not designated as systemically important by the U.S. Financial Stability Oversight Council and that are not involved in activities with a more complex risk profile are not required to maintain “cover 2” default resources.
As part of the Agreement, with respect to EU CCPs, the CFTC has indicated that it will propose a determination of comparability (i.e., a “substituted compliance” determination) as soon as practicable. This proposal should conclude that a majority of the EU requirements for EU CCPs are comparable to the CFTC’s rules for DCOs. Any such proposal would be subject to notice and public comment. Upon the finalization of this determination of comparability, EU CCPs will be permitted to comply with certain requirements under EMIR in lieu of complying with the CFTC’s requirements for DCOs. As such, EU CCPs that are registered as DCOs or are applying to become registered as DCOs may comply with EMIR requirements (in lieu of the CFTC requirements) and continue to be registered under, and be deemed to be in compliance with, the CFTC’s regulations for DCOs.5 The Agreement also indicates that the CFTC will propose rules that would streamline the registration process for EU CCPs seeking to register with the CFTC as DCOs.
As part of the Agreement, the European Commission and the CFTC agreed to monitor for issues regarding potential regulatory arbitrage between CFTC-registered DCOs and EU CCPs. In addition, the European Commission and the CFTC agreed to take steps to permit EU market participants to clear trades through CFTC-registered DCOs to satisfy the mandatory central clearing requirements under EMIR. Under EMIR, the requirements for central clearing of interest rate derivative contracts will not take effect until June 21, 2016; the European Commission and CFTC anticipate that DCOs will be in a position to be recognized by ESMA by that date.
In addition, the Agreement notes that ESMA recently consulted with EU CCPs on the possibility of EU CCPs complying with client margining standards that are similar to the CFTC’s requirements. The European Commission stated that this issue should be addressed rapidly in order to avoid regulatory arbitrage between DCOs and EU CCPs.
Finally, in the Agreement, the European Commission and CFTC agreed that each of their respective regulatory regimes for CCPs has a “high degree of similarity.” However, the Agreement indicates that “the CFTC staff and the European Commission Services believe that there is scope to expand the range of, and add further detail to, the international principles in this area.”
In a statement on the Agreement, Chairman Massad hailed it as “a significant milestone in harmonizing regulation of our derivatives markets.” Chairman Massad noted that the Agreement “comes after detailed and careful analysis to determine how best to reach a common approach” and highlighted that the “analysis showed that, with respect to customer accounts, U.S. requirements typically result in more margin being available at the CCP to protect against losses.” CFTC Commissioner J. Christopher Giancarlo also issued a statement with respect to the Agreement noting his support of it. Commissioner Giancarlo explained that the Agreement “avoids unacceptable changes to four decades of U.S. clearinghouse margin policy and higher costs of hedging risk for America’s farmers, ranchers, financial institutions, energy firms and manufacturers.” In addition, Commissioner Giancarlo expressed the opinion that the dispute solved by the Agreement was prompted by the “massive regulatory overreach[ing]” of the previous CFTC administration. Commissioner Giancarlo concluded that the world “must reduce regulatory uncertainly and political risk in world financial and derivatives markets in order to foster a return to global economic growth and prosperity.”