The European Securities and Markets Authority (ESMA) has published its final report containing the final draft of regulatory technical standards (RTS) for the central clearing of credit derivatives under Regulation No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR). The report follows from ESMA’s consultation on a first version of the draft RTS.

The European Commission has up to three months from the date on which ESMA submitted the final fdraft RTS to endorse them. Provided that there is no objection from the European Parliament and the Council, the RTS will enter into force and become effective 20 days after their publication in the Official Journal of the European Union (OJEU).

Classes of credit derivative subject to the clearing obligation

EMIR introduces the obligation to clear certain classes of OTC derivatives with central counterparties. Credit derivatives are the second class of OTC derivatives to be submitted by ESMA to the European Commission following the draft RTS submitted in relation to interest rate swaps[1]. ESMA proposes that two classes of credit derivative are made subject to central clearing:

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ESMA has determined that the above credit derivative classes are suitable for clearing in keeping with the underlying objectives of EMIR following consultation and an analysis of all credit derivative classes that are currently offered for clearing by central counterparties (CCPs) authorised or recognised in the European Union.

Implementation schedule

The final draft RTS provide an implementation schedule to market participants for whom central clearing of the defined IRS classes will become mandatory. ESMA distinguishes four categories of market participants and envisages the following phase-in periods for each of them:

  • Category 1 (Clearing members): will start centrally clearing credit derivatives that are subject to the clearing obligation nine months after the RTS enter into force.
  • Category 2 (Financial counterparties (FCs) and alternative investment funds (AIFs) that are non-financial counterparties above the clearing threshold (NFC-s) which, in each case, are not included in Category 1 and which belong to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives over a certain three-month period is above €8 billion): This category will start centrally clearing credit derivatives subject to the clearing obligation 15 months after the RTS enter into force.
  • Category 3 (FCs and other AIFs which are not included in Category 1 or 2): will start centrally clearing credit derivatives subject to the clearing obligation 21 months after the RTS enter into force.
  • Category 4 (NFC-s not included in Categories 2 and 3): will start centrally clearing credit derivatives subject to the clearing obligation three years after the RTS enter into force.

Implications for UCITS

The RTS do not resolve concerns regarding the implications for credit derivatives subject to the clearing requirements entered by a UCITS.  

Applicable regulations prohibit UCITS from acquiring loans. Under standard CDS contracts physical delivery is a possible fallback settlement method (resulting in the delivery of a loan at settlement of the transaction). If the standard terms of a CDS apply, a UCITS may be obliged to accept delivery of, or itself deliver, a loan in conflict with its obligations under the UCITS Directive. In order to prevent this, the terms of transactions to which a UCITS is party generally contain a clause that prevents the UCITS from receiving or being obliged to deliver loans. ISDA has published additional provisions relating to credit derivative transactions with a restricted delivery party where physical settlement applies which is used by UCITS and their counterparties (a Restricted Delivery Party Clause).

CDS transactions entered by UCITS also typically contain a unilateral right for the UCITS to terminate the transactions at fair value at any time.  The requirement for this provision is contained in Article 50.1(g)(iii) of the UCITS Directive which requires that OTC derivatives “can be sold, liquidated or close by an offsetting transaction at any time at their fair value at the UCITS’ initiative” (an Early Termination Clause). 

Respondents to the Consultation Paper suggested a number of ways around this potential conflict between the UCITS Directive and EMIR, including excluding transactions with either a Restricted Delivery Party Clause or and Early Termination Clause from the clearing obligation or encouraging CCPs to accept transactions with such clauses. It was also suggest that national competent authorities are encouraged to allow UCITS to accept or deliver loans.

Although ESMA acknowledges that steps must be taken in order to ensure that UCITS are able to comply with both the general obligations under EMIR and UCITS specific requirements, its focus under EMIR is on identifying which classes of derivative should be cleared “rather than modifying specific requirements applicable to certain counterparties”. The issue therefore remains live and UCITS will carefully monitor how the clearing obligation for credit derivatives develops.

Next steps

All market participants captured by the RTS will need to put in place appropriate clearing arrangements as soon as possible and in any event before the relevant phase-in period ends.

Further consultation papers and reports are likely to be published in due course in respect of other asset classes.