ESMA Consults on Counterparty Risk Calculation Methods for UCITS Subject to Clearing

ESMA has launched a consultation on the calculation of counterparty risk by UCITS which enter into OTC derivative transactions which need to be centrally cleared under EMIR.

Counterparty risk exposure limits

The UCITS Directive allows UCITS to invest in both exchange-traded derivatives (ETDs) and OTC derivatives. However, only investments in OTC derivatives are subject to counterparty risk exposure limits (5% of the assets of a UCITS or 10% when the counterparty is a credit institution).

Under EMIR, certain OTC derivative transactions will become subject to clearing obligations. ESMA is seeking stakeholders’ views on how the limits on counterparty risk in OTC derivative transactions that are centrally cleared should be calculated by UCITS and whether the same rules for both OTC transactions that are centrally cleared and ETDs should be applied by UCITS.

Clearing arrangements

The consultation distinguishes between different clearing arrangements. For each of those clearing arrangements, ESMA analyses the impact of a default of the clearing member and the client for the calculation of the counterparty risk by UCITS.

The clearing arrangements referred to in the consultation are as follows:

  • Direct Clearing Arrangements
    • Individual client segregation
    • Omnibus client segregation
    • Other types of segregation arrangement
    • Segregation arrangements with a non-EU CCP outside the scope of EMIR
  • Indirect Clearing Arrangements

Next steps

The deadline for submission of comments is 22 October 2014. ESMA will use the feedback received from the public consultation to determine its final views on the appropriate way forward, including a possible recommendation to the European Commission on a modification of the UCITS Directive.

It should be noted that all responses will be published on ESMA’s website, unless otherwise requested. As a result, commercially confidential information should not be included in responses to the consultation.

Frontloading update

In our previous article EMIR update: frontloading backdated we highlighted ESMA’s letter to the European Commission which sought the Commission’s views on a proposed phasing-in of the EMIR frontloading requirement. The frontloading requirement is the obligation to clear OTC derivative contracts entered into after a central counterparty has been authorised under EMIR and before the date of application of the clearing obligation. The phasing-in was suggested with a view to providing legal, operational and financial certainty to the market. The concern highlighted by ESMA was to ensure that market participants were not, with a view to avoiding consequences of frontloading, disincentivised from hedging.

In short, ESMA’s letter suggested that trades entered into during the time between authorisation of a CCP and the entry into force of regulatory technical standards (RTS) on the clearing obligation be excluded from the frontloading obligation. Similarly, trades which have 6 months or less to maturity and which were entered into following the time the relevant RTS came into force were suggested as being out of scope.

On 8 July, ESMA received a response from the Commission which indicated its agreement with ESMA’s proposal. The Commission, however, did not indicate its views on the manner in which frontloading could be introduced. That being said, it did recognise the challenges in implementing frontloading correctly and the importance of legal certainty for market participants in the absence of finalised RTS. Also it considered that the “determination of remaining maturities should be carefully assessed and duly motivated”.

The Commission’s letter would therefore appear to support the earlier ESMA proposals and it is now unlikely that these will change.

Consultations on the clearing obligation

ESMA has launched a first round of consultations to prepare for centralised OTC clearing. The separate consultation papers seek views on RTS for the clearing of interest rate swaps (IRS) and credit default swaps (CDS).  The IRS consultation is open until 18 August 2014 and the CDS consultation until 18 September 2014. ESMA will then prepare final RTS on the clearing obligation for IRS and CDS for endorsement by the European Commission. The clearing obligation will take effect following a phased implementation, with the current proposal ranging from six months to three years (depending on the types of counterparties concerned) following the entry into force of the RTS.

Updated Q&A

On 23 June and on 9 July ESMA published updated Q&A on the obligations arising under EMIR.

The 23 June Q&A focuses on reporting and, in particular provides advices in relation to the reporting of collateral and valuations (including details relating to the categorisation of valuations as mark-to-market or mark-to-model, how to report contracts with no maturity date, how to report on OTC derivatives novations and how to report on outstanding positions following the entry into force of the backloading obligations). Importantly, this set of Q&A emphasises that counterparties who delegate reporting nonetheless remain responsible for the accuracy of reporting. The Q&A also provides that delegating counterparties are responsible for periodically ensuring that they are in agreement with the reports submitted on their behalf.

The 9 July Q&A focuses on segregation and the obligations of third country entities using EU CCPs. Specifically, it confirms that Article 39 must be adhered to in the context of each clearing member’s clients. It is, therefore, irrelevant if a clearing member client is EU or non-EU based. Clearing members must, therefore offer clients an option between individual and omnibus segregation and advise of the costs and level of protection associated with each option. Furthermore (in the context of a third country insolvency regime which may adversely affect omnibus or individual segregation obligations) ESMA considers that the clearing member should offer its clients alternative possibilities for segregation. This would be with a view to ensuring clients receive, at the very least, a choice between omnibus client segregation and individual client segregation with, where appropriate alternatives including clearing solutions provided by another clearing member of the CCP.