On December 13, 2013, the Federal Council presented a first bill for consultation for a new Financial Market Infrastructure Act (“Pre-draft FMIA“) that shall implement both, the G-20 obligations and the recommendations of the Financial Stability Board on over-the-counter (OTC) derivatives trading. The new law also aims to secure EU market access by the implementation of a regulation that is equivalent to that in the EU.
The Pre-draft FMIA proposes a new legal framework for derivative transactions and, in particular, imposes clearing, reporting, risk mitigating as well as trading obligations not only on regulated financial institutions but also on all other financial and non-financial entities that enter into derivative contracts. While a certain level of harmonization with the European Market Infrastructure Regulation (“EMIR“) is intended, the Pre-draft FMIA deviates from the EMIR on important aspects.
The new FMIA is expected to enter into force within the first half of 2015.
Who is in caught under the FMIA?
The Pre-draft FMIA imposes certain obligations on all legal entities domiciled in Switzerland (including their foreign branches) that enter into (i.e. are a counterparty to) derivative contracts (“Counterparties“).
Small market participants may benefit from certain exemptions under the Pre-draft FMIA, if they either qualify as a small financial Counterparty or as a small non-financial Counterparty (see below)
What does the FMIA require?
Counterparties are subject to the following four obligations (which are described in more detail below):
Transaction has to be cleared through a central counterparty (“CCP“)
- Not applicable, if at least one Counterparty is a small market participant
- Applies only to standardized contracts
- Clearing by a recognized foreign CCP is deemed equivalent
- Intragroup transactions are exempt
Conclusion, modification and termination of transaction have to be reported to a trade repository
Risk mitigation obligation
Risk mitigation measures have to be taken
- Not applicable, if clearing obligation applies
Value of outstanding contract has to be marked-to- market on a daily basis
Small market participants are exempt
The parties have to exchange adequate collateral
- Small non-financial market participants are exempt
- Intragroup transactions are exempt
Obligation to trade over a platform
Derivatives have to be traded over a recognized platform
Will not become effective before no such obligation exists under EU regulation
Who qualifies as a small market participant?
The Pre-draft FMIA divides Counterparties into two categories: financial Counterparties and non-financial Counterparties. The distinction plays a role insofar as a small market participant is defined for each of these two categories differently. Small market participants are exempt from certain obligations under the FMIA.
(Small) financial Counterparties
The following legal entities are considered to be financial Counterparties: (i) banks, securities traders, insurance and reinsurance companies, parent companies of a financial group or an insurance group; (ii) entities that are regulated pursuant to the Federal Collective Investment Schemes Act (including, inter alia, fund managers and asset managers of collective investment schemes); and (iii) pension funds and investment foundations pursuant to the Federal Law on Occupational Retirement.
A financial Counterparty qualifies as a small financi- al Counterparty, if it enters into OTC derivative contracts for the sole purpose of hedging risks resulting from mortgage-transactions directly entered into with its clients, provided that the rolling average gross positi- on of such OTC derivative transaction is below a certain threshold (see def. below).
(Small) non-financial Counterparties
All other legal entities are considered to be non-financial Counterparties (e.g. industrial, commercial, service enterprises).
A non-financial Counterparty qualifies as a small non-financial Counterparty, if their outstanding OTC derivative contracts have a rolling avera- ge gross position below a defined threshold (see def. below). Derivatives transactions for purposes of reducing risks (hedging) are not included in the calculation of such positions if they are directly connected to the business activity or the liquidity or financial management of the relevant Counterparty or the group.
The level of the relevant thresholds and calculation methods will be determined by the Federal Council in one of its ordinances for each derivative category separately. A threshold is not deemed to be met if the relevant level has not been reached during a 30 day period, provided that such level has not been excee- ded within the four preceding months. Positions of fully consolidated group entities are to be aggregated. The threshold is deemed to be exceeded if the rolling average gross position is above the threshold during 30 consecutive days. If the threshold is exceeded, the Counterparty will become subject to the relevant obligation with regard to all derivative contracts of any category.
It remains to be seen whether the Federal Council sets the relevant thresholds at a EU level, which is at EUR 1 billion for credit and equity derivatives, and at EUR 3 billion for interest rate, foreign exchange and commodity derivatives. As long as we have no certainty in this regard, Counterparties may make preliminary assessments on the basis of the EU thresholds, since it is unlikely that the thresholds for Switzerland will be higher than those applicable under the EU regulation.
What obligations have to be fulfilled by whom?
The Pre-draft FMIA imposes the following four obligations on Counterparties:
The Swiss Financial Market Supervisory Authority FINMA (“FINMA") will specify the types of derivatives that are subject to the clearing obligation (a certain degree of standardization and liquidity will be required). Such derivative contracts have to be cleared through a CCP authorized or recognized by FINMA. In contrast to EMIR, the clearing obligation also applies to derivative contracts traded over a stock exchange.
Basically, the clearing obligation applies if both parties to the derivative contract are Counterparties. In cross-border transactions, also the foreign party to the derivative contract is considered as Counterparty, if it were subject to the clearing obligation, would it be domiciled in Switzerland.
The clearing obligation does not apply if at least one party to the derivative contract is either a small financial or a small non-financial Counterparty. Further, the clearing obligation is deemed to be fulfilled if cle- aring is effected by a CCP that is subject to foreign regulations which have been recognized by FINMA. Finally, intragroup transactions are exempt from the clearing obligation if, inter alia, both Counterparties are subject to the same full consolidation.
Counterparties have either access to a CPP if they are direct clearing members or if indirect access to the CPP is granted to them through the direct clearing members.
Counterparties and CCPs have to report the details of a derivatives contract upon conclusion, modification or termination of the contract to a trade repository authorized or recognized by FINMA. The information is collected by the trade repository and published in anonymized form.
The reporting obligation applies to all Counterparties as well as to CCPs. Intragroup transactions are not exempt from the reporting obligation. The reports shall specify at least: the parties to the contract (as opposed to EMIR, not the beneficiary) as well as the main characteristics of the contract, such as its type, the due date, notional value, price, settlement date and currency. The reporting may be delegated to a third party.
A Swiss Counterparty (in particular a Swiss bank) may be asked by its foreign counterparty that is subject to foreign reporting regulation to report a transaction to a foreign trade repository. While such a reporting is ge- nerally permitted, no personal data must be reported to the foreign trade repository without the consent of the person involved.
The risk-mitigation obligation applies if the derivatives contracts do not have to be cleared by a CCP (see above “clearing obligations“; e.g. if one party is a small financial or a small non-financial Counterparty; or in intragroup transactions).
The risk-mitigation obligation is threefold:
- Mitigating the operational risk. Each Counterparty has to ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risks and counterparty credit risks, including in particular (i) the timely confirmation of the terms of the relevant derivative contract; and (ii) adequate processes to reconcile portfolios, to manage the associated risk, to monitor the value of outstanding contracts, and to identify disputes between parties early and resolve them.
- Valuation of outstanding contracts. Each Counterparty, except for a small financial or a small non-financial Counterparty, has to mark-to-market on a daily basis the value of outstanding contracts. Where market conditions prevent marking-to-market, valuation models have to be used that are adequate and recognized in the industry.
- Exchange of collateral. Each Counterparty, except for a small non-financial Counterparty, has to exchange appropriate collateral (margins) with the other Counterparty. Intragroup transactions are exempt, provided that certain requirements are met, inter alia: There must be no burden (neither legal, nor factual) to the immediate transfer of capital or repayment of liabilities by the relevant affiliates – a requirement that may be difficult to fulfill in practice.
Obligation to trade over a platform
The Pre-draft FMIA provides for an obligation to tra- de all derivatives that have to be cleared by a CCP (i.e. each transaction that is subject to a “clearing obligation“; see above) over a platform authorized or recognized by FINMA. however, the obligation to trade over a platform will not become effective before such obligation has not been implemented under the applicable EU regulation (MiFID II/MiFIR).
Are there any penalties?
A violation of any of the four obligations set out above may be punished by a fine of up to 500,000 Swiss francs (in case of intent) and up to 250,000 Swiss francs (in case of negligence). In addition, regulated Counterparties (i.e. most of the financial Counterparties) may become subject to enforcement by FINMA in case of a violation of the obligations imposed on them by the FMIA.
What should I consider?
As set out above, some of the obligations imposed by the Pre-draft FMIA on Counterparties do not have to be fulfilled by small market participants. In particular, a small-non financial Counterparty only has a reporting obligation and an obligation to mitigate the operational risk.
Since the relevant thresholds are still to be determined by the Federal Council, various companies (in particular small- and mid-sized firms) may not be able to assess yet whether they can benefit from the exemptions.
However, on the basis of the thresholds applicable under the EU regulation (see above) at least a rough assessment can be made. As mentioned, derivative contracts used for hedging purposes that are directly connected to the business activity or the liquidity or financial management of the relevant Counterparty or the group can be deducted.
In order to fulfill the obligation to mitigate the operational risk, a Counterparty should at least have the implementation of the relevant internal procedures on its corporate agenda. Further, each Swiss entity using derivative contracts should in particular ask itself:
- Would I be considered as a small financial or small non-financial Counterparty if thresholds will apply that are similar to the EU thresholds?
- Do I have a system in place for assessing on a daily basis whether a certain threshold has been reached?
- Do I have the required procedures in place to measure, monitor and mitigate operational risks and counterparty credit risks?
- Can collateral be provided under my derivative contracts?
- Do I have sufficient collateral available?
- Will I enter into intragroup derivative transactions?
As mentioned, the new regulation is expected to enter into force within the first half of 2015. The Federal Council will have to determine whether the new rules will also apply to derivative transactions that are outstanding at the time of the entering into force of the new law.