This update considers some of the common areas of negotiation when putting in place clearing arrangements with clearing members in the European Union and some of the different positions on these points.
Following the G20 commitment to implement measures to increase transparency and reduce counterparty credit risk and operational risk in the derivative markets, the European Commission introduced a new EU regulation on over-the-counter (OTC) derivatives, central counterparties and trade repositories, also known as the European Market Infrastructure Regulation (EMIR). EMIR introduced clearing obligation and risk mitigation techniques for certain derivative contracts, trade reporting, registration, financial and risk management requirements for clearing organisations and new trade execution requirements.
Under Article 4 of EMIR, all financial counterparties, as well as non-financial counterparties which have derivative positions (excluding transactions concluded for hedging purposes) for a global notional amount above the clearing thresholds set out by EMIR, will have to clear (subject to the intra-group exemption) OTC derivative transactions that are within a class of OTC derivatives which the European Securities and Markets Authority (ESMA) has declared to be subject to mandatory clearing. The relevant derivatives transaction must then be cleared through various central counterparties concluded by the client in the OTC market or on any multilateral or other trading facility.
The clearing obligation in respect of certain classes of interest rate products became effective on June 21 2016 for clearing members and will become effective on:
- December 21 2016 for financial counterparties and alternative investment funds which are non-financial counterparties with derivative positions which in each case are not in the previous category, but belong to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for January, February and March 2016 is above €8 billion;
- June 21 2017 for financial counterparties and alternative investment funds which are non-financial counterparties with derivative positions which in each case are not in the above categories; and
- December 21 2018 for non-financial counterparties with derivative positions which are not in any of the above categories.
Where a derivative contract is concluded between two counterparties in different categories, the date from which the clearing obligation takes effect is the latest date.
The International Swaps and Derivatives Association, Inc (ISDA) has published the ISDA/Futures and Options Association (FOA) Client Cleared OTC Derivatives Addendum, which is a market standard document in Europe available to counterparties and their clearing members as a basis for drafting their clearing arrangements.
The clearing member will have no obligation to accept eligible transactions for clearing, but the client should be able to rely on approved trading limits. The clearing arrangements will provide that the clearing member has no obligation to consent to the clearing of transactions submitted by the client. This principle will hardly be negotiable; however, it may and should be mitigated by an agreement by the clearing member to accept, or to make a good-faith and commercially reasonable attempt to accept, transactions for clearing, provided that such acceptance would not result in any approved credit, product, position, trading or other limits being exceeded. Furthermore, in case the clearing member is allowed to decide the reduction of the clearing limits, such right should be subject to prior written notice and should apply only to transactions submitted by the client on or after the effective date of such notice ? that is, if the effect of a reduction in the clearing limits is to render existing transactions accepted for clearing by a central counterparty and cleared through the clearing member before such effective date in breach of the reduced clearing limits, the client shall be under no obligation to reduce or close out any such cleared transactions to remedy the breach.
The considerations set out above in relation to the consequences of reduced clearing limits on cleared transactions apply equally to any other discretionary right of the clearing member to terminate clearing services in relation to a central counterparty or a central counterparty service. It is of concern to some clients that where the clearing member is allowed to terminate clearing services in relation to transactions already accepted for clearing by the clearing member, there is an argument that any right to terminate the clearing services in relation to a central counterparty should apply only to transactions submitted by the client for clearing after the effective termination date. As a fallback, sufficient prior notice is requested to allow the client time to attempt to transfer the existing transactions affected by the termination of the clearing services by the clearing member to another clearing member of the central counterparty.
Porting by the client of its transactions to or from the clearing member to or from another clearing member of the relevant central counterparty should be subject to limited conditions.
'Porting' is the process whereby positions and margin of the client registered with a central counterparty are transferred from one of its clearing members to another clearing member of the central counterparty. In case of default by its clearing member, the benefit of porting (as compared to a close-out and distribution by the central counterparty) is that the client can potentially continue to trade with its back-up clearing member (ideally as it did under the original cleared derivatives transaction). Timely post-default porting could substantially reduce the costs, risks and disruptions that the client may incur as a result of the failure of its clearing member.
Under the clearing arrangements, the clearing member and the client will agree the conditions to be complied with in order for the client to be allowed to require the clearing member to:
- transfer a cleared transaction to another back-up clearing member; or
- act as back-up clearing member for the transactions of the client cleared through another clearing member of the central counterparty.
From the perspective of a client, ideally those transfer conditions and the notice period shall be as limited as possible, since porting of transactions will be very important for the client in a number of situations, including where the clearing member or other clearing member has been declared in default by the relevant central counterparty (as pointed out above), but also in any of the following circumstances:
- The clearing member or other clearing member decides on a reduction in clearing limits, which not only applies to future transactions submitted for clearing to the clearing member or the other clearing member, but also affects existing transactions cleared through the clearing member or other clearing member, which means that the client must terminate or transfer those existing transactions affected by reduced clearing limits;
- The clearing member or other clearing member has the right (and exercises its right) to terminate clearing services for a given central counterparty or central counterparty service, including in respect of existing transactions cleared through such central counterparty or central counterparty service. During the notice period preceding the termination date notified by the clearing member or other clearing member, as applicable, the client should then be entitled to transfer the relevant transactions to another clearing member acting as the back-up clearing member; or
- The clearing member or other clearing member (as applicable) is in breach of its obligations under existing transactions, but has not been declared as a defaulted clearing member by the relevant central counterparty. Under the ISDA/FOA addendum, the client will not be entitled to terminate the transactions with the defaulting clearing member until the central counterparty has formally declared that the clearing member is in default; in the meantime, the client may want to transfer those transactions to the back-up clearing member without waiting until the central counterparty's formal declaration has been made.
The initial margin will be posted by the client. The clearing member will calculate the amount and type (cash or securities) of margin required at any time in respect of the cleared transactions, and in accordance with the terms of the clearing arrangements and rules of the relevant central counterparty. The margin requirements relating to initial margin may be in excess of the total amount of initial margin required by the relevant central counterparty.
While the requirements for excess margin (also known as the 'additional collateral amount') are market practice, as this is used as a cushion by the clearing member to cover the risk resulting from mismatches in the timing for intra-day transfers of margin by the client to the clearing member and by the clearing member to the central counterparty, the amount of excess margin is more a question of negotiation. This can range from a maximum percentage of the amount of initial margin expected to be received by the relevant central counterparty to an amount determined by the clearing member in its discretion.
In particular, provisions allowing the clearing member to increase excess margin requirements should be carefully considered. For example, clients often will argue that such right should not be at the absolute discretion of the clearing member, but should be subject to a sufficient prior notice and a cap amount (which is also expressed as a percentage of the initial margin amount required by the relevant central counterparty).
The client will need to consider how the requirements of the central counterparties relating to eligible collateral posted by the clearing member will affect compliance with its own obligations to transfer margin to the clearing member.
The types of collateral that the clearing member is permitted to post to a central counterparty and the haircuts that the central counterparty applies to certain types of collateral will necessarily affect the margin requirements at the level of the client.
The client should first check the extent to which the clearing member requirements applicable to the transfer of margin by the counterparty are more onerous than the requirements of the central counterparty for the transfer of margin by the clearing member to the central counterparty. If there are differences, the basis and reasons for such differences should be discussed with the clearing member.
Furthermore, the client may not have the types of assets that would be considered eligible collateral by the central counterparty. To solve this issue the clearing member may offer collateral transformation services which allow the client to post to the clearing member ineligible assets that do not meet the central counterparty eligibility standards, and swap them for eligible assets which can then be posted by the clearing member on to the central counterparty. An assessment should be made of the cost of this service when compared with potential collateral transformation options which its internal treasury departments or its custodians may also provide.
The valuation by the clearing member of transactions and collateral assets for the purpose of determining margin requirements should reflect the valuations of the central counterparty.
To reduce mismatches relating to cash flows between the client and the clearing member on one side, and cash flows between the clearing member and the central counterparty through which transactions are cleared on the other, the clearing arrangements should provide as follows:
- The calculation by the clearing member of the variation margin amount for transactions cleared through a central counterparty (ie, the valuation of those transactions) will reflect the calculation by the central counterparty of the variation margin amount for those transactions. If the clearing arrangements are documented on the basis of the ISDA/FOA addendum, it means that the option 'central counterparty exposure matching' will be selected with respect to the relevant central counterparty; and
- The valuation by the clearing member of the assets transferred by the client as collateral (whether in respect of initial margin or variation margin) in relation to transactions cleared through a central counterparty will reflect the valuation by the central counterparty (if any) of such collateral assets. If the clearing arrangements are documented on the basis of the ISDA/FOA addendum, then the option 'central counterparty valuation matching' will be selected with respect to the relevant central counterparty.
The collateral assets transferred by the client to the clearing member pursuant to margin requirements will be used in turn by the clearing member to comply with margin requirements by the central counterparty (in respect of the transactions cleared through such central counterparty). Following a default by the clearing member, the entitlement of the client to receive from the central counterparty (in respect of the transactions cleared through the central counterparty) the collateral assets registered in the account of the clearing member held at the level of the central counterparty (in respect to the transactions) will depend on whether such account of the clearing member is an individual segregated client account or an omnibus segregated client account.
Omnibus segregated client account
Individual segregated client account
Records both assets and transactions that relate to the client and the assets and transactions that relate to other clients of the clearing member.
Records only assets and transactions that relate to the client.
Assets that are provided to the central counterparty as collateral for transactions recorded in the account may be used only to cover any losses in that account, whether such losses pertain to the transactions relating to the client or transactions relating to another client of the clearing member.
Assets that are provided to the central counterparty as collateral for transactions recorded in the account may be used only to cover losses in that account.
The central counterparty may not know which transactions and assets recorded in the account relate to the client.
The central counterparty will know that all the transactions and assets recorded in the account relate to the client.
The value of the assets that relate to transactions of the client could be reduced because the assets posted in relation to transactions of the other clients of the clearing member have decreased in value.
The value of the assets that relate to transactions of the client cannot be reduced because the assets posted in relation to transactions of the other clients of the clearing member have decreased in value.
There is a significant risk that transfer to another clearing member of the central counterparty will not be achieved for positions and assets that are recorded in the account and relating to the client.
If the client has complied with all of the conditions required by the central counterparty and the back-up clearing member, transfer to the back-up clearing member of the central counterparty is more readily facilitated for positions and assets that are recorded in the account and relate to the client, in the event of a default of the clearing member.
While an individual segregated client account is preferable for the client from a legal risk perspective, there are often associated costs. An analysis will thus need to be made of the potential cost savings against the legal risk involved.
The clearing member may offer netting services to the client. Where the client clears its transactions with a variety of base currencies, the clearing member may offer the option to convert its multi-currency variation margin requirements into a single selected currency per central counterparty. The client may then be given the option to pool these different variation margin requirements across central counterparties into a single aggregated margin call.
The clearing member may also offer further options which net margin, settlements, fees and commissions into a single requirement for all transactions per central counterparty (or for all transactions and central counterparties), where calls are reported and met daily in one movement, rather than each individual item being reported and met separately. This significantly reduces the number of cash movements, which ? in addition to reducing costs ? significantly mitigates operational risk.
The client should consider the variety of netting services offered by the clearing member and the central counterparties, as well as the fees associated with such services.
The clearing member will want to include provisions about limited recourse and limitation of liability, including provisions stating that:
- performance and payment of its obligations by the clearing member to the counterparty under cleared transactions are limited by, and contingent on, actual performance or payment by the relevant central counterparty to the clearing member under such cleared transactions; and
- the clearing member shall have no liability to the client for losses incurred by the client in relation to:
- performance or non-performance by the relevant central counterparty;
- breakdown or delay of any system used by the central counterparty or the clearing member; and
- actions that the clearing member takes or fails to take for the purposes of compliance with the rules of the central counterparty or applicable law relating to cleared transactions which are market practice and reflect the 'riskless' nature of the intermediary role of the clearing member.
However, there are often negotiations over the circumstances in which such limitations of liability shall not apply (eg, in the case of fraud, wilful default, negligence or breach of the central counterparty rules by the clearing member).
The clearing member will want to include indemnity provisions and will require the client to indemnify it for losses incurred in relation to transactions, including as a result of:
- the client's breach of the clearing arrangements or the relevant central counterparty rules; or
- any action or inaction by the clearing member in reliance on instruction originating from the client.
The principle of an indemnity undertaking by the client is standard. This being said, as with any limitation of liability, clients will often look to limit the scope of this indemnity. Circumstances in which this arises include:
- recovery of indemnity by the clearing member being excluded for the contributory negligence, bad faith or wilful default of the clearing member; or
- indemnity provisions relating to losses incurred by the clearing member in relation to the actions of third parties other than the central counterparty being drafted as narrowly as possible, since the client has no control over third parties and may have to compensate the clearing member for the costs of investigating and defending a regulatory or legal claim from a third party, even if the client has done nothing wrong or the claim turns out to be baseless.