While a part of the derivatives market is already cleared through central counterparties at present, the Swiss regulation of derivatives transactions under the Financial Market Infrastructure Act introduces now a clearing obligation for certain OTC derivatives in line with international commitments.
The clearing obligation for OTC derivatives (i.e. derivatives transactions not traded on an exchange or multilateral trading facility) through central counterparties (CCPs) implements the policy goal of concentrating counterparty credit risk with CCPs and thereby limiting contagion risk in the event of a failure. This constitutes one of the key objectives of the post-crisis regulatory reform of derivatives markets besides a push for increased transparency, which was implemented with the obligation to report OTC derivatives and exchange-traded derivatives (ETDs) to trade repositories, and the introduction of risk mitigation measures for OTC derivatives not cleared through CCPs. One of these risk mitigation measures was the introduction of bilateral margin requirements for uncleared OTC derivatives transactions (see our newsletter of March 2017).
Under the Swiss Financial Market Infrastructure Act (FMIA), the legislator gave the Swiss Financial Market Supervisory Authority (FINMA) the competence to determine which OTC derivatives must be cleared through CCPs. FINMA defined the criteria for making such determination in its Financial Market Infrastructure Ordinance (FINMA-FMIO) by referring, inter alia, to the liquidity of the derivatives market and the degree of standardization of the documentation and the operational processes. FINMA now amends the FMIA-FMIO as of 1 September 2018 by specifying the types of OTC derivatives that will fall into the scope of the clearing obligation. With its determination, FINMA mirrors the EU rules in place under European Market Infrastructure Regulations (EMIR) by specifying that certain interest rate derivatives and credit derivatives fall into the scope of the clearing obligation.
2 Affected Parties
The Swiss clearing obligation will only apply to transactions entered into between large Financial Counterparties (FCs) and/or large Non-Financial Counterparties (NFCs).
FCs include regulated entities subject to prudential supervision such as banks, broker-dealers, insurance and re-insurance companies, parent companies of bank and insurance groups, fund management companies, asset managers of collective investment schemes, collective investment schemes and pension funds. As opposed to the EU rules under EMIR, the Swiss clearing obligation will only apply to large FCs (FC+), which is determined by reference to a threshold of CHF 8 bn. The calculation is made by reference to the aggregate notional amounts of outstanding OTC derivatives (average gross positions, calculated over 30 working days) including derivatives of all asset classes and aggregating the positions of all group companies that are FCs. The calculation includes also hedging transactions, but it excludes physically settled FX forwards and swaps and certain commodity derivatives carved-out from the derivatives regulation generally.
NFCs are all undertakings not qualifying as FCs. The status of a large NFC (NFC+) is determined, in the same way as under the rules of EMIR, by reference to five separate thresholds per asset class, i.e. (i) CHF 1.1 bn for credit derivatives, (ii) CHF 1.1 bn for equity derivatives, (iii) CHF 3.3 bn for interest rate derivatives, (iv) CHF 3.3 bn for FX derivatives and (v) CHF 3.3 bn for commodities and other derivatives. To the extent that an NFC exceeds one of these thresholds, it is a large NFC for all derivatives it enters into. The calculation is done by reference to aggregate notional amounts of outstanding OTC derivatives according to the same principles as set out above for FCs, except that hedging transactions are not included in the calculation. For this reason, only very few NFCs qualify as large NFCs.
"The Swiss clearing obligation will only apply to transactions entered into between large FCs and/or large NFCs."
3 Clearing before implementing swiss rules
3.1 Market share
Clearing of OTC derivatives is already in place today. According to the statistical data of the Bank for International Settlements (BIS), the share of centrally cleared OTC derivatives is measured by notional amounts - about 75% for interest rate derivatives, 55% for credit default swaps and 2% for FX derivatives as at the end of 2017 (https:// www.bis.org/publ/otc_hy1805.htm).
LCH SA from France and Eurex Clearing AG from Germany) and the recognition of further CCPs is pending (including CME Inc. and ICE Clear Credit LLC from the US and ICE Clear Europe from the UK).
Even without a FINMA recognition, a foreign CCP may provide indirect clearing services to Swiss counterparties clearing derivatives transactions voluntarily through a foreign clearing member. However, the FINMA recognition of foreign CCPs was a prerequisite for the implementation of the clearing obligation under the FMIA, because the clearing obligation can only be introduced in respect of a type of derivative contract that may be cleared through a CCP that is authorised or recognised by FINMA.
3.3CONTRACTUAL SET-UP When clearing OTC derivatives through a CCP, the derivative contract is still entered into bilaterally between two parties to a derivative contract (e.g. two parties to an ISDA Master Agreement). However, when the trade is accepted for clearing, it is novated into two separate agreements as follows: (i) one trade between one party and the CCP and (ii) a mirror image trade with opposite terms between the CCP and the other party with the result that the two trades economically match the original transaction. As a result of this process, the CCP has become the counterparty of both parties.
4 SCOPE OF SWISS CLEARING OBLIGATION 4.1AFFECTED PRODUCTS The Swiss clearing obligation will only apply to certain interest rate derivatives and certain credit default swaps referencing indices. The list of in-scope transactions will include transaction types currently also in scope of the clearing obligation under EMIR, including the following products (the transaction types in scope of the clearing obligation under EMIR includes also other currencies):
Interest rate derivatives
>> Basis swaps in EUR, GBP, JPY and USD with a term between 28 days and 50 years
>> Fixed-to-floating swaps in EUR, GBP, JPY and USD with a term between 28 days and 50 years
>> Forward rate agreements in EUR, GBP and USD with a term between 3 days and 3 years
>> Overnight index swaps in EUR, USD and GBP with a term between 7 days and 3 years
An incentive for voluntary clearing is that the parties do not have to comply with the requirements for exchanging bilateral margin under the rules of the FMIA if the clearing occurs through a CCP that is recognised by FINMA.
>> Index credit default swaps on iTraxx Europe Main in EUR for a 5 year term
3.2CENTRAL COUNTERPARTIES Clearing of derivatives necessarily involves a CCP. At present, there are no Swiss CCPs clearing derivatives transactions. To clear derivatives on behalf of Swiss clearing members, a foreign CCP must obtain a FINMA authorisation under the processes specified in the FMIA.
Nine foreign CCPs have recently been recognised by FINMA under the FMIA (including LCH Ltd. from the UK,
>> Index credit default swaps on iTraxx Europe Crossover in EUR for a 5 year term
CHF interest rate derivatives will not be in scope of the clearing obligation.
4.2TIMELINE The Swiss clearing obligation will enter into effect as follows:
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Transactions between two clearing 1 March 2019 members (qualifying as FC+ or NFC+) of a CCP recognized by FINMA
Transactions between an FC+ and a clearing member (qualifying as FC+ or NFC+) of a CCP recognized by FINMA
1 September 2019
Transactions between two FC+
1 September 2019
Transactions between any other FC+ 1 March 2020 and NFC+
As opposed to the rules of EMIR, the Swiss clearing obligation will only apply to new transactions entered into after the respective go-live date (i.e. there will be no frontloading that would bring transactions outstanding for a certain period before such date into the scope of the clearing obligation).
"CHF interest rate products will not be in scope of the clearing obligation."
The phase-in of the clearing obligation is not aligned internationally. Under the rules of EMIR, the clearing obligation entered into effect or will enter into effect as follows:
Category 4 Large NFC not in
21 December 2018 (interest rate products in EUR, GPB, JPY and USD) / 9 May 2019 (credit derivatives) / 9 August 2019 (other interest rate derivatives)
Therefore, the clearing obligation under EMIR is already in place for some counterparty types. To what extent the Category 3 Parties will become subject to a clearing obligation by 21 June 2019 depends on whether the EU will introduce exemptions for small FCs similar to the Swiss rules in the context of the EMIR reform.
5 CROSS-BORDER TRANSACTIONS 5.1SCOPE The Swiss clearing obligation will apply to cross-border transactions entered into between a Swiss party and a foreign counterparty both qualifying as large FCs or NFCs under the Swiss rules.
5.2RELEVANCE OF FOREIGN LAW To the extent that Swiss parties falling into the scope of the EMIR clearing obligation trade derivatives transactions with EU counterparties, they are already subject to the EMIR clearing obligation today and they must clear transactions with a CCP authorised by EU authorities today.
Category 1 Party
both parties clearing members with recognised CCP
21 June 2016 (interest rate products in EUR, GPB, JPY and USD) / 9 February 2017 (other derivatives)
Category 2 Party
FC above EUR 8 bn threshold (calculated by reference to outstanding notional amounts)
21 December 2016 (interest rate products in EUR, GPB, JPY and USD) / 9 August 2017 (other derivatives)
Alternative investment fund that is NFC above EUR 8 bn threshold
Category 3 Party
FC below EUR 8 bn threshold (calculated by reference to outstanding notional amounts)
21 June 2019 (may be subject to change)
Alternative investment fund (AIFs) that is NFC below EUR 8 bn threshold
5.3SUBSTITUTED COMPLIANCE When the Swiss clearing obligation will enter into effect, Swiss parties falling into the scope of the EMIR clearing obligation may choose to comply with their Swiss clearing obligation by way of substituted compliance under the rules of EMIR, provided that they clear through a CCP authorised or recognized by FINMA. However, at present, it is not possible to apply any foreign rules other than those of the EU by way of substituted compliance (e.g. US clearing rules) to meet the requirements of the FMIA clearing obligation.
6 IMPLEMENTATION 6.1SOURCING CLEARING SERVCICES To implement the clearing obligation, a party to a derivatives transaction may become a clearing member of a CCP that is authorised by FINMA.
As an alternative, it would also be possible to source clearing services from a clearing member of a CCP that is authorised by FINMA or from a client of a clearing member of a CCP that is authorised by FINMA (indirect clearing arrangement).
6.2COMPLIANCE WITH CCP RULES For these purposes, note that the rules of the CCP determine the margin requirements that must be met for providing collateral to the CCP. Also, the rules of the foreign market, where the CCP is established will apply with respect to the account structure and any segregation requirements to be taken into account.
For instance, under the EU rules, the Markets in Financial Instruments Regulations (MiFIR) and EMIR require that the maximum length of the chain of intermediaries involved in the clearing may generally not involve more than a CCP,
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clearing member, a client of a clearing member and the end-client (i.e. four parties). To the extent that the chain involves further parties (long chain), at least two of them must belong to the same group.
Also, in an indirect clearing arrangement, under the rules of MiFIR and EMIR, the end-client must have the choice of choosing between "omnibus segregated accounts" (OSAs), where client positions and margin are commingled on one account, and "gross omnibus segregated accounts" (GOSAs), where the positions and margin assets may be ring-fenced in a default scenario.
clearing solution in Switzerland necessarily requires the involvement of a foreign CCP. As a result, Swiss parties have to take into account the requirements which the foreign regulation of the CCP imposes on the use of its clearing services. Also, the implementation of a clearing solution will require parties to put in place further documentation (e.g. a cleared derivatives execution agreement or a redocumentation of transactions under terms accepted by the CCP).
The clearing obligation is an intermediate step towards the further goal on the reform agenda of introducing a platform trading obligation for certain standardized derivatives.
7 OUTLOOK The introduction of the clearing obligation affects the most frequently traded interest rate derivatives (other than CHF products) and some credit derivatives and mirrors the obligation in place in the EU. The implementation of a
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