INTRODUCTION

In response to the global financial crisis, regulators have been seeking to bring more stability and transparency to the OTC derivatives market. Last month the European Commission published a draft regulation that will introduce far-reaching reform. The proposals have considerable traction globally, being consistent with the EU’s G20 commitments and the recent approach adopted by the United States in relation to OTC derivatives. On 28 September 2010 a joint statement was issued by EU Commissioner Michael Barnier and CFTC Chairman Gary Gensler providing mutual support to these proposals and the US equivalent, the Dodd-Frank act.

Many energy market participants, including producers and significant consumers, who are likely to engage in OTC derivatives trading to a greater or lesser extent, could be significantly impacted if they are caught by the new rules.

THE KEY REFORMS

1. Reporting of Derivatives Positions

The Commission’s proposals will require OTC derivatives trades in the EU to be reported to trade repositories. This information will be available to regulators within the EU who will then be able to monitor trading activity and associated risks. A new body, the European Securities and Markets Authority (ESMA), will be responsible for licensing and overseeing the activities of trade repositories.

2. Central Counterparty Clearing

The Commission’s proposals will require standardised OTC derivatives (that is having met predefined eligibility criteria) to be cleared through central counterparties (CCPs). A CCP will interpose itself as buyer to every seller and seller to every buyer for each eligible OTC transaction. Margin will have to be posted with CCPs to reflect the exposure, which should go some way towards preventing the collapse of one market participant triggering the collapse of its counterparties. Contracts by non-financial firms below a certain threshold will not need to be cleared. Similarly, the Commission points out that ‘commercial hedging activities’ undertaken to mitigate business risk will not be counted towards the threshold and will not need to be cleared.

SCOPE OF REFORM

The Commission’s proposals apply to all types of OTC derivatives and are applicable to both financial firms and non-financial firms with ‘large’ positions in OTC derivatives. There is clearly scope, therefore, for the reforms to include all manner of industrial and commercial businesses, including energy producers and consumers (e.g. chemicals, manufacturing and aviation).

COMMENT

Although the Commission has sought to provide as much guidance as possible on the scope of its proposals, much remains to be decided, including:

  • What will constitute a ‘large’ OTC derivatives position for non-financial firms?
  • The information reporting thresholds have to be established.
  • What will constitute a ‘standardised’ OTC derivatives contract subject to central clearing?
  • The role of the ESMA has not been fully defined, though it is clear it will have certain amount of discretion to decide whether OTC derivatives must be centrally cleared.
  • How different asset classes will be treated and, if they are to be treated to differently, what the impact of this will be. There could also be some variation of the treatment of different OTC derivatives within the same asset class.
  • The amount of collateral that will need to be posted in respect for OTC derivatives subject to the central clearing obligation.
  • The capital requirements of OTC derivatives that are not cleared through a CCP and the extent to which this will differ, if at all, from the margin requirements of CCPs.
  • How a CCP will be supported if it is in financial difficulty or goes into insolvency has not been fully defined.
  • Precisely how OTC derivatives contracts will need to be amended to reflect the new regime.

CONCLUSION

Although the Commission’s proposals have been broadly welcomed in some quarters, serious concerns have been raised by energy producers and consumers alike that increased margining costs could adversely impact competitiveness. Similar concerns are being raised in the United States in response to the Dodd-Frank Act. Many of the finer points of detail will emerge over coming months and, until these emerge, the regulatory precise landscape for OTC derivatives will remain unclear.