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ESMA sets out its draft approach to OTC derivative regulation


The European financial markets watchdog has set out how it plans to monitor over-the-counter (OTC) derivatives trading when new EU regulations come into force next year.

The European Securities and Markets Authority (ESMA) has published draft technical standards for consultation. The document sets out the type of transactions that will need to be centrally cleared under the new obligations, as well setting out risk management techniques for those transactions exempt from the clearing process. It also sets out how it intends to regulate the new trade repositories, or central data centres, with which all derivatives transactions must be registered.

The European Market Infrastructure Regulation (EMIR) comes into force next year to improve transparency in the derivatives trading markets and protect against market abuse. Under EMIR, all OTC derivative contracts will have to be cleared through central counterparties (CCPs), while all derivative contracts including those involving OTC derivatives will have to be reported to central trade repositories.

"OTC derivatives impact both financial markets and the real economy but have not been subject to regulatory requirements," said Steven Maijoor, ESMA chair. "This absence has resulted in negative consequences for financial markets, investors and the real economy. These proposals will contribute to enhancing the protection of investors and promote stable and well-functioning financial markets in the EU, and allow the EU to play its role in strengthening the global financial regulatory system."

A derivative is a type of financial contract linked to the underlying value of the asset to which it refers, such as the movement of interest rates or currency value, or the possible bankruptcy of a debtor. OTC derivatives are those not traded on a regulated stock exchange but instead privately negotiated between two parties. EMIR will apply to all derivatives trades which are not "executed on a regulated market" – over 95% of the derivatives market, according to EU figures.

EMIR was drafted as a response to the financial crisis and the collapse of major financial services firm Lehman Brothers in 2008. The firm was a leading player in the OTC derivatives market. The G20 group of major global economies, which includes 19 countries as well as the EU, agreed to introduce mandatory clearing in September 2009.

Last week the European Banking Authority (EBA) published its own consultation on the draft Regulatory Technical Standards (RTS) which will apply to CCPs under the new regime. CCPs assume the counterparty risk during a trade between two parties, ensuring financial performance if one party does not meet its commitments.

ESMA said that it would consider certain "classes" of derivatives in order to decide whether clearing requirements would apply, although noted that it may "apply a more granular approach within that class" depending on feedback from CCPs and competent authorities. No CCP would, it said, be "forced to clear contracts that it is not able to manage". OTC derivatives will be classed based on the degree of standardisation of their contractual terms, the volume and liquidity of the relevant contracts and the availability of "fair, reliable and generally accepted" pricing information. Classes of OTC derivatives subject to the clearing obligation will be displayed on ESMA's website, it said.

The clearing obligation will not apply to derivatives traded below a class-based "threshold", it said. In addition, certain non-financial counterparties that use OTC derivatives to protect themselves against commercial risks directly linked to their commercial activities or treasury financing activities will be exempt from the requirements.

The draft also sets out risk mitigation techniques for contracts not subject to the clearing obligation. Other risk management techniques will be developed by ESMA in conjunction with the other European financial services regulators, the EBA and the European Insurance and Occupational Pensions Authority (EIOPA).

The final version of EMIR is due to be published by the European Commission by the end of August while the requirements themselves are intended to come into force from 1 January 2013. The Commission recently published a revised draft (238-page / 613KB PDF) of the Regulation.

The draft technical standards must be fully adopted by the European Commission by the end of 2012 in order for the EU to meet its G20 commitments. ESMA is due to submit its final draft to the European Commission by the end of September.

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