Mandatory clearing on the way for EU interest rate derivatives trades

The rules fulfil an international agreement to improve transparency and minimise the risks involved when trading over the counter (OTC), or privately traded, derivatives, which dates back to 2009. Similar clearing requirements are already in place in the US and Japan.

EU financial services commissioner Jonathan Hill said that the Commission had taken “a significant step to implement our G20 commitments, strengthen financial stability and boost market confidence” with the new rules. “This is also part of our move towards markets that are fair, open and transparent,” he said.

"The introduction of mandatory clearing rules in respect of interest rate derivatives marks the end of a long road of consultation and appears to strike a reasonable balance between the interests of the regulators and the derivatives industry," said derivatives expert Stephen Woods of Pinsent Masons, the law firm behind Out-Law.com. "The phase-in periods should give smaller market participants sufficient time to implement the necessary contractual arrangements and processes which underpin central clearing."

Central counterparties (CCPs) stand between two parties during a trade to ensure financial performance if one of them defaults. LCH.Clearnet is the largest such facility in the EU.

Interest rate derivatives are the most commonly-traded derivative product, making up around 80% of all global derivatives as of December 2014, according to the Commission. Its new rules will cover plain ‘vanilla’ interest rate derivatives, basis swaps, forward-rate agreements and overnight index swaps denominated in euros, pounds sterling, Japanese yen or US dollars. An estimated €1.5 trillion of interest rate swaps in these four currencies were traded in the EU in April 2013, according to the Commission.

Under the European Markets Infrastructure Regulation, the European Securities and Markets Authority (ESMA) is required to make recommendations to the European Commission about the types of OTC contracts that should be subject to mandatory clearing. The Commission can then implement its recommendations in the form of a delegated regulation, and the rules in relation to interest rate swaps mark the first time it has done so. Similar regulations requiring central clearing of other types of OTC derivative are likely to follow “in the near future”, the Commission said.

EMIR also contains measures to manage the risks associated with trading OTC derivatives that do not require central clearing, and to encourage the central clearing of those transactions.

The European Parliament and Council will now be given three months to scrutinise the new rules, which will then enter into force assuming there are no objections. The requirements will be phased in over three years “to allow additional time for smaller market participants to begin complying”, the Commission said.

As part of its ‘work programme’ for 2015, the Commission has committed to legislating for EU-wide rules should a CCP fail. This reflects the increased “systemic importance” of these institutions within the financial system, given the increased role they will play in underpinning derivatives trades as more OTC derivatives become subject to mandatory clearing requirements.