The euro swaps surprise

As surprises come, it should have been a non-event. On March 18, Swedish clearing house Nasdaq OMX announced it had been authorised as a central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR), the first in Europe to get the regulatory nod of approval. Clearers had to submit their applications by September 15 last year, and national authorities had a six-month limit to consider them once they were confirmed as complete, meaning the authorisation was well in line with the schedule outlined by the European Securities and Markets Authority (ESMA).

Nonetheless, the announcement caught the market completely unawares, and has led to a situation where European derivatives users are unsure how to price and risk-manage euro-denominated interest rate swaps, the largest segment of the interest rate derivatives market.

How did this happen?

It all boils down to the oddly named and much misunderstood frontloading requirement under EMIR. Frontloading is a bit of a misnomer – it actually refers to a requirement to backload certain derivatives transactions to a CCP, specifically those trades conducted between the point in time ESMA is told a clearing house has been authorised to clear certain derivatives classes and the start of a clearing obligation for those products.

The problem arises because it’s uncertain which trades will be captured by this requirement, and when. Once ESMA is notified of a CCP authorisation, it has six months to conduct a consultation and draw up regulatory technical standards for each class of products it thinks may be suitable for mandatory clearing. The European Commission (EC) then has up to three months to endorse the standards, before they pass to the European Parliament and Council of the European Union, which have up to two months to accept the rules if they haven’t been modified by the EC and up to six months if they have. The rules are then published in the official journal, and come into force 20 days later.

According to a time line published by ESMA last year, the earliest a clearing mandate will come into effect after a CCP is authorised is nine months; the latest is 16 months. But there could be phase-ins written into the rules that extend the start date beyond that.

This all matters because Nasdaq OMX doesn’t just clear the smaller Scandinavian currencies – it also clears euro interest rate swaps. That means the clock is now ticking, and any euro swap transacted by a European participant from March 18 onwards may need to be backloaded to a CCP at some unknown time in the future.

This creates some real risk management headaches for European derivatives users. Should individual trades now be treated as cleared, non-cleared, or a mixture of both? It’s virtually certain a clearing mandate will apply for euro interest rate swaps at some point, but it’s not clear when. The situation is even less clear for other, less liquid products – ESMA may decide after its consultation period that some instruments are not yet suitable for mandatory clearing, particularly if they are only cleared by a single CCP.

Market participants had hoped regulators would provide further clarity on frontloading before the first CCPs were authorised. Without this guidance, derivatives users can’t be sure whether any single trade will ultimately be subject to frontloading or not. That’s why the approval of Nasdaq OMX came as such a shock.

Further clarity will come at some point. But the sooner the better. Until it does, uncertainty will continue to hamper risk management in the euro swaps market, making it more difficult for end-users in Europe to implement the hedges they need.

Progress, of a sort

Eight months on from the much-heralded “path forward” agreement that set a roadmap for how US and European regulators would deal with cross-border regulatory issues, the fruits of the new cooperative approach have started to emerge. In February, the Commodity Futures Trading Commission (CFTC) issued conditional no-action relief allowing US entities to continue trading on European multilateral trading facilities that haven’t registered as swap execution facilities, so long as those platforms meet requirements that are identical to those applied in the US.

It may not have been exactly what some European venues were hoping for, but this represented notable progress. At one point last November, following two clarifications by the CFTC that seemed to extend US rules further than ever before, it looked like the path forward would become a road less traveled.

There’s still a huge number of cross-border issues that need to be tackled – among the most urgent, Europe’s equivalence determinations for US central counterparties (CCPs). Under the European Market Infrastructure Regulation (EMIR), European banks would not be allowed to act as clearing members of any CCP in a non-equivalent jurisdiction, while Europe’s Capital Requirements Regulation prevents them from applying the lowest possible 2% risk-weight for cleared exposures at those venues. Together, these rules could have a devastating impact on the business of any non-equivalent clearing houses.

A comparison between US and European clearing rules throws up a number of seemingly intractable inconsistencies – for instance, a one-day margin period for futures contracts under US rules less onerous than the two days required under EMIR. Nonetheless, some have speculated that the new-found spirit of cooperation between US and European regulators may allow a compromise to be reached.

That doesn’t answer what happens elsewhere, though. Trades conducted between US and European entities account for a large portion of the cross-border universe, but there are plenty of transactions involving counterparties from other jurisdictions too – Australia, Hong Kong, Japan, to name but three. Some regulators have set out broad parameters for equivalence or substitutability determinations, but these are imprecise and lacking in detail.

Generally, regulators agree that foreign rules should be deemed equivalent if they pursue the same outcome. But beyond a pretty clear global consensus on central clearing and reporting – both key Group of 20 (G-20) objectives and initiatives supported by ISDA and the derivatives market – the desired outcomes differ from jurisdiction to jurisdiction. Dodd-Frank, for instance, covers everything from trading, clearing, reporting and business conduct rules to broader bankruptcy and resolution proceedings. EMIR covers clearing and reporting, with trade execution covered by the revised Markets in Financial Instruments Directive, but many other countries with smaller derivatives markets have opted to tackle clearing and reporting only.

The risk is that some national regulators will approach each outcomes-based equivalence determination as a broad, like-for-like comparison of their own regulatory and legislative framework. That tactic would likely doom any equivalence process to failure. Rather, regulators need to focus on whether the core objectives set by the G-20 are being met, taking foreign legal regimes and local market practices into account.

The trouble is getting to this point, as well as having a mechanism in place to deal with any disputes. The International Organization of Securities Commissions has suggested it may be able to play a role here, drawing up a set of principles – perhaps similar to those published by ISDA last year – and intermediating in equivalence determinations. This could involve peer reviews, colleges of supervisors and regulatory visits, comparable to what the Basel Committee on Banking Supervision has in place for Basel III. It seems like a good idea, and could do much to resolve potential problems and ensure the global derivatives market continues to be just that: global.