The first clearing obligations are already in place in the US and Japan, and the European Union is now set to follow with its first mandates next year. One of the sticking points has been the fine-tuning of the frontloading requirement – a rule unique to Europe that essentially requires certain trades conducted before the clearing obligation comes into effect to be subsequently cleared.
The concept may sound simple enough, but it’s a requirement that is packed with complexity – and it has been an issue that ISDA and its members have continually flagged since the rules were first published. Recent modifications by the European Commission (EC), however, help eliminate many of the uncertainties, and pave the way for the introduction of Europe’s first clearing mandate for interest rate swaps.
The preceding iteration of the rules appeared in final draft regulatory technical standards (RTS), submitted by the European Securities and Markets Authority (ESMA) to the EC for endorsement on October 1. This version established four categories of derivatives users (an increase from the previous three) and also introduced a new threshold calculation – based on derivatives notional outstanding – to determine whether financial institutions that are not clearing members had to apply the frontloading requirements.
But the way the rules were constructed created significant legal uncertainty. For instance, non-clearing-member financial institutions would have had to determine what category they fall into based on derivatives notional outstanding figures in the three months prior to the official publication of the final rules, meaning the assessment would have been based on criteria not yet finalised, published or in force. What is more, the start and end points for the three months of data depended on an unknown date of publication of the final rules – at which point, the frontloading requirement would also have started.
Taken together, the rules would not have given any time for derivatives users to communicate their status to counterparties, meaning trading partners could have faced real uncertainty as to whether any trade conducted after the publication of final rules would be subject to frontloading.
The EC adjustments tackle these issues. Crucially, the assessment period for non-clearing-member financial institutions will now run in the three months after the RTS come into force, creating greater legal certainty for these entities. Those categories of firms subject to frontloading will also have two months to get the necessary systems, controls and procedures in place and to inform counterparties of their status. The phase-in dates for the start of the clearing obligation remain unchanged, however.
Another important change relates to treatment of cross-border intragroup trades – in other words, transactions between a European institution and a counterparty from the same corporate group based in a third country. These trades are exempted from the clearing obligation under the European Market Infrastructure Regulation (EMIR), but the exemption would only have applied if the intragroup counterparty is based in a jurisdiction with equivalent rules. Given the absence of equivalence decisions, these transactions could inadvertently have been caught by the frontloading requirement once the final RTS are published, as well as by the clearing obligation after the phase-in period. The EC modifications include a three-year exemption for these trades.
ISDA and its members have played a key role in highlighting these concerns, and have worked with regulators to develop practical responses. The end result will ensure the clearing obligation can be introduced in a safe and efficient way, and in a manner that is more consistent across jurisdictions.