OTC Derivatives [EU]

Table of Contents

EU rules on derivatives contracts

Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories

The European market infrastructure regulation (known as ‘EMIR’), lays down rules regarding over-the counter (OTC) derivative contracts, central counterparties (CCPs)* and trade repositories*, in line with the G20 commitments made in Pittsburgh in September 2009.
EMIR aims to reduce systemic risk, increase transparency in the OTC market and preserve financial stability.

Key Points

To increase transparency in the OTC market, the regulation provides that all information on all European derivative contracts must be reported to trade repositories and made accessible to supervisory authorities, including the European Securities and Markets Authority (ESMA).

To reduce counterparty credit risk*, the regulation sets out strict organisational, business conduct and prudential obligations for CCPs. Standard derivative contracts must be cleared through CCPs (see clearing*).
To reduce operational risk*, the regulation requires that electronic means must be used for the timely confirmation of the terms of OTC derivatives contracts.

The clearing and reporting obligations apply to:
financial firms, e.g. banks and insurance firms,
non-financial firms, e.g. energy companies and airlines, which have large holdings in OTC derivatives.
ESMA is responsible for identifying contracts that should be subject to the clearing obligation, that is, those that are standardised and must be cleared by CCPs. ESMA also supervises trade repositories.

The European Commission has adopted a number of measures, including technical standards on the basis of ESMA drafts, to implement the terms of the regulation. The technical standards developed by ESMA cover a range of topics including, e.g. capital requirements of CCPs, the minimum data to be reported to trade repositories and supervisory reporting of institutions of the liquidity coverage requirement.

The Commission has also adopted decisions on the ‘equivalence’ of the regulation regimes for CCPs in certain non-EU countries.
In August 2015, the Commission adopted a delegated regulation that determines that some classes of OTC interest rate derivative contracts be cleared through central counterparties. It covers interest rate swaps denominated in euros, pounds sterling, Japanese yen or US dollars that have specific features, including
the index used as a reference for the derivative;
its maturity — when it becomes payable; and
the notional type (i.e. the nominal or face value that is used to calculate payments made on the derivative).

On 5 June 2015, the European Commission adopted a delegated regulation in accordance with Article 85(2) of EMIR. This extends temporary exemption from central clearing requirements for pension scheme arrangements (PSAs) until 16 August 2017. PSAs — which include all categories of pension funds — hold neither significant amounts of cash nor highly liquid assets. If PSAs had to source cash for central clearing, imposing such a requirement on them would require very far-reaching and costly changes to their business model which could ultimately affect pensioners’ income.

In June 2016, Commission Delegated Regulation (EU) 2016/1178 introduced additional rules on the classes of OTC derivatives and categories of counterparties subject to the clearing obligation and the dates from which the clearing obligation takes effect.

Application & Background

It has applied since 16 August 2012.

Over-the-counter (OTC) derivatives are generally negotiated privately. The information concerning them is consequently only available to the contracting parties, which can make it difficult to identify the nature and level of risks involved.

For more information, see:

Derivatives / EMIR on the European Commission’s website;
‘Financial stability: new Commission rules on central clearing for interest rate derivatives’ (press release).
KEY TERMS

Over-the-counter (OTC) derivative: a derivative is a financial contract linked to the future value or status of an underlying entity such as an asset, index or interest rate.

An OTC derivative is a derivative not traded on an exchange or on an equivalent non-EU market but is instead privately negotiated between 2 counterparties, for example, a bank and a manufacturer.

Central counterparty (CCP): a body that acts between the 2 counterparties to a transaction, acting as the buyer to every seller and the seller to every buyer.

A CCP’s main purpose is to manage the risk of a counterparty being unable to make the required payments when they are due, and defaulting on the deal.

Trade repository: a central data centre where details of derivatives transactions are reported. Trade repositories are commercial firms. There are global trade repositories for credit, interest rate and equity OTC derivatives (a particular class of derivative such as options or futures).

Counterparty credit risk: a risk that a counterparty, i.e. the other party in a financial transaction, will default on payment.

Clearing: all activities from the time a commitment is made for a transaction until it is settled.

Operational risk: a risk of loss resulting from inadequate or failed internal processes or external events, e.g. fraud, human error, terrorism.

MAIN DOCUMENT

Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (OJ L 201, 27.7.2012, pp. 1-59)

Successive amendments and corrections to Regulation (EU) No 648/2012 have been incorporated in the basic text. This consolidated version is of documentary value only.

OTC Derivatives [EU]

EU rules on derivatives contracts

Key Points

Application & Background

MAIN DOCUMENT

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