The European Securities and Markets Authority (ESMA) has published its final technical standards for European OTC derivatives reforms, giving central counterparties (CCPs) a large degree of flexibility on how they managed cleared swaps.
ESMA, Europe’s securities regulator, was required to decide on standards that would accompany the European market infrastructure regulation (EMIR), including specific details on the operation of CCPs and data repositories.
Under EMIR, OTC derivatives contracts traded in Europe will be standardised where possible for they are suitable for trading on exchange-like platforms – defined via MiFID II – and cleared through CCPs. Reporting of swaps exposures will also be required via newly created data repositories.
To determine the contracts suitable for central clearing, CCPs will have to notify ESMA of the derivatives they wish to clear in a so-called ‘bottom-up’ approach. The securities watchdog will then analyse the characteristics of the instruments to ensure they are suitable for clearing.
Under EMIR, ESMA can also identify types of OTC derivatives that no CCP has received authorisation to clear.
“The purpose of this second approach is to ensure the development of clearing solutions for particular classes of OTC derivatives,” read the ESMA paper. “No CCP will be forced to clear contracts that it is not able to manage and the clearing obligation will actually enter into force following the bottom-up approach.”
ESMA will consider the degree of standardisation of the contractual terms and operational processes, the volume and the liquidity of an instrument and the availability of fair and reliable pricing information.
Clearing houses be permitted to determine for themselves the margin they request against each contract they clear so that they can “duly manage the risk they face”.
To discourage risky competition between clearers, the ESMA standards state, “margin calculations should follow some specific requirements in their basic components. In this sense, margins should take into account a full range of market conditions including periods of stress.”
There is also an easing of the restrictions on portfolio margining, i.e. the instances in which correlations between two different types of derivatives can be netted and therefore reduce the collateral burden on market participants.
As part of the consultation process prior to the formation of technical standards, ESMA noted that some respondents expressed concern on ESMA’s initial approach to portfolio margining, revealing that some described cases of a full offset without any risk for the CCP that would still require a 20% margin call.
“ESMA considers that other restrictions on the way the offsets are calculated are not necessary and would unnecessarily restrict CCPs’ possibilities to innovate and ensure an efficient use of collateral, with negative macroeconomic consequences on collateral availability,” read the paper.
As such, CCPs will be able to rely on reliable methodological approaches for the development of portfolio margining.
The standards laid out by ESMA will now be subject to final approval by the European Commission.