Industry seeks urgent clarification on frontloading

Market participants are seeking answers from European regulators on a frontloading obligation for OTC derivatives after it was recently triggered by the approval of the first central counterparty.

Market participants are seeking answers from European regulators on a frontloading obligation for OTC derivatives after it was recently triggered by the approval of the first central counterparty (CCP).

In a joint letter to the European Securities and Markets Authority (ESMA) last week, the International Swaps and Derivatives Association (ISDA) and FIA Europe called for “swift action” on guidance for the industry on frontloading.

Nasdaq OMX Clearing last week became the first clearing house to get the green light by regulators under the European market infrastructure regulation (EMIR), sparking a countdown to mandatory clearing of OTC derivative trades, now expected to take effect in 2015.

But Barry Hadingham, head of derivatives and counterparty risk at Aviva Investors, told theTRADEnews the approval of Nasdaq OMX has also caused confusion. The frontloading window is now open, meaning any eligible swaps entered into after CCP authorisation may also need to be cleared once rules kick-in.

“Knowing that you will have to clear existing transactions at some future date introduces further uncertainty,” he said. “Using a listed product might be a safer route than continuing with OTC contracts.”

With trades presently being priced as a bilateral OTC contract, market participants are left wondering how that price will change when – and if – ESMA deems a particular product clearable in future.

Cost versus price

Lee McCormack, client clearing business development manager, futures and derivatives clearing at Nomura, said clearing members are looking at whether they should pass on the potential cost of clearing to clients now or take it up internally.

“The price is different when you put a trade into clearing. There not only is an initial margin impact, which could be positive or negative, but there is also a pricing impact because of the discounting valuation,” he said.

“At the moment, a trade is priced on the discount curve based on what currency you agreed to exchange in your ISDA Credit Support Annex.”

McCormack said brokers could estimate the cost of the contracts and which clients are likely to be caught in frontloading, based on products likely to be mandated for clearing by ESMA, including euro-denominated interest rate swaps.

“But we don’t know for sure which products ESMA will pick and we don’t know what the residual maturity will be,” he said. “What Nomura thinks will be the probable outcome may be different than another dealer, so my price may be different too and that can fragment liquidity.”

McCormack said the industry is waiting to see the outcome of urgent discussions being held with regulators.

Urgent action

ISDA and the FIA Europe, formally the Futures and Options Association, have asked ESMA to work with the Commission and Parliament to resolve the confusion over frontloading as soon as possible.

“Affected OTC derivatives contracts cannot be accurately priced once frontloading is triggered – this in turn reduces market certainty and potentially discourages market participants, including end-users, from comprehensively managing their risk exposures,” the associations wrote.

“Swift action is essential to ensure that Europe’s capital markets can continue to serve its end-users and the real economy.” 

FIA Europe CEO Simon Puleston Jones said ESMA understands why frontloading is problematic, but the issue now came down to politics. “Politicians who agreed on frontloading are now being asked to change their minds.” 

The concept of a minimum remaining maturity has been raised, Puleston Jones said, meaning only trades with a life span of 30 or 50 years, for example, would be caught by the frontloading obligation.

Any changes won’t result in the re-writing of the regulation, but instead it could be added to ESMA’s technical standards. “If it were to happen, it would be a good thing because it will mean European authorities acknowledge that perhaps they had gone further than needed, or it was operationally viable,” Puleston Jones said.

“But they will be wary about doing it because it could set a precedent – agreeing to regulation, only to find years or months later that it is changed.”

Following the approval of Nasdaq OMX Clearing, ESMA has up to six months to conduct a public consultation on clearing and submit draft technical standards to the European Commission for approval. The European Parliament and Council will then need to pass the clearing mandate.

ESMA would not comment on the ISDA/FIA Europe letter, but said in relation to frontloading, it is “verifying that the approach envisaged is acceptable to all EU institutions”. The regulator wouldn’t specify what the “envisaged” approach is or whether it would be outlined before the release of the technical standards. 

The joint ISDA/FIA Europe letter can be downloaded here.