Set up in 1960, the European Banking Federation Is the Voice of the European Banking Sector

EBF ref.:D1374D

Brussels,30 July 2012

Set up in 1960, the European Banking Federation is the voice of the European banking sector (European Union & European Free Trade Association countries). The EBF represents the interests of some 5000 European banks: large and small, wholesale and retail, local and cross-border financial institutions.

The EBF is committed to supporting EU policies to promote the single market in financial services in general and in banking activities in particular. It advocates free and fair competition in the EU and world markets and supports the banks' efforts to increase their efficiency and competitiveness.

EBF comments on the ESMA Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories

Key points:

• Banks strongly consider that a “big bang” implementation should be avoided. Astep wise and phased-in implementation of both the clearing and transaction reporting obligationswould reduce risks and promote a smoother implementation.
• The EBF strongly supports the objective that counterparties can fulfill the clearing obligation in EMIR via Indirect Clearing Arrangements. However, it has concerns that many of the ICA provisions exceed level 1. For example, there is no directly applicable article which prescribes the effects set out in recital 64 of EMIR which ESMA argues would override national insolvency laws. Moreover, EMIR and its RTS is nowhere near comprehensive enough to be accepted by the courts as an acceptable insolvency framework.

• Article 10 of the level 1 text is very clear that the Non Financial Company is itself responsible for controlling whether they are in compliance with the clearing threshold. Banks are certainly not in any position to determine by whether a non-financial counterparty is subject to the clearing obligation or not.

• The EBF is highly concerned by the new requirements in Annex V which set out an obligation to report the market value and the amount of collateral posted in view of every single transaction to be reported. The Federation does not see any legal basis in the EMIR text for such an extensive and constant reporting obligation. Similarly, EMIR does not provide ESMA a mandate to develop delegated acts covering such reporting, which was not covered in the ESMA Discussion Paper of March 2012 and rightly so.
• The EBF appreciates the efforts by ESMA to work towards overlapping EMIR and MiFID requirements in terms of future reporting in order to avoid duplication of reporting.
• The EBF is concerned about the use of any ‘interim’ solutions for identifying either contracts or counterparties. Ideally, the reporting requirement should await the finalisation of the LEI and UPI standards. Should this not be possible, the Federation asks ESMA to consider carefully the cost of building interim systems which would have to be changed shortly afterwards.
• Finally, the EBF has made several comments and suggestions as regards the tables in Annex V and VI.

The EBF welcomes the opportunity given by ESMA to give its views on the different aspects contained in this consultation in the context of the implementation of the Regulation on OTC derivatives, CCPs, and Trade Repositories (“EMIR”).

Any reference to the regulation is to be understood as a reference to the regulation on OTC derivatives, central counterparties and trade repositories. References to individual provisions of the regulation refer to the text as adopted by the council on 4 July 2012, document dated 15 June 2012, document No. 2010/0250 (COD). Any reference to a draft delegated regulation is to be understood as a reference to the relevant draft delegated act setting out the regulatory or implementing technical standards proposed in the consultation paper.

• There are stilldeep uncertainties regarding how the rules and regulations will work in practice. With the very tight lead times it will be difficult for independent software suppliers to be ready in the time available. Another issue causing uncertainty is the lack of necessary technical standards and definitions at this late date.Therefore the EBF would like to stress that it is of the utmost importance that sufficiently long phase-in periods for both the clearing and transaction reporting obligations are foreseen to implement the EMIR provisions, as they give rise to very significant modifications in many areas:

• Processes evolution
• Bilateral contracts to be renegotiated
• Additional resources to be found
• Modification of legal set-up
• Changes in CCP rules
• New reporting obligations with introduction of Trade Repositaries

• One should bear in mind that in the United States, a number of technical implementing rules of the Dodd Frank Act have already been delayed in order to ensure a balanced implementation of this new financial legal framework. Indeed, the harmonisation of the time frame with the other jurisdictions (US in particular) is very important to avoid regulatory arbitrage and unlevel playing field;
• We strongly encourage EU regulators to synchronize the timing of CRD IV implementation with availability of eligible CCPs under EMIR. The potential mismatch could have material adverse impact on market liquidity as well as the costs for trading OTC-derivatives;
• Regarding risk-mitigating techniques for non-centrally cleared trades, theRTS/ITS for certain parts will be drafted by ESMA in co-operation with EBA and EIOPA. If those standards are ready by 31 December 2012 (or another date), there is a need for an appropriate conformance period in respect of the Risk Mitigation Techniques. A phase -in period of three years would be reasonable;
• We note that every proposed regulation has its own set of definitions although a number of these defined terms are used in more than one draft delegated regulation. This may cause uncertainty over the understanding of such terms as it is unclear whether these have to be interpreted autonomously or whether the definition in a separate delegated regulation is also meant to apply to another. E.g. we wonder why “confirmation” is defined in annex V while not defined in annex II. The same applies to the six classes of derivatives (equity, credit…).We would deem it very advantageous to consolidate these definitions into one set;

• In view of the international nature of the derivative markets close coordination between the regulatory authorities in respect of the future international regulatory framework, in particular the recognition of CCPs and trade repositories as well as the classification of counterparties as being subject to a clearing obligation, is of utmost importance. The EBF stresses the importance a level international playing fieldand an appropriate mutual recognition focused on outcomes. We understand that ESMA and its international counterparts are currently engaged in discussions with a view to ensuring coherence between the regulatory frameworks, including the issue of the recognition of equivalent regulatory provisions. In particular the question of the recognition of a regulatory framework or parts thereof as equivalent will have far reaching practical implications. Market participants are therefore highly interested in obtaining information on the progress of these discussions. The issue is of such importance that it may merit a separate hearing or at least further communication.

• The EBF appreciates the overall approach by ESMA to propose standards that consider the current market practices and provide flexibility. As an example, the EBF welcomes the coverage of various hedging strategies as a good starting point.

• Specifically for this consultation paper, we have concerns regarding the process and information requirements as part of the intra-group transaction notification details, e.g. the lack of a clear definition of intra-group transactions. We understand that an additional consultation paper will be issued covering this part of the regulation. While we intend to conduct a review and provide comment to this additional Consultation Paper, we would (at this stage) like to state the importance of clarity of the definition, exemptions, reporting as well as other topics related to intra-group transactions.

• The EBF is concerned about the use of interim solutions for identifying contracts or counterparties. Reporting and building systems are very costly and takes times and resources. To impose a requirement to set up an interim solution at this point of time is at least very problematic. Before such a requirement is introduced the consequences and costs should be considered in depth.

1.Indirect Clearing Arrangements (Art. 1 to 4 ICA of the draft delegated regulation)

The EBF strongly supports the objective that counterparties can fulfill the clearing obligation in EMIR via Indirect Clearing Arrangements (ICAs). While we appreciate that the provisions relating to indirect clearing were a relatively late addition to the EMIR Level 1 text, the EBF feels that many aspects of ESMA’s proposed draft technical standards establishing indirect clearing arrangements go beyond the intent of the legislation both in terms of meeting the wider objective of lowering systemic and counterparty risk, and in the case of indirect clearing, ensuring that client clearing arrangements:“do not increase counterparty risk and ensure that the assets and positions of the counterparty benefit from protection with equivalent effect to that referred to in Article 39 and 48.” (EMIR Level 1 text, Title II, Article 4 (3)”[1]

This is supported by paragraph 15 of the draft RTS consultation, which states:

“In order to comply with the clearing obligation, a counterparty must become a clearing member, a client or establish indirect clearing arrangements. These indirect clearing arrangements cannot increase counterparty risk and have to ensure that the assets and positions of a counterparty entering into an indirect clearing arrangement benefit from protections with equivalent effect to those allowing segregation and portability for direct clients. According to the EMIR mandate, ESMA is required to draft RTS specifying the types of indirect contractual arrangements that meet the conditions mentioned above”[2]

The purpose of the indirect clearing arrangements according to ESMA is to ensure that indirect clients have an equivalent level of protection as direct clients while not increasing counterparty risk. When considering how this can be achieved, ESMA expressly rejected the possibility that direct clients should have exactly the same rights as direct clients when it clearly stated:

“It should be noted that the fact that indirect clients should have an equivalent level of protection as direct clients does not necessarily mean that indirect clients should have exactly the same rights as direct clients...[3]”

The EBF supports the objective that indirect clients should have an equivalent level of protection as direct clients. However, indirect clearing arrangements cannot have the purpose of insulating indirect clients from all risks at the cost of the clearing members which have to absorb these risks. Leaving aside the issue that such legal protection cannot be achieved without substantial and far reaching changes to national insolvency laws through a separate legal instrument harmonising insolvency laws within the EU (see comments below), such an objective would effectively increase counterparty risk for clearing members and thus run directly contrary to the central purpose of the regulation. The current proposal would also provide indirect clients with a superior set of rights regarding default protections than those enjoyed by direct clients and could have unintended consequences if a number of clearing members discontinue acting as clearing members for clients. This would be quite an unacceptable outcome which is contrary to the interests of clearing members, direct clients and indirect clients. These issues are explored further below.

1.1Art. 2 ICA para. (1):

To avoid uncertainties and in order to ensure an adequate regulatory framework for any client offering indirect clearing services it should be considered to specify the regulated entities which are considered to be subject to appropriate regulation for the purposes of indirect clearing services.

1.2Art. 2 ICA para. (2):

Article 2 ICA Paragraph 2 Sentence 1 impliesthat the direct client shall have the sole discretion in determining the contractual terms of an indirect clearing arrangement. Sentence 2 however goes on to specify that the contract governing the terms and conditions under which transactions are to be entered into the clearing system of a CCP via a clearing member would have to include a contractual term obligating the clearing member to accept and “honour any obligations” agreed between the client and indirect client in the event of a default of the client.

This is a deeply problematic from a counterparty risk perspective and is completely unworkable both law and practice. In law, the problem with this provision would be twofold. First, a contractual arrangement between two parties (in this case the direct client and the indirect client) cannot be binding upon a 3rd party (the clearing member) where that 3rd party is a non-signatory. Accordingly, contractual terms concerning the consequences of a default of one of the parties to that contract may not be enforceable or effective under applicable insolvency law in the event of such default. ESMA has stated that EMIR’s status as a Regulation does provide it with legal force to override such national laws[4]. In the opinion of the EBF is no directly applicable article in EMIR which prescribes the effects set out in recital 64 of EMIR. Furthermore, we would add that such a wording as in recital 4 of Annex II should not be found in a technical standard or delegated act (regulatory technical standards shall be technical and …. their content shall be limited by the legislative act, on which they are based, please see article 10 of the ESMAregulation). A statement in a recital cannot alone (without an article in the legislative act) override existing laws of the member states.

Moreover, EMIR and its RTS are nowhere near comprehensive enough to be serve as an acceptable insolvency framework. In practice, a contractual agreement solely concluded between the indirect client and direct client can only contain provisions setting out an obligation of the direct client to ensure that the client enters or has entered into a contractual agreement with the relevant clearing member which adequately addresses the consequences of a default of itselfon the indirect client and the relevant transaction (or representations to this effect).

Secondly, while ESMA has argued that EMIR as a regulation does have force in overriding contrary national laws, this provision still fails when considered against the entire insolvency framework. Whether and, if so, to what extent these contractual provisions and obligations agreed as between the indirect client and client on the one hand and the client and the clearing member on the other hand remain applicable or enforceable is a matter of the applicable insolvency law. Notwithstanding ESMA’s views concerning the power of a regulation to override contrary national laws, in its present form EMIR does not establish a satisfactory legal basis on which to underpin such a fundamental departure from existent legal principle. As such, the risk remains that courts will still consider those parts of these national insolvency laws untouched by EMIR to be contrary to the contractual rights established under EMIR between indirect and direct clients. This situation can only be averted by further harmonisation of insolvency laws of the EU member states and the introduction of special provision protecting the position of the indirect client in this specific situation. Harmonising the European insolvency law by the means of provisions in EMIR seems unrealistic and not feasible. This needs to be recognised when defining or interpreting any requirements to provide for protection of positions by purely contractual means.

Not only is this section unworkable from a legal perspective, it is also utterly undesirable in practical terms from the position of the direct client. In practice, if a clearing member is to take on a direct client and facilitate indirect clearing, the clearing member must have the right to take on the direct client only if it is satisfied that the contractual arrangement between the direct client and the indirect client are robust and aligned with its interests. This necessarily requires that the clearing member has the right to only accept clients offering indirect clearing subject to the condition that the contractual arrangements used by the client for indirect clearing are suitable for the purpose and do not result in additional unforeseen risks. This necessarily entails that the clearing member has the right to either review the agreements to be used or require the client to conform to a certain standard or use standard terms and provisions.

The provision also raises serious concerns since it does not strike the right balance between the interests of the clearing member on the one hand and of the client and their indirect clients on the other:

The clearing member cannot be and should not be being obligated to accept transactions of indirect clients of their client’s without knowing the terms these are governed by, considering that the clearing member will generally be acting as a guarantor vis-à-vis the CCP in view of all transactions submitted for clearing to the CCP and, in particular, since the clearing member may be forced to take on that indirect client’s positions for 30 days in the event of the direct client default (Art. 4 (6) ICA). Consequently , in order to provide itself with some measure of protection against the potential risk posed by the indirect client, clearing members will necessarily be able to prescribe certain terms and provisions regarding the contractual terms to be agreed between a direct client and its indirect clients. The clearing member will also have to ensure that it is able to meet all regulatory obligations in respect of the transactions and the indirect clients in the case it has to take on their positions in accordance with Art. 4 (6) ICA, including customer due diligence requirements. .

However, since contracts between direct clients and indirect clients are bespoke and reflect their specific interests and needs the direct client has an interest in being able to determine these terms autonomously. Moreover, since the identity of its indirect clients and the commercial terms agreed are sensitive information, the client has a considerable interest in keeping this information confidential.While EMIR requires clearing members to build Chinese walls[5] to protect sensitive information, this is wholly inadequate and not reflective of commercial realities.