European Securities and Markets Authority (ESMA) presented a set of Draft Technical Standards earlier this month, with regard to regulation on over-the-counter (OTC) derivatives, Central Counterparties (CCPs), and Trade Repositories.
ESMA has to write about 40 technical standards to meet a G20 pledge for reform of the OTC derivatives market, in order to protect the market participants from significant systematics risk. This pledge is a direct response to the market failure of 2008, which has largely been blamed on the freely functioning OTC markets.
However, the standards proposed by ESMA have been under severe criticism by the investment community.
One of the provisions of the proposal is that under the new rules, the clearing members would be forced to guarantee trades executed by their clients on terms the member firms have not yet agreed upon. Market participants feel that the rule would leave clearing members exposed to too much risk.
Since the direct clients are allowed to sign up clients of their own, they would use most attractive terms to woo customers. These terms might not always be in line with the clearing member’s objectives, but the clearing member would still be obligated to abide by this agreement, even though it is not a signatory to the contract.
The rule has its plus side, however, as it allows small regional banks and other small financial end-users to access clearing services, by functioning as indirect customers. Furthermore, it expands clearing members’ access to a greater investment source, as their capacity to sign up direct members is limited.
ESMA standards also propositioned that indirect clients should receive the same protection as the direct clients, and should have access to the clearing services, even if the direct client through which they are dealing goes bankrupt. This protects the indirect clients at the expense of the clearing member, who is unfamiliar with the indirect client’s credit history, but is obligated to provide the client with all services for a period up to 30 days.
“The requirement that clearing members guarantee the positions of indirect clients for at least 30 days following the default of the direct client is unworkable. Prior to clearing for a direct client, there should be some form of tripartite agreement between the clearing member, indirect clearer, and the indirect clients, so a commercial relationship is established beforehand,” says Edwin Budding, policy officer, risk and financial regulation, at ISDA.
The Investment Management Association (IMA) in London presented its comments on the draft technical standards and said that the rules could be modified to provide protection for clearing parties. They called for enabling clearing houses to be able to identify owners of positions in the event of defaults. They also said that it would be better if the clearing house could identify the true owner of all positions and be able to perform credit checks. This would effectively expand the clearing members’ base of customers, without compromising their portfolio integrity.
The Chartered Financial Analysts (CFA) Association also feels that there is also serious ambiguity on the definition of indirect clients, which are clients that will use a counterpart that is not a clearing member. The draft is not clear as to what clients are included in the category of indirect client and hence excludes some indirect clients from enjoying the benefits of unique accounts. However, all final clients should have the right to a segregated account at clearing member level, with the same level of protection as an account held at the CCP.
Overall, many feel that in the future, market regulation should allow central clearing for all members, regardless of the size of their investments. This would simplify the process and make transactions easier to track. It would also improve market transparency and enhance the integrity of the capital markets in the long-run.