The approval of the first central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR) – Sweden’s Nasdaq OMX on March 18 – has focused attention on how a clearing determination will be applied across the European Union (EU). Alongside an assortment of interest rate derivatives, Nasdaq OMX was authorised to clear several single-name, basket and equity index futures and options, kick-starting a six-month process by the European Securities and Markets Authority (ESMA) to determine whether a clearing obligation should apply for those classes of derivatives.
Given this process is now under way, ISDA and its members believe the criteria used to determine a clearing obligation, as proposed in an ESMA discussion paper published on July 12, 2013, must be carefully considered. In particular, the criteria used to define a ‘class’ of equity derivatives for the purposes of determining a clearing mandate should be highly granular, taking into account both the specificities of the equity derivatives market, as well as the important differences between exchange-traded and over-the-counter (OTC) instruments. An overly broad definition for an equity derivatives class could mean certain products unsuitable for clearing end up being captured by a clearing mandate, which would ultimately be detrimental for market participants that rely on those instruments for investment and risk management purposes.
There is already a well-developed cleared business for exchange-traded contracts, which make up the vast majority of the overall equity derivatives market, and this has proved to be highly responsive to client demand. Where there has been a need for greater standardisation, exchange-traded, cleared contracts have emerged – and this trend is expected to continue in the future. A number of OTC products are becoming increasingly standardised, and may migrate to exchange trading and clearing over time as customer need for these services grows.
Despite the size of the cleared exchange-traded market, however, there continues to be strong demand for the flexibility and customisation offered by non-cleared OTC products. These instruments exist because they allow market participants to meet unique, tailored hedging and investment needs – demands that cannot be met by using more standardised contracts. An overly broad clearing mandate could leave end-users unable to access customised instruments that meet their specific objectives, resulting either in an increase in risk in the system or a restriction in investment choices by market participants.
As recognised in EMIR, and by ESMA in its joint draft regulatory technical standards on risk mitigation techniques for non-cleared derivatives2, there is a role for tailored OTC contracts that meet end-user risk management needs, but which aren’t suitable for clearing. Those customised, non-cleared trades are subject to mandatory reporting, and capital and margin requirements will be applied to mitigate other potential risks.