ESMA Answers All Your Questions

By George Bollenbacher, G.M. Bollenbacher & Co., Ltd.

Originally published on TABB Forum 

The European Securities and Markets Authority has created a 'living Q&A' document where it responds to industry questions about the unfolding implementation of derivatives reform in Europe. It’s required reading for anyone doing business with a counterparty in the EU. 

In the unfolding implementation of derivatives reform in Europe (which is occurring at the same time as it is in the US, Canada, Asia and pretty much everywhere else), the European Securities and Markets Authority (ESMA) has adopted the welcome approach of issuing a “living Q&A” document where the regulator responds to industry questions over time. The most recent issue came out in early August and provides some clarifications for ongoing issues. It includes a total of 25 new answers, which is too many to cover here, but we will highlight some of the most important.

FC, NFC and NFC+ 

Before we start, though, we need to take care of some acronyms. In the EU, market participants are divided into financial counterparties (FCs) – which includes, among others, what in the US are called swap dealers (SDs) – and non-financial counterparties (NFCs), which has the meaning you might expect. NFCs are further divided into those whose unhedged positions are below the clearing threshold (plain NFCs) and those whose unhedged positions are above the clearing threshold (NFC+s). Once a NFC becomes a NFC+, all its new positions, including hedges, must be cleared.

The first significant new answer from ESMA relates to the ruling that swaps contracts executed on an EU regulated exchange don’t count toward the unhedged position threshold for NFCs. By the same token, ESMA now says contracts executed “on non-EU exchanges that are equivalent to a regulated market” don’t count toward the clearing threshold either; but, since there is no list of equivalent non-EU exchanges at the moment, for now all swaps on all non-EU exchanges count toward the NFC+ threshold. Stay tuned to ESMA for further developments on that one. One additional new wrinkle is that for internal back-to-back trades, in which a firm uses an affiliate to execute trades with the Street, when the internal affiliate’s trades are not hedging, all the trades (including internal ones) count against the threshold.

The living document then gets into some really meaty questions. For example, OTC Question 13:

“(a) How should a counterparty determine whether an entity established in third countries would be a financial counterparty if it were established in the Union? (b) How should a counterparty determine whether an entity established in a third country which they believe would be an NFC is an NFC+ or NFC-?” 

Buried under these questions is the real one: How market participants should resolve a contradiction in which the EU has one definition and another jurisdiction has a different definition.

Unfortunately, ESMA’s answers to these questions aren’t all that enlightening. For (a) they say:

“This needs to be assessed by individual counterparties, … taking into account the nature of the activities undertaken by the counterparty in question. The process and any assumptions made in order to arrive at such a determination should be documented.” 

For (b) ESMA instructs the EU-regulated C/P to calculate the outstanding positions for the non-EU C/P and make the determination itself.  In other words: “You children should resolve your disputes without bringing them to your mother and me.”  I suppose, if the two parties agree, and document, that the more lenient definition of FC and NFC+ prevails, ESMA will go along with their view. Right?

CCP Questions 

The next significant new question (CCP Question 4) relates to the protection of securities on deposit with a CCP, and asks whether a CCP can deposit securities it holds with a central securities depository (CSD) such as Euroclear if they are rehypothecated. This is indicative of the wide-ranging discussions globally about the safety of CCPs and the protection of customer assets.

Here the answer is a bit more helpful. It says:

“Yes, provided that the CCP demonstrates to its competent authority that the arrangements do not prevent compliance with Article 47(3) of EMIR, namely that the CSD and the linked CSD ensure the full protection of the financial instruments.” 

Further down the list, ESMA gets to the crux of the collateral safety question, previously addressed (for better or worse) by the CFTC in its LSOC provisions. CCP Question 8 asks, “May a CCP meet the requirements of Article 39(3) of EMIR by identifying only the value of collateral due to a client; or is it necessary to identify the specific assets due to a client?”

In summary, the answer says:

“Article 48(6) of EMIR requires that a CCP’s model of individual segregation provides for the transfer of the assets and positions held for the account of an individually segregated client to another clearing member. … Alternative approaches to segregation that identify only the value due to the accounts of the clients (while recording the assets provided for the account overall) may be offered in addition, provided they meet the relevant requirements of Article 39 of EMIR, but they do not meet the requirement to offer individual client segregation.” 

A little further down is this question: “Can a CCP apply surpluses in a clearing member’s house account to an omnibus client account or an individually segregated client account?” The answer:

“CCPs are ... permitted to have rules and procedures which facilitate the use of surplus margin on a defaulted clearing member’s house account (that would otherwise have been payable by the CCP to the estate of the clearing member) to meet any obligation of the clearing member in respect of losses on a client account of that clearing member. For the avoidance of doubt, surplus margin on a client account of a defaulted clearing member cannot be used to meet any losses on the defaulted clearing member’s house account(s).” 

That appears to me to answer a different question, and maybe an illogical one. If a clearing member has defaulted, how could it have surplus margin in its account?

Reporting Questions 

Under reporting, one new line of questioning is: “How should information on collateral and valuation be reported to TRs? Is there a need to specify the type of collateral? Should the variation margin be taken into account for the calculation of the mark-to-market value?”

And the answer is:

“There is no such field for the moment given that reporting is performed at portfolio level. Field 22 on collateralisation refers to any collateral posted by a counterparty that covers/reduces the actual exposure and there is no field querying or rule limiting the type of collateral to be reported (without prejudice of rules on how to collateralise, or others outside the reporting section of EMIR and that may be applicable to certain counterparties). 

“No. It is not permissible to report zero in this field on the grounds that there is no market risk because variation margin has been paid. Any margin paid would be reflected in Counterparty Data field 25 and not in this field.” 

Another set of questions involves the role parties play in a trade: “If a counterparty is itself the Clearing Member (CM) to a trade, should it be reported in both the ‘counterparty’ and ‘CM’ fields?” and “If a CM is itself the broker to a trade, should it be reported in both the ‘CM’ and ‘broker’ fields?” The answer in both cases is “yes.”

And finally, “Should intragroup transactions be reported?” The answer:

“Yes. There is no exemption for intragroup trades from the reporting obligation. They should be reported as any other trades and the corresponding field 32 ‘Intragroup’ should be filled with the value ‘yes’.” 

There are many more useful questions and answers in this document. It’s required reading for anyone doing business with a counterparty in the EU, and, because it’s a living document, we’ll all have to keep an eye out for future installments.