An Analysis Of The EU And U.S. Regulations Affecting OTC Derivatives

Author:Mr Richard Frase, Philip Hinkle and Alexander Pannett

The financial crisis that started in 2008 saw the collapse, nationalisation or merger of a number of major financial institutions. The ensuing liquidity crisis prompted governments to pledge reform of the regulation of over-the-counter ("OTC") derivatives, with the aim of reducing counterparty risk and improving transparency. World leaders at the G20 summit in October 2009 proposed that OTC derivatives should be cleared through central counterparties ("CCPs"), and that these transactions should be reported to trade repositories. Various global initiatives are being implemented to enact the proposed reforms, most importantly the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank") in the United States and both the European Market Infrastructure Directive ("EMIR") and a revision of the Markets in Financial Instruments Directive ("MiFID") (the revisions being collectively known as "MiFID II") in the European Union. This article looks at the scope of the above regulations and their approach to clearing, margin, trading venues, position limits and reporting. Scope of Regulations EU OTC derivatives contracts are defined as derivative transactions that are executed neither on an EU regulated market nor on a non-EU country market considered as equivalent to a regulated market. A regulated market is defined under MiFID as a multilateral system operated and/or managed by a market operator. It brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments in the system and in accordance with its non-discretionary rules in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems. A regulated market must be authorised and function regularly in accordance with MiFID. The definition of OTC derivatives covers a wide range of swaps, options, futures and other derivatives contracts on securities, currencies, interest rates, financial indices, credit, commodities and other underlyings specified under MiFID. Spot foreign exchange and forward foreign exchange contracts are currently not deemed to be OTC derivatives though this may be subject to revision. U.S. Dodd-Frank is intended to cover nearly all OTC derivatives, which are regulated by both the U.S. Commodity Futures Commission ("CFTC") and the U.S. Securities and Exchange Commission ("SEC") and are divided into "swaps", which are regulated by the CFTC, and "security-based swaps", which are regulated by the SEC. Entities that use both "swaps" and "security-based swaps" are subject to regulation by both the CFTC and the SEC. "Swaps" include options, contingent forwards, exchanges of payment or transactions that are based on an underlying financial product, and products that become known as swaps in the market. These include, among other things, interest rate swaps, commodity swaps, credit default swaps, currency swaps, foreign exchange swaps, forwards and options and total return swaps. "Security-based swaps" are defined as swaps that are based on (i) a narrow-based security index (generally defined as containing nine or fewer components), (ii) a single security or loan or (iii) the occurrence or non-occurrence of an event relating to a single issuer of a security in a narrow-based security index, provided that such event directly affects the financial statements, financial condition or financial obligations of the issuer concerned. These terms are defined in Dodd-Frank, which requires that the CFTC and SEC further define them via rulemaking (scheduled to be adopted in a joint rulemaking in 2012). Clearing EU EMIR requires that certain classes of OTC derivatives between financial counterparties must be cleared through a CCP. Financial counterparties include: investment firms; credit institutions; insurance, assurance and reinsurance companies; UCITS funds; pension funds; and alternative investment funds. The CCP will be an intermediary and will be contractually placed in between the two financial counterparties to a given transaction. The CCP will be a buyer to...

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