5. Mandatory Clearing of OTC derivatives

Article 4(1)(b) of EMIR mandates the clearing of the OTC derivative contracts (pertaining to a class of OTC derivatives that have been declared subject to the clearing obligation).

5.1. Process to determine the scope of the clearing obligation

To assist in the management and reduction of systemic risk relating to derivative trading activity EMIR introduces an obligation to clear certain derivatives with an authorised or recognised CCP. The derivatives in scope are determined by using either a bottom-up or a top-down approach,

Under the bottom-up approach ESMA determines the classes of over-the-counter (OTC) derivative contracts subject to the clearing obligation from among classes of derivatives that where clearing is already offered by central counterparties (CCPs). So instruments can come into scope when new CCPs are authorised or recognised or when clearing is offered for additional instruments. Typically, ESMA wants there to be at least 2 CCPs offering clearing for a particular type of derivative to prevent a monopoly situation arising.

Under the top the top-down approach, ESMA identifies classes of OTC derivatives that they believe should be subject to clearing based on analysis of trade repository data, but for which no CCP offers clearing. ESMA will then publishes a call for a development of proposals for the clearing of those classes of derivative.

5.2. What derivative instruments are in scope for mandatory clearing?

To bring derivatives within the scope of the mandatory clearing requirements, ESMA must consult and publish a supplementary RTS. As such we expect there to be additions over time to the list of derivative instruments that will be subject to the clearing obligation. ESMA must publish the Clearing Obligation Public Register which contains details of the OTC derivatives for which clearing services are offered and the full list of OTC derivatives subject to the clearing obligation.

5.2.1. IRSs in scope for mandatory clearing

So far we have finalised RTS for Interest Rate derivatives denominated in the G4 currencies (i.e. EUR, GBP, JPY and USD) and a consultation in launched in May 2015 to extend the IRS mandatory clearing scope to instruments in 6 other currencies, namely the Czech Koruna (CZK), Danish Krone (DKK), Hungarian Forint (HUF), Norwegian Krone (NOK), Polish Zloty (PLN) Swedish Krona (SEK). Currently the table below identified the IRSs in scope:

UID Type Reference Index Settlement Currency Maturity Settlement Currency Type Optionality Notional Type
A.1.1 Basis Euribor EUR 28D-50Y Single Currency No Constant or variable
A.1.2 Basis LIBOR GBP 28D-50Y Single Currency No Constant or variable
A.1.3 Basis LIBOR JPY 28D-30Y Single Currency No Constant or variable
A.1.4 Basis LIBOR USD 28D-50Y Single Currency No Constant or variable
A.2.1 Fixed-to-float Euribor EUR 28D-50Y Single Currency No Constant or variable
A.2.2 Fixed-to-float LIBOR GBP 28D-50Y Single Currency No Constant or variable
A.2.3 Fixed-to-float LIBOR JPY 28D-30Y Single Currency No Constant or variable
A.2.4 Fixed-to-float LIBOR USD 28D-50Y Single Currency No Constant or variable
A.3.1 FRA Euribor EUR 3D-3Y Single Currency No Constant or variable
A.3.2 FRA LIBOR GBP 3D-3Y Single Currency No Constant or variable
A.3.3 FRA LIBOR USD 3D-3Y Single Currency No Constant or variable
A.4.1 OIS EONIA EUR 7D-3Y Single Currency No Constant or variable
A.4.2 OIS FedFunds USD 7D-3Y Single Currency No Constant or variable
A.4.3 OIS SONIA GBP 7D-3Y Single Currency No Constant or variable

5.2.2. CDSs in scope for mandatory clearing

For CDS the ESMA RTS issued for consultation will bring the following into scope in due course:

Untranched iTraxx Index CDS (Main, EUR, 5Y)
Untranched iTraxx Index CDS (Crossover Series 17, EUR, 5Y).

5.2.3. FX in scope for mandatory clearing

Regarding FX instruments ESMA consulted in October 2014 with a proposal of mandatory clearing for certain FX products, namely non-deliverable forwards, or NDFs but has opted not to propose a clearing obligation on those classes at this stage.

5.3. What entities are in scope for the clearing obligation?

From 21 June 2016 mandatory clearing will firstly affect firms who are individual or general clearing members of an authorised or recognised CCP for at least one of the instruments in scope above. Six months later category 2 firms will be caught and category 3 firms a further six months after that. So firms need to assess what category they will fall within, but also what category their counterparts will fall within as that will determine if and when mandatory clearing applies.

The contracts in scope of the clearing obligation are determined by the categorisation of both of the counterparties to each trade as per the table below:

Category Definition
1 Clearing members of an authorised or recognised CCP for at least one of the above classes of instruments in scope for mandatory clearing
2 Financial Counterparties and NFC+ AIFs that which are not included in category 1, and which belong to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for January, February and March 2016 is above EUR 8 billion
3a Financial Counterparties and AIFs NFC+ which are not included in Category 1 or 2
3b Trades with a third country group entity meeting the conditions for derogation
4 NFC+s that are not included in categories 1, 2 or 3

The party in the lowest category determines the clearing requirements including the timing of when the clearing obligations will take effect.

Firms that aren’t in category 1 will need to do some data crunching to calculate whether their group is above or below the €8bn clearing threshold, something Kaizen can support. Each of the three categories will need to be wary of the frontloading obligation which captures trades entered into or novated on or prior to 21 February 2016 dependent on the instrument and the remaining maturity on the trade. So firms will need to consider the potential for eventual clearing of these trades if they remain open once their clearing obligation kicks in.

The table in section 5.5., below, provides the definitions for each category and when the clearing obligation takes effect.

5.3.1. Clearing of trades with group entities where one party is outside of the Union

There are specific provisions which will delay the applicability of the mandatory clearing obligation for the scenario where a firm trades with a group entity (i.e. included both entities are included in the same consolidated accounts) but one entity is outside of the EU, i.e. a third country entity within its consolidated group.

In these situations, where an intragroup exemption has not been granted the following table determines the timing of when such trades would be subject to the clearing obligation.

Example Effective date Commission Equivalence status
1 21 December 2018 in case has been adopted No equivalence decision taken
2 The later of:
1. the date when the clearing obligation takes effect; or
2. 60 days after the equivalence decision
Equivalent
3 No derogation - clearing obligation applies as per Article 3(1) Not equivalent

For this derogation to apply:

  1. both counterparties must be subject to appropriate centralised risk evaluation, measurement and control procedures; and
  2. the EU entity must have notified their Competent Authority in writing that the relevant conditions are met; and
  3. within 30 days of receipt the Competent authority has confirmed the conditions are met

5.3.2. Trades with non-EU counterparties

Under certain conditions, the clearing obligation may also apply to third-country (non-EU) counterparties including when:

EU counterparties trade with entities established outside the EU;
Two entities established outside the EU trade together, and an impact on EU markets exists (a direct, substantial and foreseeable effect in the EU).

The final ESMA report on draft regulatory technical standards on direct, substantial and foreseeable effect in the EU was endorsed by the European Commission on 13 February 2014 (Commission Delegated Regulation (EU) No 285/2014).

5.4. The frontloading obligation

Contracts already in existence when the clearing obligation becomes effective can still represent significant risk to the overall economic system. ESMA has therefore required some of these contracts particularly those with a reasonably long life to be subject to clearing. The majority of short term instruments will be out of scope of this requirement.

Instruments captured by the frontloading obligation are determined by a number of factors:

  • The instrument must be a derivative subject to mandatory clearing in the first place per the table
  • The categorisation of the counterparties to the trade, with the junior party’s obligations determining the ultimate obligation and timing
  • The remaining maturity of the contract as at the time the clearing obligation takes effect
  • The table below sets out the relevant factors. Assuming the instrument concerned is in scope for mandatory clearing, to establish whether the trade will be subject to the frontloading obligation you must assess it from the perspective of the junior party in terms of categorisation

5.4.1. Pre-frontloading dates

As ESMA has categorised the remaining maturity from the date the clearing obligation takes effect and set this at the maximum term for in scope instruments entered into prior to the frontloading date, none of the instruments in scope for mandatory clearing will be caught. As such firms will only need to consider trades entered into after the frontloading date and assess whether the remaining maturity is more than 6 months and therefore caught under the clearing obligation.

5.5. Categorisation of firms for the clearing obligation

Firm Category Category definition Date of application of clearing obligation Frontloading obligation Remaining Maturity
1 Clearing members of an authorised or recognised CCP for at least one of the above classes of instruments in scope for mandatory clearing 21 June 2016 Yes - frontloading date of 21 February 2016 Pre-frontloading date:
- 50 years Table 1 or 2
- 3 years Table 3 or 4
Post-frontloading date:
- 6 months Table 1 to 4
2 Financial Counterparties and NFC+ AIFs that which are not included in Category 1, and which belong to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for January, February and March 2016 is above EUR 8 billion 21 December 2016 Yes - frontloading date of 21 May 2016 Pre-frontloading date:
- 50 years Table 1 or 2
- 3 years Table 3 or 4
Post-frontloading date:
- 6 months Table 1 to 4
3a Financial Counterparties and AIFs NFC+ which are not included in Category 1 or 2 21 June 2017 Yes - frontloading date of 21 June 2017 Pre-frontloading date:
- 50 years Table 1 or 2
- 3 years Table 3 or 4
3b Trades with a third country group entity meeting the conditions for derogation 21 June 2017 Yes - frontloading date of 21 June 2017 Pre-frontloading date:
- 50 years Table 1 or 2
- 3 years Table 3 or 4
4 NFC+'s that are not included in categories 1, 2 or 3 21 December 2018 Not applicable -

5.6. What contracts are in scope for the clearing obligation

OTC Contracts entered into or novated either on or after the date from which the clearing obligation takes effect for that instrument or during the frontloading period detailed in Article 4(1)(b)(ii) (see below) and under certain conditions.

  • Whenever a novation takes place (i.e., there is a new counterparty to the trade), the clearing obligation will be triggered if the instrument is subject to mandatory clearing
  • Whenever a new contract is entered into in an instrument subject to mandatory clearing the trade will have to be cleared
  • Swaps resulting from the exercise of a swaption as below

5.6.1. Are swaps resulting from the exercise of swaptions in scope?

ESMA’s EMIR Q&As it makes clear that for in scope derivatives instruments and counterparties:

  1. For swaptions entered into prior to the frontloading window the resultant swaps will not be subject to the clearing obligation irrespective of when the swaption is exercised
  2. For swaptions entered into after the start of the frontloading period:
    Mandatory clearing applies where he swaption is exercised during the frontloading period and the resultant swap is above the minimum remaining maturity per the RTS
  3. And for any swaptions exercised after the clearing obligation takes effect the resultant swap will be subject to the clearing obligation

5.6.2. Are novations to a new counterparty subject to the clearing obligation?

ESMA’s EMIR Q&As it makes clear that for in scope derivatives instruments and counterparties all novations of any type which result in a new counterparty will be in scope of the reporting obligation.

5.7. Populating the clearing obligation field

The “clearing obligation” field tells ESMA whether or not the contract entered into is subject to mandatory clearing obligation. Identifying derivatives in scope for mandatory clearing is all important as the clearing obligation flag must be correctly populated. That means in scope derivatives will need to be identified irrespective of whether they are already being cleared or not, including those captured under the frontloading obligations. A contract is subject to mandatory clearing obligations from the point that the obligation takes effect for that category of counterparty, rather than when the contract is to be cleared.

That will mean assessing all trades entered into after the frontloading period begins. Currently, this field should be populated with an “N” but for Category 1 firms this may change post 21 June 2016. Trades which will be subject to mandatory clearing entered into prior to this date should be flagged as “N” in the clearing obligation field until the clearing obligation takes effect the timing of which will be based on the firm’s category and that of its counterparty.

For contacts that are not subject to the clearing obligation and contracts in the other asset classes, the clearing obligation is not applicable so “it is considered that counterparties should report ‘X’”. It is considered that “N” would also be acceptable as the contracts are not subject to the clearing obligation.

For interest rate derivatives, the authors think that the obligation to flag either Y or N will apply to all categories of counterparty from the first front loading date of February 21 for G4 interest rate swaps. This is based on the diagram provided by ESMA which shows category 2 counterparties having to flag their contracts with an “N” where they are entered into before the category 2 front loading period begins but after the category 1 frontloading period commencement date of February 21, 2016.

The diagram above is a copy of the one presented by ESMA in the Q&As (page 92). These authors believe that it can be extended for category 3 and 4 counterparties by extrapolating from the requirements for category 2 counterparties. Using this approach, category 3 and 4 counterparties will have to populate the clearing obligation field with an “N” until the front loading obligation comes in for category 3 counterparties on June 21, 2017 and the clearing obligation takes effect for category 4 counterparties on December 21. Similarly, non-financial counterparties below the clearing threshold (NFC-) should continue to populate the “clearing obligation” field with “X”.

FCs and NFC+ firms should therefore have already been populating the clearing obligation field for their interest rate products.

5.7.1. Novations and Swaptions

The ESMA Q&As also provide clarity on dealing with novations and swaptions. These should be dealt with as below:

  • All novations of any type which result in a new counterparty will be subject to the clearing obligation.
  • For swaptions entered into prior to the frontloading window, the resultant swaps will not be subject to the clearing obligation irrespective of when the swaption is excercised.
  • For swaptions entered into after the start of the frontloading period:
    • Mandatory clearing applies where the swaption is exercised during the frontloading period and the resultant swap is above the minimum remaining maturity per the RTS

For any swaptions exercised after the clearing obligation takes effect, the resultant swap will be subject to the clearing obligation.

5.8. Mandatory clearing scenarios

5.8.1. Trade pre-frontloading date

5.8.1.1. Scenario 1

Scenario: Prior to the frontloading date, two firms both clearing members of ICE (and therefore category 1 firms) enter into a 50yr LIBOR GBP basis swap.

Analysis: Evaluate the remaining maturity at the point where the clearing obligation takes effect. For two category 1 firms this will be 21 June 2016. By that time there is 49.5 years remaining maturity on the derivative. As the derivative instrument is a basis swap from table 1 the minimum remaining maturity must be 50 years.

Conclusion: This trade will not be subject to the clearing obligation as it is below 50 years.

5.8.1.2. Scenario 2

Scenario: Prior to the frontloading date, two firms both clearing members of ICE enter into a 60yr LIBOR GBP basis swap.

Analysis: As the swap has a 60 year maturity when entered into, the instrument is not within the table of instruments subject to mandatory clearing.

Conclusion: This trade will not be subject to the clearing obligation as the instrument is out of scope.

5.8.1.3. Scenario 3

Scenario: Pre the frontloading date, two firms one Category 1, a clearing member of ICE and one Category 2 an NFC+ enter into a 50yr LIBOR GBP basis swap.

Analysis: Evaluate the remaining maturity at the point where the clearing obligation takes effect. For a category 1 firm and a category 2 firm this will be 21 December 2016. By that time there is 49.3 years remaining maturity on the derivative. As the derivative instrument is a basis swap from table 1 the minimum remaining maturity must be 50 years.

Conclusion: This trade will not be subject to the clearing obligation as it is below 50 years.

5.8.2. Trade post-frontloading date

5.8.2.1. Scenario 1

Scenario: Post the frontloading date, two firms both clearing members of ICE enter into a 50yr LIBOR GBP basis swap.

Analysis: Evaluate the remaining maturity at the point where the clearing obligation takes effect. For two category 1 firms this will be 21 June 2016. By that time there is 49.8 years remaining maturity on the derivative. As the derivative instrument is a basis swap from table 1 the minimum remaining maturity must be 6 months.

Conclusion: This trade will be subject to the clearing obligation as the instrument is in scope (Table 1) and the remaining maturity is over 6 months (post-frontloading date) as at the mandatory clearing date.