Europe serves up OTC reprieve

Introduction

The EU’s proposed legislation on OTC derivatives hit the headlines again on Tuesday when the European Parliament’s EAC approved the Commission’s proposals.

The proposed legislation originated with concerns about the safety and transparency of the OTC derivatives markets following the collapse of Lehman Brothers and the bailout of a number of other institutions including AIG. At a summit in Pittsburgh in September 2009, the G20 leaders made a commitment that all standardised OTC derivatives should be cleared through CCPs by the end of 2012 and that all OTC derivatives should be reported to trade repositaries.

What are OTC derivatives?

OTC derivatives are contracts concluded directly between two parties, without going through an exchange or CCP. OTC derivatives are now fairly commonly used by UK occupational pension schemes, for example inflation and interest rate swaps are used to help reduce inflation and interest rate risk. Investment managers – particularly bond managers – have also increasingly been authorised in recent years to make use of OTC derivatives as part of the efficient management of their portfolios.

Pension schemes have been concerned that the proposals could make it much more difficult for them to make use of OTC derivatives in an efficient way for risk reduction or efficient portfolio management. EU pension schemes are already subject to prudential restrictions on the use of derivatives, so a number of bodies have suggested that pension schemes should be exempt from the new requirements.

EU Proposals

The EU proposals in essence carry forward the commitments made by the G20 leaders – i.e. to require OTC derivatives to be cleared through CCPs and reported to trade repositaries.

Mandatory for new transactions only

In a move that will be welcomed, the EAC has confirmed that clearing will only be mandatory for transactions concluded after the regulations come into force. The EAC has accepted that the application of the new rules to existing transactions “would result in legal difficulties and create major problems for counterparties”.

Special regime for pension schemes

The EU Parliament’s press release says that there will be a “special regime” for pension funds, “provided that the national capital requirements provide a guarantee similar to cleared contracts”.

Our understanding of the Commission’s proposal (which appears to have been accepted by the EAC) is that pension schemes will be exempt for three years from the requirement to clear OTC transactions through CCPs if the transaction is objectively measurable as reducing risks directly related to the financial solvency of pension scheme investments. The Commission will have power to extend the three year period if the burden for pension schemes of clearing through CCPs would still be disproportionate.

If this is carried forward, it could mean that OTC transactions which are aimed more at “efficient portfolio management” than at risk reduction would have to be cleared.

The proposals do not exempt pension schemes from the requirement to report transactions to trade repositaries (to enhance transparency for regulators).

What next?

This is not the end of the story. The next stage is that the proposal will go before the European Parliament for clearance (at a full plenary session) in July 2011. The proposal then moves on to the European Council where there could be further negotiations. Swift implementation is therefore not certain and it is entirely possible that there will be changes before the proposal becomes European law.

The law will be a directive, so it will then be for each member state of the EU to develop legislation to implement the directive and for national regulators and the new European Securities and Markets Authority to develop the regulatory framework. We will be monitoring developments.