OTC Credit Default Swaps (CDS) mandatory clearing
- Category: EMIR
In the OTC Credit Default Swaps (CDS) asset class the number of active European counterparties oscillated between around 2,000 in February 2015 and 2,800 one year later.
In turn, ESMA Report on Trends, Risks and Vulnerabilities No. 2. 2017 “EU derivatives markets ─ a first-time overview” (ESMA50-165-421, p. 4, 5) evidences 9,829 unique counterparty identifiers reported in the credit derivative segment.
Nevertheless, it is the smallest derivatives market in terms of the number of counterparties, as firms entering into credit derivative contracts are typically those with substantial financial hedging needs.
The vast majority of trades were OTC.
The CDS market is highly concentrated - an important number of counterparties account for only a small fraction of the total volume.
Consultation Paper on the clearing obligation for financial counterparties with a limited volume of activity of 13 July 2016 (ESMA/2016/1125, p. 11 - 13) mentions that counterparties with portfolios of OTC credit derivatives above EUR 500mn represent 98.6% of the activity, and 14.5% in terms of number of counterparties.
Commission Staff Working Document of 13 June 2017 (SWD/2017/0246 final - 2017/0136 (COD), p. 18) evidenced only one EU CCP clearing credit derivatives while the aforementioned ESMA Report on Trends, Risks and Vulnerabilities No. 2. 2017 “EU derivatives markets ─ a first-time overview” refers to six CCPs in total that are active in the credit derivatives market – two of which are authorised in the EU, while the other four are established in third countries.
The said Report also observes there are 76 clearing members active in this market segment.
Mandatory clearing with respect to CDS asset class covers the following types of contracts:
- untranched iTraxx Index credit default swaps (Europe Main, five-year tenor, series 17 onwards, with EUR as the settlement currency)
- untranched iTraxx Index credit default swaps (Europe Crossover, five-year tenor, series 17 onwards, with EUR as the settlement currency).
The legal base for the clearing obligation with respect to CDS derivatives is the Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation.
The detailed specification of Credit Default OTC derivatives classes subject to the clearing obligation is as follows:
European untranched Index CDS Classes
|| Geographical Zone
|Untranched Index||Europe||iTraxx Europe Main||EUR||17 Onwards||
||Untranched Index||Europe||iTraxx Europe Crossover||EUR||17 Onwards||
Overall, these rules supplement the European Market Infrastructure Regulation (EMIR) and form part of the implementation of the agreement by G20 leaders in 2009 that standardised OTC derivative contracts should be cleared through central counterparties (CCPs).
In this respect ESMA consulted stakeholders in July 2014 (ESMA's document of 11 July 2014 ESMA/2014/800).
Although the feedback received to this consultation was broadly positive, ESMA temporarily suspended the delivery of the final proposal to the European Commission until the first rules on the Interest Rate Swaps (IRS) mandatory clearing were finalised.
ESMA adopted the Final draft Regulatory Technical Standard for CDS on 2 October 2015.
The respective Regulatory Technical Standard for CDS has been adopted by the European Commission on 1 March 2016 (C (2016) 1165 final)).
On 19 April 2016, the said EU Commission Delegated Regulation has been published in the European Union's Official Journal.
The said RTS defines types of CDS contracts, which will have to be centrally cleared, the types of counterparties covered by the obligation and the dates by which central clearing of CDS will become mandatory.
The new rules on Index CDS mirror the overall approach of the first RTS on IRS mandatory clearing, in particular with regards to the categorisation of counterparties, the scope for frontloading and the treatment of intragroup transactions.
They will be phased in over three years.
The Delegated Regulation confirms the start date for the mandatory clearing of the relevant credit derivative contracts from 9 February 2017 onwards, subject to phase-ins, as detailed in the Delegated Regulation.
Certain firms will also be subject to the frontloading requirement from 9 October 2016.
Among the most vital points are: the counterparties' categorisation, dates from which the CDS mandatory clearing takes effect, intragroup treatment and frontloading (of note is the fact that the European Commission's propositions as regards the reform of the EMIR framework published in May 2017 provide for the removal of frontloading requirements - see point (b) of Article 1(2) the Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 of 4 May 2017).
For the purposes of the clearing obligation counterparties in the CDS asset class are broadly categorised in the following manner:
- Clearing members for at least one of the classes of OTC CDS subject to clearing;
- Financial counterparties and alternative investment funds (AIFs) which are not clearing members and which have a higher level of activity in OTC derivatives (to be measured against the quantitative threshold (i.e. with individual portfolios above EUR 8 bn);
- Financial counterparties and alternative investment funds (AIFs) which are not clearing members and which have a lower level of activity in OTC derivatives (to be measured against the aforementioned quantitative threshold);
- Non-financial counterparties not included in the other categories.
This is expressed in Article 2 and Recitals 3 - 7 of the Commission Delegated Regulation (EU) 2016/592 of 1 March 2016 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation.
When it comes to the breakdown of the cleared volumes in the credit derivative asset class to the above categories, analytical data show the following:
- clearing members (Category 1) represent 85.6% of the volume and 0.7% of the number of counterparties;
- counterparties classified in the Category 2 (i.e. with individual portfolios above EUR 8 bn) represent 9.3% of the volume and 5.9% of the number of counterparties;
- counterparties classified in the Category 3 (i.e. with individual portfolios below EUR 8 bn) represent 5.1% of the volume and 93.5% of the number of counterparties (Consultation Paper on the clearing obligation for financial counterparties with a limited volume of activity, 13 July 2016, ESMA/2016/1125, p. 19).
However, these numbers may be somewhat skewed as a financial counterparty with a portfolio of CDS derivatives below EUR 8 bn may be classified primarily under Category 3 whereas in reality, it may belong to Category 2 because it is part of a larger group (the fact recalled by the ESMA itself).
See below in the boxes some excerpts in this regard.
In turn, the Brexit’s impact on the timelines of EMIR CDS mandatory clearing has been addressed by Commission Delegated Regulation (EU) 2019/565 of 28 March 2019 amending Delegated Regulation (EU) 2015/2205, Delegated Regulation (EU) 2016/592 and Delegated Regulation (EU) 2016/1178 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council as regards the date at which the clearing obligation takes effect for certain types of contracts.
Amendments involved with the cessation of the publication of LIBOR settings
ICE Benchmark Administration (IBA), the administrator for LIBOR, announced that GBP and JPY LIBOR settings will cease publication at the end of 2021, whereas the publication of certain settings of USD LIBOR will cease in June 2023.
On 5 March 2021, the United Kingdom Financial Conduct Authority confirmed that all LIBOR settings will either cease to be provided by any administrator or no longer be representative. In addition, the Commission, the European Central Bank in its banking supervisory capacity (ECB Banking Supervision), the European Banking Authority (EBA) and the ESMA issued a joint statement to strongly encourage counterparties to stop using any of the LIBOR settings, including USD LIBOR, as a reference rate in new contracts as soon as practicable and in any event by 31 December 2021.
After 31 December 2021, counterparties will hence no longer be able to enter into OTC interest rate derivatives contracts referencing GBP LIBOR as that benchmark will have ceased and counterparties are expected to no longer enter into OTC interest rate derivatives contracts referencing USD LIBOR.
As a result of these market developments, to adjust EMIR clearing obligation to the new set of liquid benchmarks, on 8 February 2022 the European Commission adopted Commission Delegated Regulation amending the regulatory technical standards laid down in Delegated Regulation (EU) 2015/2205 as regards the transition to new benchmarks referenced in certain OTC derivative contracts (C(2022) 619 final).