Regulatory Technical Standards prejudge that facilitating indirect clearing arrangements is not mandatory for clearing members – the contentious issue as yet.
So, certain basic parameters for indirect clearing relations have been proposed by ESMA to the European Commission.
I have in mind obviously the Draft regulatory technical standards on OTC derivatives Commission Delegated Regulation supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, risk mitigation techniques for OTC derivatives contracts not cleared by a CCP enclosed to the ESMA’s Final Report of 27 September 2012 ESMA/2012/600 (Regulatory Technical Standards or RTS).
The notions for „indirect client‟ and „indirect clearing arrangement‟ have been defined at the very beginning of the RTS, thus for the purpose of EMIR:
(1) „indirect client‟ means the client of a client of a clearing member;
(2) „indirect clearing arrangement‟ means the set of contractual relationships between the CCP, the clearing member, the client of a clearing member and indirect client that allows the client of a clearing member to provide clearing services to an indirect client.
The very meaning of indirect client relationship had been interpreted in a divergent way so far, there was also confusion whether the definition of an indirect clearing arrangement encompasses traditional client relationships with CCP clearing members (see: Types and consequences of indirect clearing arrangements for CCP-cleared OTC emissions trades under EMIR). When RTS become binding law (i.e. after adoption of the relevant regulation by the European Commission) there will be no legal ground for further ambiguities in that regard.
Indirect clearing obligation
Regulatory Technical Standards also prejudge that facilitating indirect clearing arrangements is not mandatory for clearing members – the second contentious issue as yet.
Regulatory Technical Standards state that where a clearing member is prepared to facilitate indirect clearing, any client of such clearing member will be permitted to provide indirect clearing services to one or more of its own clients, provided that the client of the clearing member is an authorised credit institution, investment firm or an equivalent third country credit institution or investment firm.
On the basis of the said provision it follows that providing indirect clearing services:
1) has been restricted to authorised credit institutions and investment firm, and
2) is legally required of such a firms only “where a clearing member is prepared to facilitate indirect clearing”.
It can be inferred a contrario that “where a clearing member is not prepared to facilitate indirect clearing” he has not legal obligation to do so. And in this way has been resolved the problem that had been battering financial market participants for some time.
The procedure for indirect clearing contract
The contractual terms for an indirect clearing arrangement are to be agreed obviously between the client of a clearing member and the indirect client, but RTS specify that it should be done after consultation with the clearing member on the aspects that can impact the operations of the clearing member.
The procedure must include contractual requirements on the client to honour all obligations of the indirect client towards the clearing member. RTS envision that these requirements refer only to transactions arising as part of the indirect clearing arrangement, the scope of which must be clearly documented in the agreed contracts.
Portability and segregation
At the request of a clearing member, the CCP must maintain separate records and accounts enabling each client to distinguish in accounts held with the CCP the assets and positions of the client from those held for the accounts of the indirect clients of the client.
Such a rule of the RTS can be viewed as a second step in accounts segregation in comparison with Article 39 of the EMIR.
Article 39 of EMIR prescribes the CCP to keep separate records and accounts that enable it, at any time and without delay, to distinguish in accounts with the CCP the assets and positions held for the account of clearing member from:
1) the assets and positions held for the account of any other clearing member and from its own assets; and
2) from those held for the accounts of its clients (‘omnibus client segregation’).
The said provision also mandates a CCP to offer to keep separate records and accounts enabling each clearing member to distinguish in accounts with the CCP the assets and positions held for the account of a client from those held for the account of other clients (‘individual client segregation’). Upon request, the CCP shall offer clearing members the possibility to open more accounts in their own name or for the account of their clients.
EMIR is not clear as regards segregation of indirect client account as it only requires that a clearing member must keep separate records and accounts that enable it to distinguish both in accounts held with the CCP and in its own accounts its assets and positions from the assets and positions held for the account of its clients at the CCP.
However, the choice between omnibus client segregation and individual client segregation is left to the competence of the client of the clearing member. The consequences of this decision are significant, however, this is an interesting topic for another post.
In any case, when facilitating indirect clearing arrangements, a clearing member must implement the following segregation arrangements as indicated by the client:
(a) keep separate records and accounts enabling each client to distinguish in accounts with the clearing member the assets and positions of the client from those held for the accounts of its indirect clients; or
(b) keep separate records and accounts enabling each client to distinguish in accounts with the clearing member the assets and positions held for the account of an indirect client from those held for the account of other indirect clients.
The requirement to distinguish assets and positions with the clearing member is met where:
(a) the assets and positions are recorded in separate accounts;
(b) the netting of positions recorded on different accounts is prevented;
(c) the assets covering the positions recorded in an account are not exposed to losses connected to positions recorded in another account.
Another key point for indirect clients is to contractually ensure the possibility for transferring the positions and assets to an alternative client or clearing member in case of the default of a client that provides indirect clearing services. In order to do so, from an indirect client point of view it is necessary to verify the procedures, the clearing member possesses to manage the default of a its clients.
RTS specify that a client or clearing member is not obliged to accept these positions unless it has entered into a prior contractual agreement to do so. The clearing member must also ensure that its procedures allow for the prompt liquidation of the assets and positions of indirect clients and the clearing member to pay all monies due to the indirect clients following the default of the client.
RTS also impose an obligation on clients that provide indirect clearing services to keep separate records and accounts that enable it to distinguish between its own assets and positions and those held for the account of its indirect clients. Indirect clients must be offered a choice between the above-specified alternative account segregation options and fully informed of the risks associated with each segregation option. The information provided by the client to indirect clients must also include details of arrangements for transferring positions and accounts to an alternative client.
The specific segregated account held at the CCP by the client that provides indirect clearing services must be for the exclusive purpose of holding the assets and positions of its indirect clients.
When referring to the above issues it is also important to mention Article 48(7) of EMIR, which stipulates that clients’ collateral distinguished in segregated accounts may be used exclusively to cover the positions held for their account. Any balance owed by the CCP after the completion of the clearing member’s default management process by the CCP must be readily returned to those clients when they are known to the CCP or, if they are not, to the clearing member for the account of its clients.
The practical importance of the above considerations is highlighted by Lehman and MF Global instances where in both cases, which involved cleared derivatives, clients suffered losses whereas clearing members did not (the fact referred to by the International Swaps and Derivatives Association (ISDA) in a document of 3 April 2012 ‘Industry Response to the European Banking Authority, European Securities Markets’ Association and European Insurance and Occupational Pensions Authority Joint Discussion Paper on Risk Mitigation Techniques for Trades not Cleared by a Central Counterparty’).
Admittedly, ISDA is right emphasising the key issue, which is the segregation depends on local law and insolvency regulation and the interactions between jurisdictions can be lengthy and complex.