Category: European Union Electricity Market Glossary

Published: 31 March 2014

Last Updated: 08 December 2023

 

Over-the-counter (OTC) derivatives are privately negotiated and not traded on a regulated exchanges such as regulated markets.

6 April 2022  Commission Implementing Decision (EU) 2022/552 of 4 April 2022 determining that national securities exchanges of the United States of America that are registered with the Securities and Exchange Commission comply with legally binding requirements which are equivalent to the requirements laid down in Title III of Directive 2014/65/EU and are subject to effective supervision and enforcement published In the EU Official Journal

 

OTC derivatives are generally less standardised and more complex than Exchange-Traded Derivatives (ETDs). They may be bought for a variety of reasons, for example, they may work as a hedge for a particular position in the balance sheet, or might have been taken with the intent of benefiting from market movements. OTC derivatives therefore have a significant impact on the real economy, from mortgages to food prices. 

The definition of "OTC derivative" is not harmonised at a global level and varies among jurisdictions (Technical Guidance, Harmonisation of the Unique Transaction Identifier, Committee on Payments and Market Infrastructures, Board of the International Organization of Securities Commissions, February 2017, p. 6).

 

  

 

When it comes to the European Union legal framework, pursuant to Article 2(7) of EMIR Regulation, OTC derivatives are defined as derivatives contracts whose execution does not take place on a regulated market (or on a third-country market considered as equivalent to a regulated market in the prescribed manner).

The European Securities and Markets Authority (ESMA) has acknowledged in its Questions and Answers that under EMIR derivatives contracts whose execution takes place on Multilateral Trading Facility (MTF) and Organised Trading Facility (OTF) are OTC derivatives.

The ESMA in the Q&As on EMIR Implementation OTC Q.1(d) indicated some 'OTC derivatives' terminology complexities:

"Derivatives transactions, such as block trades, which are executed outside the trading platform of the regulated market, but are subject to the rules of the regulated market and are executed in compliance with those rules, including the immediate processing by the regulated market after execution and the clearing by a CCP, should not be regarded as OTC derivatives transactions.

Therefore, these transactions should not be considered for the purpose of the clearing obligation and the calculation of the clearing threshold by NFC that only relates to OTC derivatives.
Derivatives transactions that do not meet the conditions listed in the first paragraph of this sub-answer (d) should be considered OTC. For example, derivatives contracts that are not executed on a regulated market and are not governed by the rules of an exchange at the point of execution should be considered OTC even if after execution they are exchanged for contracts traded in a regulated market. However, the replacement contract itself may be considered exchange traded if it meets the relevant conditions."

A significant share of the OTC derivative market will eventually be brought to central clearing as a result of the clearing obligation gradually entering into force in Europe.

See also:   Physically settled commodity derivatives in MiFID II   C6 energy derivatives contracts   Financial instruments   Commodity   Energy commodity contract

The OTC character of the product has several implications in particular as regards specific risks. Among them are:

- a counterparty risk,
- principal-to-principal contracts are concluded once the the position is opened, which means the position will have to be closed with the same counterparty,
- the risks of leveraged trading, both in a normal trading environment and in stressed market conditions, particularly for CFDs and rolling spot forex,
- further specific risks for CFDs and rolling spot forex such as negative price movement in the underlying can potentially lead to a margin call and the subsequent triggering of an automated margin close-out of positions. 

See, moreover, general remarks on the 'OTC' notion, including, among others, the REMIT Regulation context (having its specificity).

 

Third country aspect

 

Derivative contracts executed on a third-country market which has been considered to be equivalent to an EU regulated market by the European Commission in accordance with Article 2a of EMIR, are not OTC derivatives under EMIR and do not count for the purpose of the determination of the clearing threshold under Article 10 of EMIR. However, derivative contracts executed on third-country markets which have not been considered to be equivalent to an EU regulated market, will count for the determination of the clearing threshold.

Article 2a states that the European Commission shall publish a list of those markets that are to be considered to be equivalent.

ESMA maintains on its website a consolidated list of third-country markets that have been considered to be equivalent to an EU regulated market for the purpose of the OTC derivative definition under EMIR (see here the list of non-EU exchanges equivalent to a regulated market).

 

Brexit's impact

 

The European Commission in Notice of 14 July 2020 on Withdrawal of the United Kingdom and EU rules in the field of post-trade financial instruments (REV1 - replacing the notice dated 8 February 2018) reminds that after the end of the transition period, derivatives traded on a UK regulated market will no longer fulfil the definition of exchange traded derivatives (ETDs) under EU law. According to Article 2(32) of MIFIR, ETDs are derivatives traded on an EU regulated market, or on a third-country market considered to be equivalent. Thus, under EU law, after the end of the transition period, ETDs traded on a UK regulated market will be over-the-counter (OTC) derivative contracts.

An ETD that becomes an OTC derivative will thus become subject to all EMIR requirements applicable to OTC derivatives transactions.

With the exception of hedging transactions entered into by non-financial counterparties, all OTC derivatives transactions count towards the calculation of the clearing threshold in accordance with the provisions of EMIR, and will be subject to the EMIR clearing obligation, provided that the product concerned has been made subject to that obligation, as well as certain risk mitigation techniques (notably the exchange of margins).

The Commission is empowered by Article 2a of EMIR to declare a third country market equivalent. While the assessment of the UK’s equivalence in this area is ongoing, the assessment has not been finalised. All stakeholders thus have to be informed and ready for a scenario where derivatives traded in the UK regulated markets are treated as OTC derivatives.

 

EMIR/MiFIR complexities

 

The comparison of the meaning of the term: "OTC derivative" under EMIR on the one hand, and the MiFIR on the other, exhibits some nuances - MiFIR meaning being narrower than the EMIR one (see box). Under EMIR derivatives are considered to be executed on an OTC basis when they are not traded on, or not subject to the rules of, a regulated market. In turn, the definition of derivatives executed over-the-counter (OTC) under MiFID II comprises derivatives not traded on, or not subject to the rules of, a regulated market, multilateral trading facility (MTF) or organised trading facility (OTF).

 

Reporting for OTC derivatives under EMIR

 

Commission Delegated Regulation (EU) 2017/104 of 19 October 2016 amending Delegated Regulation (EU) No 148/2013 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards on the minimum details of the data to be reported to trade repositories prescribes the following EMIR reporting format for OTC derivatives (Field 15 of the Table 2 (Common data)):

- where a contract was concluded OTC and the respective instrument is admitted to trading or traded on a trading venue, the MIC code 'XOFF' should be used;

- where a contract was concluded OTC and the respective instrument is not admitted to trading or traded on a trading venue, the prescribed MIC code is 'XXXX'.

 

OTC derivatives market
 

The European derivatives are traded mainly OTC. According to the document: "Risk Assessment on the temporary exclusion of exchange traded derivatives from Articles 35 and 36 of MiFIR of exchange traded derivatives from Articles 35 and 36 of MiFIR" of 4 April 2016 (ESMA/2016/461, p. 11) the OTC derivatives market is dominated: 

- by interest rate derivatives (IRD) - when measured by outstanding notional amounts (75% of the volumes), 

- by foreign-exchange (36%), interest rates (28%), and equity (23%) - when measured by outstanding number of trades.

The ESMA Report on Trends, Risks and Vulnerabilities No. 2. 2017 “EU derivatives markets ─ a first-time overview” (ESMA50-165-421, p. 8) notes that the OTC transactions are predominant on FX, credit and interest rate derivatives markets. Gross notional value of the global over-the-counter derivatives market amounted to US$544trn in the first six months of 2016, a 10% increase over the previous six months but down from US$696trn three years earlier. 62% of OTC derivatives notional was cleared through central counterparties as of June 2016. OTC derivatives market is dominated by interest rate derivatives with gross notionals totaling US$438trn at the end of June 2016 (Derivatives-Swaps notional jumps to US$544trn in first half - BIS). As of end-June 2016, the outstanding notional of OTC derivatives amounted to USD 544.1 trillion, corresponding to 89% of the overall derivatives market (Bank for International Settlements, Triennial Central Bank Survey - OTC derivatives positions at end-June 2016, Table 1, Monetary and Economic Department, 11 December 2016). As of 31 December 2019, the outstanding notional amount of OTC derivatives was about EUR 500 trillion worldwide, of which interest rate derivatives represented more than 75 % and foreign exchange derivatives almost 20 %. About 30 % of all OTC derivatives were denominated in euro and other Union currencies.

The market for central clearing of OTC derivatives is highly concentrated, in particular the market for central clearing of euro-denominated OTC interest rate derivatives, of which more than 90 % are cleared in a single UK CCP (Recital 4 of Commission Implementing Decision (EU) 2020/1308 of 21 September 2020 determining, for a limited period of time, that the regulatory framework applicable to central counterparties in the United Kingdom of Great Britain and Northern Ireland is equivalent, in accordance with Regulation (EU) No 648/2012 of the European Parliament and of the Council).

Explanatory Memorandum to the European Commission Proposal of 25 November 2021 for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 600/2014 as regards enhancing market data transparency, removing obstacles to the emergence of a consolidated tape, optimising the trading obligations and prohibiting receiving payments for forwarding client orders (COM(2021) 727 final) mentions that “OTC derivatives markets are dealer markets, where major international banks offer bespoke contracts to their clients, e.g., for taking a position to protect against future price movements (hedging). There is very little post-trade transparency in OTC markets. The 2020 ESMA annual statistical report shows that OTC derivatives still account for 85% of the notional value of derivatives traded in the Union (with the remaining 15% being traded on exchange). Because there is currently no consolidated public view of prices for OTC derivatives, the high percentage of OTC trading contributes to opacity in the pricing of these derivatives and, in consequence, to information asymmetries that primarily hurt smaller market participants”. 

The legal, supervisory and enforcement arrangements applicable in the USA for OTC derivative contracts are laid down in title VII of the Dodd Frank Wall Street Reform and Consumer Protection Act (‘Dodd-Frank Act’) and in the specific implementing rules adopted by the Commodity Futures Trading Commission (‘CFTC Regulations’).

The Dodd-Frank Act, which entered into force in July 2010, established a new regulatory framework for certain OTC derivatives defined as swaps in section 1a(47) of the Commodity Exchange Act (‘CEA’), aiming at reducing systemic risk, increasing transparency and promoting market integrity within the financial system.

The CFTC has jurisdiction over swaps and most of the operative provisions of title VII of the Dodd-Frank Act became applicable in 2011 (Recital 6 of the Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories).

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