On September 15th, the European Commission issued its “Proposal for a Regulation of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories” (the “EC Proposal”).
The EC Proposal states that it is part of a larger international effort to increase the stability of the financial system, in general, and the OTC derivatives market, in particular. It further states that an internationally coordinated approach is required to avoid the risk of “regulatory arbitrage.” In that regard, the EC Proposal notes that it has a broadly identical scope of application to the Dodd-Frank legislation in the United States relating to derivatives.
As one of its primary areas of focus, the EC Proposal encourages the central clearing of standardized derivatives contracts. It does so by introducing two approaches: (i) a “bottom-up” approach, under which a central clearing party (“CCP”) would decide to clear certain types of contracts and would be authorized to do so by its competent authority which, in turn, would inform the European and Securities Markets Authority (“EMSA”) which would then decide whether all such contracts should be centrally cleared and (ii) a “top-down” approach, under which EMSA, together with the European Systemic Board, would determine which types of contracts should potentially be subject to central clearing. Also, similar to Dodd-Frank, the EC Proposal provides an end-user exemption to clearing. In particular, the EC Proposal recognizes that central clearing should not be required of “non-financial (corporate)” counterparties, provided that their OTC derivatives positions do not reach a specified threshold and they are not considered to be systemically important. To this end, the EC Proposal sets out a process to help identify non-financial institutions with systemically important positions in OTC derivatives and subjects them to certain additional obligations.
CCPs are to play a significant role under the EC Proposal. As a result, the EC Proposal focuses great attention on the governance arrangements, operational systems and controls and financial resources of CCPs established in European Union member states. Also, similar to Dodd-Frank, the EC Proposal includes requirements for the reporting of transactions and requirements for trade repositories. Among other things, detailed information regarding derivatives transactions will be required to be reported to trade repositories, which will make the data available to national regulatory authorities.
In several respects, the EU Proposal lines up quite closely with the Dodd-Frank provisions for the regulation of the derivatives markets. However, the two are far from identical. Unlike Dodd-Frank, the EC Proposal appears not to require the trading of standardized contracts on exchanges or execution facilities or the “push-out” from banks of certain types of derivatives transactions. It remains to be seen whether the United States and European efforts will diverge in any significant respects in their implementation, leading to regulatory arbitrage that market participants could exploit and, ultimately, to market confusion and instability.