by Alston & Bird LLP and Melinda C. Calisti
Today, the European Commission (EC) released proposed regulations on over-the-counter (OTC) derivatives, central counter parties and trade repositories, which is intended to bring ‘more safety and more transparency to the OTC derivatives market.’ Separately, the EC also today released proposed regulations which would require an increase in the disclosure of short selling and certain aspects of credit default swaps (CDS).
Regulation of OTC Derivatives
This proposed regulation of OTC derivatives follows agreements by G-20 leaders September 2009 that ‘all standard OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest’ and ‘OTC derivative contracts should be reported to trade repositories and that non-centrally cleared contracts should be subject to higher capital requirements.’ The EC’s proposal implements the G-20 commitments and is intended to closely align with the regime contemplated under the Dodd-Frank Act. According to Michel Barnier, Commissioner for Internal Market and Services, ‘the absence of any regulatory framework for OTC derivatives contributed to the financial crisis and the tremendous consequences we are all suffering from. Today, we are proposing rules which will bring more transparency and responsibility to derivatives markets – so we know who is doing what and who owes what to whom.’
Key elements of the proposal include:
- Greater transparency: The proposal requires that trades in OTC derivatives in the EU be reported to trade repositories and that these trade repositories make public aggregate positions by class of derivatives to provide market participants with a ‘clearer view’ of the OTC derivative market. However, the data will not be published at trade level due to the commercially sensitive nature of the information. In addition, the new European Securities and Markets Authority (ESMA) will be responsible for the identification of contracts subject to clearing obligations. Under the proposal the ESMA will also be responsible for the surveillance of trade repositories, the granting and withdrawing registration and the development of technical standards for the application of the proposed regulation.
- Reducing counterparty risks: The proposal also requires that OTC derivatives that have met pre-defined eligibility criteria be cleared through central counterparties (CCPs). Risk management standards will apply to ineligible contracts that are not subject to CCP clearance. The EC believes that this proposal will reduce counterparty risk because clearance by a CCP involves the posting of higher collateral, which will increase the amount of collateral in the system. Since CCPs will be assuming more risks under the new proposal, the proposal mandates stringent conduct of business, and organizational and prudential requirements on CCPs to ensure safety and reduce risks related to the concentration of collateral.
- Reducing operational risks: Finally, the proposal requires that market participants measure, monitor and mitigate operational risk, which is ‘the risk of loss resulting from inadequate or failed internal processes, people and systems, or from external events.’ To achieve this objective, the proposal requires the use of electronic means to confirm the terms of the OTC derivative contracts.
Selling and CDS
According to Mr. Barnier, ‘[I]n distressed markets, short selling can amplify price falls, leading to disorderly markets and systemic risks. Today’s proposal will increase transparency for regulators and markets, and make it easier for regulators to detect risk in sovereign debt markets.’ Similar to the provisions of the Dodd-Frank Act requiring the SEC to adopt rules for at least monthly public disclosure of the amount of short sales by institutional investment managers, and in light of the expectation that the CFTC and SEC will produce joint rules to implement comprehensive CDS regulation, the EU sought to achieve the following objectives in its proposed regulation:
- Increased transparency: The proposal requires greater transparency on short positions held by investors in certain EU securities to address the current lack of information for market participants and regulators. Under the proposal, all share orders on trading venues must be flagged as ‘short’ if they involve a short sale. In addition, investors must disclose significant net short positions to regulators if they amount to 0.2% of the issued share capital of a company, and to the market at a higher 0.5% threshold. This disclosure requirement is intended to better inform market participants and allow regulators to monitor the market and detect risks.
- Power of Intervention for Regulators and Coordination with the ESMA: The proposal also provides the Member States with powers to intervene, with coordination with the ESMA, in exceptional situations, including during periods of volatile trading, to temporarily restrict or ban short selling. This proposal is aimed at reducing both “systemic risks and risks to financial stability and market confidence arising from short-selling and CDS.
- Reduction of settlement risks: Finally, the proposal seeks to reduce settlement risks and other risks connected with uncovered or “naked” short selling. Under the proposal, ‘naked’ short selling will only be allowed in limited circumstances. The proposal requires that ‘to enter a short sale, an investor must have borrowed the instruments concerned, entered into an agreement to borrow them, or have an arrangement with a third party to locate and reserve them for lending so that they are delivered by the settlement date [at the latest 4 days after the transaction].’ According to the EC, ‘this approach addresses the risks of settlement failure while taking into account existing best practice in many markets, which is for firms to locate shares for borrowing prior to executing a short sale order.’
In addition, certain exemptions have been included in the proposed regulation:
- Market making activities are exempted because they ‘play an important role in providing liquidity, and restricting their ability to short sell would have a significant adverse effect on the liquidity of markets.’
- Primary market operations because they are ‘legitimate functions that are important for the proper functioning of primary markets’; and
- Shares whose principal market is outside the EU ‘because it would not be proportionate to apply short selling requirements where most trading of the share takes place outside the EU.’
Approval and Implementation
The proposals must be approved by both the European Council and European Parliament. The EC anticipates that, once adopted, the short-selling and CDS regulation would be in effect on July 1, 2012 and the OTC derivatives regulation would be in place and operational by the end of 2012.