Paola Lucantoni

Financial Market Law and Regulation

 a very technical and detailed legislation, aiming at

preventing gold plating and based on three main types

of instruments,
(i) main EU Regulation n 648 of July 4th 2012 called
EMIR (European Market Infrastructure Regulation),
on over-the-counter derivatives, central
counterparties and trade repositories, which entered
into force on August 17th 2012;
(ii) three Implementing Regulations n 1247, 1248,
and 1249, published in the OJEC on December 21st
2012;

 (iii) and six Regulatory Technical Standards developed

by ESMA (the European Securities and Markets

Authority), EBA (European Banking Authority), or
jointly by ESMA, EBA and EIOPA (European Insurance
and Occupational Pensions Authority), in order to
fulfil the obligations imposed by EMIR, which were
adopted by the European Commission as delegated
implementing regulations in particular n.
148/2013, 149/2013, 150/2013, 151/2013, 152/2013, and
153/20

 The legislation under consideration covers three main

areas, namely
(i) the CCPs (Central Counterparties) clearing
obligation for specific categories of financial OCT
derivatives, traded by non-financial counterparties
qualifying based on the amount of derivatives traded,
pursuant to Article 10, Reg. n 648/2012;
(ii) bilateral risk mitigation obligation for OTC
Derivatives contracts not cleared by a CCP, provided
for by Article 11, Reg. N 648/2012;

 (ii) the reporting obligation to Trade Repositories

(TRs) of any information concerning OCT derivatives

trading, pursuant to Article 10, Reg. n 648/2012

Otc derivatives held high level of responsibility in the

financial crisis
Focus on:
the law that governed the otc derivatives trade and
post-trade activities before the crisis
the additional requirements that the new legal
frameworks involve
a comparison of the new north-American and
European regulations

history
Derivatives have been employed for hundreds of years

(4000 bC, in Mesopotamia, future trading on

commodities)
Since 1970 the volume of derivatives has grown at a
staggering rate
Derivatives trading boomed and lead to the creation
on the CBOE (Chicago Board Options Exchange)

 In 2011, the global market for derivatives amounted to a

notional amount of $650 trillion, a value which dwarfs

the world GDP of $58.26 trillion (Source: World Bank,
World Development Indicators, 2009)
note that the notional amount does not reflect the
actual exposure of the market participants. A same
asset passed from one party to another will double the
the notional amount without actually increasing the
global amount of bets on the market

ETD versus OTC

Derivatives are separated into two categories:
(I) exchange-traded derivatives ETD
(II) over-the-counter derivatives OTC.
ETDs are the derivatives contracts which are traded

using a public exchange, whereas OTC derivatives are

contracts traded directly between two parties.

ETD
ETDs are
standardised,
relatively liquid contracts,
which are based on the most common underlyings and
come with pre-defined variable

ETD: the advantage

being centrally settled through a clearinghouse, which

concentrates cash-flows by acting as a compulsory

counterparty to each part of the contract
Through a system of margins that the clearinghouses
require from the parties, the risk that they bear is
much reduced
as a result, the counterparty default risk of ETDs is
minimal

OTC
are not standardised
and offer a high level of customisation
trading OTC derivatives offers a wider variety of

underlyings under more tailored terms and conditions

In terms of volume, OTC derivatives represent an
overwhelming majority of the global derivatives
trading, accounting for approximately 90 per cent of
this colossal market

Role of OTC Derivatives in the

crisis
Financial derivatives have been under heavy scrutiny

since the late 2000s financial crisis.

But the financial crisis did not start due to financial
derivatives
The spark that set off the crisis was the mortgage
crisis, which, in turn, led to the meltdown of many
major lending and investment institutions, such as
Bear Stearns and Washington Mutual.

CDS: the role in the crisis

At the heart of the blame on derivatives are credit

default swaps (CDSs), a product that pays out in case

of loan default
The legitimacy of these assets lies in the fact that debt
holders might want to mitigate their risk, and,
therefore, buy a CDS related to their holding
the access to CDSs allowed a relative spreading of the
risk across various actors (e.g. hedge funds) willing to
take on risk

domino effect
A large amount of the CDS- trading was purely

speculative; some investors bet on the failure of

market loans
The large volume of assets traded and
interconnectedness of the various financial companies
led to what is called systemic risk, or the so-called
domino effect.
Too big to fail: AIG bailout, cost around $182 billion

Analysing derivatives role in

the crisis
One of the main problems in the days of the financial

crisis was the dramatic lack of transparency and

liquidity in the market. Market participants did not
have access to their peers risk exposures, and could,
therefore, not properly assess the stability of their
counterparties
This was partly due to the inherent characteristics of
OTC derivatives, inter alia, the fact that they do not
have to be dealt with through a clearinghouse, and
that no centralised public record of the companies
exposures existed.

Bilateral clearing/lack of global

information
Most of the CDSs contracts were not cleared through

CCPs, but cleared bilaterally, explaining partially why

both the regulator and market participants underestimated the counterpartys credit risk
Due to the absence of information, financial
institutions found it difficult to select reliable
counterparties and the markets froze.

conclusion
In conclusion, financial derivatives were not the cause

of the financial crisis, but their existence allowed

institutions to over-expose themselves, both in terms
of volume and in terms of interconnectedness.
High levels of speculation and a lack of transparency
led the financial world close to a meltdown. Changes
in the infrastructure and legislation will try to prevent
this event from happening again in the future.

Costs and benefits

Benefits
add value to social welfare (lenders can extend more
credit without having to increase their prudential capital
by acquiring CDSs, and, therefore, using more of their
capital for its useful pro-cyclical purpose)
Costs
the costs arising from the opacity of the market and the
asymmetry of information
the systemic risk stemming from the use of these
products

opaque markets
the relation between the dealers and their clients

(end-users) is based on unequal grounds due to a

common lack of transparency on the pricing of OTC
derivatives
their misuse, which can lead to sub-optimal levels of
risk-taking, such as over-investment and overleveraging. The structure of derivatives allows for an
investor (or speculator) to bear a large position while
requiring little capital
Result: higher systemic risk in the financial markets,

CCPS
an entity that interposes itself between the

counterparties to trades, acting as the buyer to every

seller and the seller to every buyer
CCPs reduce their own risk by requiring initial margins
and margins calls based on daily variations of the value
of the derivatives
The role CCPs hold for OTC derivatives is very similar
to the role of clearinghouses for ETDs

EMIR (european market

infrastructure regulation)
Clearing CCPs (have to be authorised by their

national competent authorities)

Reporting Trade repositories (centralised registries

which preserve various information about the running

OTC derivatives contracts)
Risk mitigation bilateral clearing

Clearing
Two approaches to define which contract should be

cleared
Bottom up approach: CCPs can select contracts they

would accept too clear; CCPs have an obligation to

inform the ESMA which in turn can decide to apply a
clearing obligation on this type of contract across the
member States.
Top down approach: ESMA and European Systemic
Board can determine which currently uncleared
derivatives contract should be subject to compulsory
clearing.

Clearing
non-financial market participants enjoy an exemption

from the clearing obligation.

Nevertheless, if their exposures reach a threshold,
defined by the EMSA, and the companies are a
systemic risk to the financial markets, the exemption
will not be granted

Financial Counterparties (FC) And NonFinancial Counterparties (NFC).

Financial counterparties are listed in Article 2,

Paragraph 1, n 8), Regulation n 648/2012; in

particular, as specified in recital 25 of Regulation n
648/2012, they include investment firms, credit
institutions, insurance and reassurance undertaking,
UCITS, institutions for occupational retirement
provision, and alternative investment fund managers.
In fact, these are entities that are authorised to
perform collective and personal asset management.

 Defining non-financial counterparties referred to in

Article 2, Paragraph, 1, n 9 of Regulation n

648/2012, is more complex. Under the aforesaid
Article, non-financial counterparty means an
undertaking established in the Union other than the
entities referred to in points (1) and (8), that is, an
undertaking other than financial counterparties,
CCPs, TRs, and other than trading venue managers

 the European legislator established that non-financial

counterparties that are subject to the clearing

obligation only include those non-financial
counterparties selected through a twofold filter,
namely
(i) their exceeding a clearing threshold calculated
based on the notional value of OCT derivatives
positions;

 (ii) and by excluding from the calculation all risk-

hedging financial derivatives (hedging test). As a

matter of fact, the European legislator aimed at
extending surveillance and transparency also to OCT
derivatives trade performed by non-financial
counterparties that due to the quantity and purpose
of their positions in OCT derivatives contracts do not
meet risk hedging needs functionally related to their
core business.

Bilateral Risk-Mitigation Techniques for Non-CCPCleared OTC Derivative Contracts

The overall EMIR framework does not provide for a

clearing obligation through central counterparties for

all OTC derivative contracts. In fact, it regulates
specifically OTC derivatives whose features make them
more suitable for bilateral clearing.

 To mitigate counterparty credit risk, market

participants that are not subject to the clearing

obligation should have risk-management procedures
that require the timely, accurate and appropriately
segregated exchange of collateral. (Recital 24 Reg. n
648/2012). In rafting regulatory technical standards
specifying the ways for timely and accurate Exchange
of collateral for the management of risks related to
OTC derivatives not eligible for compensation, ESMA
considered the results of counterparty and systemic
risk analyses. (Art. 11, Regulation n 648/2012).

 following obligations:
1) timely confirmation of the contract terms;
2) portfolio reconciliation;
3) portfolio compression;
4) dispute settlement

timely confirmation of the

contracts terms
. Pursuant to Article 12 of Delegated Regulation n

149/2013, an OTC derivative contract which is not

cleared by a CCP shall be confirmed, where available,
via electronic means, or even by fax, paper or manually
processed email, as soon as possible. Confirmation is
only required when the parties have reached an
agreement on all the terms of the relevant contract.

Portfolio reconciliation
is another obligation for financial and non-financial

counterparties.
Under Article 11, 2, Regulation n 648/2012, they
shall mark-to-market on a daily basis the value of
outstanding OTC derivative contracts. The seeming
objectivity of the mechanism is however challenged by
the provision itself, as Paragraph 2 also reads: Where
market conditions prevent marking-to-market, reliable
and prudent marking-to- model shall be used .

portfolio compression
analyse the possibility to conduct a portfolio

compression exercise in order to reduce their

counterparty credit risk and engage in such a portfolio
compression exercise.

settlement of disputes
In order achieve timely resolution, dispute settlement

procedures should envisage a special process for

disputes that are not resolved within 5 business days
(Art. 15, 1, par. b), Delegated Regulation n
149/2013). The monitoring of disputes is entrusted to
financial counterparties, which shall report the
competent national authority all disputes relating to
any value higher than 15 million Euros and
outstanding for at least 15 business days

 Only financial counterparties and qualifying non-

financial counterparties are subject to obligations

pertaining to
(i) mark-to-market, and
(ii) the exchange of collateral.

mark-to-market
Pursuant to Article 11, 2 of Regulation n 648/2012,

Financial counterparties and non-financial

counterparties referred to in Article 10 shall mark-tomarket on a daily basis the value of outstanding
contracts. Where market conditions prevent markingto-market, reliable and prudent marking-to- model
shall be used.

exchange of collateral
In fact, the collateral exchange system hinges on an

exchange between the counterparties of both an initial

margin for the coverage of potential future exposure
to a counterparty that could arise from future changes
in the mark-to-market value of the contract or in the
counterpartys default risk and variation margin,
allowing assessing over time the changes in the
contract risk conditions.