Chasing payment of dues is a mundane yet critical element of every business process. Hugely time consuming, it could expose any activity large or small to counterparty risk, even more so in times of economic crisis. Counterparty risk could be defined as the commercial risk of a party to a transaction that his counterparty cannot cover his contractual financial obligations. Although the term is used to refer to the risk of default of payment in complex financial transactions, in essence the term describes risk which anyone in business is commonly exposed to. When taken in the context of Over-the-Counter (OTC) derivatives, which are privately negotiated contracts between two counterparts, counterparty risk is that risk where one of the parties to the OTC derivative defaults on the payment due to the other party.
The global economy is structured in such a way that the components/parties therein are interlinked and interdependent. Thus the default of payment by one counterparty could adversely affect the economic viability of its creditors. Taking this on a larger scale, the failure of one major player in the economy could have a domino effect resulting in the collapse of a financial system as a whole. This is what is referred to as “systemic risk”. The antithesis is when national governments and institutions, in an effort to protect the financial system and the economy, support and bail out players perceived as “too big to fail” given that they are so heavily interrelated with other players.
The use of OTC derivatives is widespread, this owing to their utility in the world of finance (hedging or speculating) and also due their flexibility and low cost. Furthermore, the manner of how counterparty risk is dealt with is left to the parties. Now, in the absence of adequate collateral being provided and negotiated between the parties to the OTC derivative, the value of the derivative is only as good as the credit-worthiness of the counterparty.
This stands in stark contrast with derivatives traded on exchanges. These are subject to specific peremptory rules enforced by the exchange itself and thus to an infrastructure which attempts to ensure the elimination/mitigation counterparty risk. Chief amongst all requirements are those that all trades on the exchange are to be cleared through a clearing house and to post margin and additional margin which is to serve as collateral to the trades made on the said exchange. The former requirement dictates that once a trade is concluded between two parties (members of the exchange) on the exchange, the clearing house interposes itself between the said two original parties and therefore assumes the counterparty risk for the trade by becoming the buyer of the derivative trade to the seller and the seller to the buyer. It is worth-while noting here that exchange-traded derivatives represent very small portion of the derivatives industry.
In an attempt to bridge the gap in counterparty risk mitigation for OTC derivatives trading, the International Swaps and Derivatives Association created a set of standards in the form of a standard contract which parties to an OTC derivative would enter in order to complete an OTC derivative transaction, the ISDA Master Agreement. Within the ISDA Master Agreement there is what is called a ‘close-out’ netting clause which provides for a process whereby, on the occurrence of a specified event, all the obligations of two parties to each other would become immediately due irrespective of the benefit of time for the performance of relevant obligations and converted (by means of netting or setoff) to one aggregate net amount owed by the party from whom the larger amount is due.
However in order for the close-out netting clause in the ISDA Master Agreement (or any other close out netting clauses in other agreements) to become enforceable in accordance with its terms under Maltese law, Malta had to enact the Set-Off and Netting on Insolvency Act which came into force in 2003. Indeed the close out netting clause provides that the close out netting process may take effect both before or after bankruptcy or insolvency, requiring the circumvention of the long-established pari passu principle entrenched in Maltese law which dictates that all creditors of an insolvent person, save for any real security obtained in terms of law or any legal set-off taking place between mutual debts which are certain liquid and due, must be paid out of estate of the insolvent person in proportion to their claim. To this end, the said Act provides that close-out netting provisions are valid and enforceable under Maltese law whether such close-out netting takes places before or after insolvency provided that the mutual debts, mutual credits and mutual dealings have arisen or occurred before the bankruptcy or insolvency of one of the parties. Similarly in Malta, it was necessary in many jurisdictions to enact specific netting legislation in order to achieve statutory recognition of the elements of the netting process described above.
Notwithstanding the efforts referred to above, the financial crisis evidenced by the default of Lehman Brothers and the bail out of AIG, highlighted that counterparty risk was not sufficiently mitigated. Many attributed the crisis and failures to the weakness or outright absence of adequate infrastructures and legal frameworks on OTC derivative.
The direct response to this was seen in September 2009, when at the G-20 Pittsburgh Summit it was agreed 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.” Furthermore, they acknowledged that “OTC derivative contracts should be reported to trade repositories and that non-centrally cleared contracts should be subject to higher capital requirements.”
On a European level the direct result of this was the Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties (CCPs) and trade repositories (TRs), otherwise referred to as the European Market Infrastructure Regulation or ‘EMIR’, which entered into force on 16 August 2012. The provisions of the Regulation largely serve to implement the G20 policy aims of improving the transparency, integrity and regulatory oversight of the OTC derivatives market and reducing counterparty and operational risk in trading- key principles which have also been tightly knitted into the Alternative Investment Fund Managers Directive or ‘AIFMD’.
It is interesting that the new body of law was drafted in the form of a Regulation rather than a Directive. This was done in order to achieve maximum harmonisation as Regulations, contrary to Directives which require transposing into national law before becoming effective, are directly applicable thus eliminating the possibility of regulatory arbitrage (divergences in national rules) within the EU.
In order to reduce counterparty risk and therefore also systemic risk, save for some limited exemptions, EMIR imposes on financial firms (banks – both universal banks and investment banks, insurance companies, funds etc.) and to non-financial firms (energy companies, airlines, manufacturers etc.) the requirement to clear certain OTC derivatives contracts through a CCP and report the said trades including to trade repositories.
A CCP is a commercial entity that interposes itself between the two counterparties to a transaction, becoming the buyer to every seller and the seller to every buyer. Thus, as in the case of clearing houses in exchange traded derivatives, a CCP assumes the counterparty risk of every party to an OTC derivative. In this way CCPs will be responsible for the clearing trades conducted through the particular CCP and reduce the potential domino effect of a major counterparty failing, as the failure would be absorbed by the CCP’s default protections such as the collecting and maintaining collateral and margin from the counterparties.
Due to the fact that risk is concentrated within the CCP and as such could lead to systemic consequences if the CCP were to become stressed and collapse, EMIR makes them subject to stringent authorisation process and to on-going conduct of business, organisational and prudential requirements. They reduce systemic risk partly by netting transactions across multiple counterparties.
Furthermore EMIR provides for a procedure for the registration of trade repositories which are commercial firms which centrally collects details/records of derivatives transactions are reported and maintained.
The rationale behind the requirement to reporting is that there is a widespread concern that there is currently little reliable information on what is going on in the OTC derivatives market in that there are no public prices available. Thus the transparency inherent in the reporting of trades which will give a much better overview of the market will in turn allow the better monitoring systemic risk.
Due to the global nature of derivatives trading, EMIR has been drafted with the express intention of aligning its requirements with similar reforms proposed in the US by means of the Dodd-Frank Act albeit it at times uses different approaches to that of its American sibling. This is essential to ensure no transatlantic regulatory arbitrage. Furthermore, it is interesting to note that Japan has also passed OTC derivatives legislation in 2010.
Like other EU jurisdictions, Malta through the MFSA, is currently working on the establishment of a legal framework for the implementation of EMIR. Whilst a set of Guidance notes on OTC Derivatives and Trade Repositories is currently being drafted and should be issued shortly, the MFSA it has issued a draft Legal Notice entitled Financial Markets Act (OTC Derivatives, Central Counterparties and Trade Repositories) Regulations, 2012 and a Draft Guidance Notes to Central Counterparties Regulation. Both proposed texts are in the process of being adopted. Furthermore, on the 19th December 2012, the European Commission adopted the technical standards which flesh out the requirements of imposed by EMIR. These were published in the Official Journal of the European Union and will enter into force on 15 March 2013. As with any other EU Regulation, their provisions will be applicable with effect from the day of their entry into force.
Whilst the benefit of EMIR is clear in that it will ensure the robustness of the financial system as a whole by mitigating systemic risk and restoring confidence in the financial markets, this will come at a price. This begs the question: are the players in the industry ready for the impending regulations? In recent study conducted by IPC Systems entitled “OTC Derivatives Trading Trend Survey” 62 percent said their firms were not well-prepared.
With this unprecedented global industry transformation looming, the key challenges to the players will be the set-up of internal operational systems and processes with respect to the compliance with the clearing and reporting obligations. There is a risk that some firms may fall behind as considerable investment will be required. The industry is expected to undergo a steep learning curve to understand impact of the Regulation. It is however, inevitable that this and the requirement of the posting of margin will render trading more expensive even more so due to the increased or additional clearing fees as well as strict collateral requirements. This may in itself also have an impact on the overall liquidity in the market.
Some 26% of respondents to the same survey believed the benefits of new regulation would far outweigh any associated costs, albeit were outnumbered by the 31% that thought the rules would have a more negative impact, leading to increases in the cost and complexity of trading. As a consequence of the increased cost of hedging we may very well see a change in investment strategies by managers of smaller funds who may decide not to hedge risk or utilise exchange traded derivatives to do so. This is just the beginning. As always, time will tell.