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FINANCIAL INSTITUTIONSENERGYINFRASTRUCTURE, MINING AND COMMODITIESTRANSPORTTECHNOLOGY AND INNOVATIONPHARMACEUTICALS AND LIFE SCIENCES
40 Minute BriefingEuropean and domestic reform: The day after tomorrow – EMIR, CASS & MiFID Hannah Meakin, PartnerNorton Rose LLP5 December 2012
Introduction and timing
Introduction
• Timing
• The latest on client clearing
• Proposed changes to CASS
• Impact on trading structures
Timeline: EMIR, MiFID and CASS
First half 2013:FSA feedback on
Parts II and III CP12/22 expected
1 January 2013:Handbook rules in
PS12/20 will come into effect
2012 2013 2014 2015
EMIR
CASSDecember
2012:Final rules on Part I CP12/22 expected
Late Q1 2013: Most
RTS expected to enter
into force
First half 2013: ESMA expected to consult on
collaterisation
From 1 July 2013 at the
earliest: Reporting obligations
for credit and IRS apply
From 1 January 2014 at the
earliest:Reporting
obligations for credit and IRS
apply
Implementation of MiFiD II legislative
proposals (at the earliest)
1 July 2015:Trades start
to be reported to
ESMA where there is no
trade repository
MiFID
European Parliament
considers legislative proposals in plenary and refers them to
ECON for reconsideration 25-26 October 2012
4 December
2012:ECOFIN meeting
20 June 2012:
Council of the EU begins
publishing compromise
proposals
August 2012: EMIR enters into force
Q4 2013: First clearing obligations expected to apply
The latest on client clearing
A quick reminder of the obligations in EMIR
Clearing
Risk management
Reporting
• OTC derivatives entered into or novated that are listed on ESMA register must be cleared through a CCP• Applies to transactions between:– Two financial counterparties– A financial counterparty and an in-scope non-financial counterparty– Two in-scope non-financial counterparties
– A financial counterparty or an in-scope non-financial counterparty and a third country entity that would be subject to clearing if established in EU
– Two third country entities that would be subject to clearing obligation if established in EU provided (a) contract has direct, substantial and foreseeable effect in EU or (b) if necessary and appropriate to prevent evasion of EMIR • Very few exemptions
• Kicks in on date obligation takes effect but some contracts existing at that date will need to be front loaded
• All OTC derivatives that are not CCP cleared
• Timely, electronic confirmations, portfolio reconciliation, portfolio compression and dispute resolution • Daily marking to market or marking to model
• Timely and appropriate exchange of collateral, segregated where possible • Hold capital to manage risk not covered by exchange of collateral
• All derivatives concluded and any modification or termination must be reported to a trade repository• No later than the following working day• Can delegate but must avoid duplication• Backloading provisions
A typical clearing structure
Clearing Member
(principal)
Counterparty(principal)
Fund(principal)
B
B
B
B
B
S
S
S
S
S
Cleared contract
CCP Rules CCP RulesC
lear
ing
Agr
eem
ent
Cle
arin
g A
gree
men
t
ISDA Master Agreement or other agreement
Cleared contractCentral
Counterparty
Clearing Member
(principal)
Asset Manager (agent)
Bac
k-of
f co
ntra
ct
Bac
k-of
f co
ntra
ct
Original Trade
Client clearing: Segregation and porting
In order to comply with clearing obligation, a counterparty must:– Become a Clearing Member of a CCP or a Client of a Clearing Member– Establish indirect clearing arrangements with a Clearing Member
CCPs and Clearing Members must offer both:– Omnibus client segregation– Individual client segregation
Requirement to distinguish involves recording in separate accounts and not netting across accounts, not exposing assets in one to losses in another
CCPs must allow Clearing Members to open further accounts for their Clients CCPs and Clearing Members must disclose levels of protection and costs - must be
reasonable commercial terms CCPs must commit to trigger procedure for porting - if Clearing Member becomes insolvent
and Client so requests, transfer Client positions and assets to another agreed Clearing Member
CCPs can actively manage their risks by liquidating positions and assets if this cannot be done within a pre-defined timeframe
Client collateral can only be used to cover positions held for relevant Client account and any surplus on a Clearing Member default should be returned to Client or, if not possible, to Clearing Member for relevant Client account
Omnibus segregation: Books and records
Client 1
Client 2
Client 3
Clients 1, 2 + 3
Clearing Member books and records
CCP books and records
Client 1
Client 2
Client 3
Clearing Member
Clearing Member
Individual segregation: Books and records
Client 1
Client 2
Client 3
Clearing Member books and records
CCP books and records
Client 1
Client 2
Client 3
Client 1
Client 2
Client 3
Clearing Member
Clearing Member
Client clearing: Porting
Clearing Member
CCP
Client
Back-up Clearing Member
Back off contracts, Clearing Agreement,
CCP mandated documentation,
provision of collateral
Cleared Contract, Rules, provision of
collateral
OTC Counterparty
OTC derivative trade
Porting of positions and assets takes place on Clearing Member default
Omnibus and individual segregation compared
Omnibus Individual
Assets and positions recorded in separate accounts
Distinguish positions and assets of Clients from those of Clearing Member
Distinguish positions and assets of one Client from those of any other Client and from Clearing Member
No netting of positions recorded on different accounts
Means positions of one Client in an account can be netted with positions of other Clients in same account
Positions of Client in that account can be netted
Assets covering positions in one account are not exposed to losses related to positions in another account
Means assets of one Client in an account can cover positions connected to losses on positions of other Clients in same account so fellow Client risk exists
Assets of Client can only be used to cover that Client’s positions in that account so no fellow Client risk
Excess collateral Margin in excess of Client’s requirement can be held at Clearing Member level
Margin in excess of Client’s requirement must be ported to CCP and not held by Clearing Member
Porting Likely to be more difficult Should be more likely
Detailed risks depend on exact set-up and operation of accounts
Choice of accounts: Questions Clearing Member must offer both May offer variations – e.g. if omnibus, may
be choice of net or gross margining
Client money currently incompatible with porting but will change
N/A if Clearing Member is a bank N/A if margin if provided for on title transfer
(and not retail)
Cash or securities? Clearing Member may need to transfer to
CCP so will need right of use if security interest
Sub-pools are subject of FSA Consultation Objective is to facilitate porting in net
margined omnibus accounts
Omnibus or individual account at CCP level?
Client money protection or not at Clearing Member level
Title transfer or security interest
Possible choice of sub-pool if omnibus client account with client money protection
Indirect Client clearing Client to honour obligations of Indirect Client to Clearing
Member – contract between three parties CCP will, on Clearing Member’s request, maintain
separate records and accounts to enable Client to distinguish its positions and assets from those of Indirect Client
If Clearing Member wants to offer indirect clearing: – Implement individual and omnibus type accounts in its books and
records
– Establish procedures to manage a Client default including:– Mechanism for porting positions and assets to an alternative Client or the
Clearing Member
– Allowing for prompt liquidation of positions and assets and return of balance to Indirect Client
– Publish terms and manage risks of arrangement If Client wants to provide indirect clearing:
– It must be an authorised credit institution or investment firm or equivalent third country entity
– Offer Indirect Clients choice of individual and omnibus type accounts and inform Indirect Clients of risks including details of porting arrangements
If Client defaults, information about Indirect Client is given to Clearing Member
CCP
Clearing Member
Client
Indirect Client
Proposed changes to CASS
Changes to CASS required by EMIR Existing client money regime undermines porting
Client money is pooled on firm failure Inconsistent with transferring to back-up Clearing Member
FSA has consulted on amendments to CASS (CP12/22) Final text expected in December 2012
Clearing Member must notify CCP but need not obtain trust acknowledgements
Clarifies that a firm can hold excess client money in a client transaction account if required to do so by law
On Clearing Member failure, balance on client transaction account is not part of general pool – it is: – Ported to back-up Clearing Member – Returned to Client – Returned to Clearing Member
Client may lose its client money regime protection if back-up Clearing Member is not subject to CASS
Clearing Member discharges client money responsibilities if money is ported or returned directly to Clients by the CCP
What about title transfer? EMIR should not prevent the use of title transfer collateral arrangements
between a Clearing Member and Client or Clearing Member and CCP EMIR will require Clearing Members to offer choice of omnibus or
individual segregation even if business is done on a title transfer basis Clearing Members will need to have separate client transaction accounts
at a CCP for positions held for its title transfer Clients and those held for any client money Clients
If the firm becomes insolvent then when this money is returned by the CCP it is not client money for the purposes of CASS but, in accordance with EMIR, must be held by the firm for the account of its Clients
Consequences of Clearing Member default1. Port
positions and margin
2. Return balance to Client
3. Return balance to defaulting Clearing Member
Not part of notional pool
Notional client money pool
‘For account of clients’?
Defaulting
CM:
Defaulting
CM:
Individual client account
Omnibus client account
CCP:
Full sum minus costs Sum rateable to client money entitlement Client:
Client money
Not Client money
Sub-pools idea for EMIR Consultation period just closed
– Feedback expected first half 2013 Objective is to facilitate porting in net margin omnibus client accounts Porting will require clients to double margin to cover back-up CM’s
exposure to each of them On Clearing Member default, there may be client money at Clearing
Member level that would facilitate porting but which will be pooled Firms could keep client money that relates to such an account but is not
passed on to a CCP in a separate pool, which is used to facilitate porting on firm’s default
Pre-default, CASS applies separately to each sub-pool and to general pool (eg. segregation, reconciliations, diversification obligations)
On default, client money can be transferred to a CCP or back-up Clearing Member
Optional Advantages and disadvantages
Sub-pools for EMIR
From FSA CP 12/22
Requirements for sub-pools Notify FSA 3 months ahead of establishing, amending and merging Sub-pool terms – to identify beneficiaries and where client money is held Disclosure document – to make Clients aware of risks arising from pool
and other Clients sharing in it– Description of purpose, whether Clients are retail or not, business line to which it relates,
advantages and risks to which Clients are exposed, how firm expects sub-pool to be distributed on failure, how beneficiaries can be identified, statement that beneficiary of pool will have no claim or interest to any other pool unless it is also a beneficiary of that other pool and (if relevant) statement that sub-pool is intended to facilitate porting
– Provide to Client and get written acknowledgement and consent– Provide copy on Client’s request and give 3 months notice of material amendments and
mergers, allowing Client to terminate relationship Provide sub-pool terms and disclosure document to FSA on request
Possible introduction of sub-pools for wider purposes FSA asking whether it should roll out sub-pools for other investment businesses Could allow firms to decide whether and how many sub-pools FSA recognises firms may get more benefit from creating bespoke
arrangements– Operating multiple pools will be costly and not all firms and clients will see benefits in
segregating along different lines– But potential lack of incentive given costs
Could mandate segregation: Retail v non-retail clients– Retail cash would not be exposed to risks taken by wholesale Clients and may allow
more rapid distribution from retail pool as fewer contentious issues Margined v non-margined– Volatile trades so riskier and likely to be more contentious issues
Alternatively, FSA could incentivise use of sub-pools by requiring firms to make Clients aware of risks with general client money pools and sub-pool options on the market
Sub-pools for wider use
From FSA CP 12/22
Wider CASS review: Achieving better results • Discussion paper on wider review
– FSA aims to produce consultation paper in first half 2013
• Objectives:
– Improve speed of return– Reduce market impact of insolvency – Achieve greater return of assets
• Review of special administration regime and broader issues arising from MF Global being undertaken by government in parallel
• Current regime prioritises accuracy over speed – FSA questions whether this is right balance
• Should it be different for retail and wholesale Clients?
• Wider review will also cover matters raised in supervisory work:
– Banking exemption– Alternative approach – Trust letters
Wider CASS review: FSA’s ideas
Achieving greater returns Require firms to hold a buffer in client
bank accounts OR seek private sector mutual insurance
An alternative approach requiring firms to hold an equivalent amount to the approximation of the monies at risk in house accounts in client bank accounts
Prioritising certain categories of Clients
Speed of return Regular Client statements detailing
balances and any right of use Placing more emphasis on the firm’s
records of account segregation Limiting use of exclusions or requiring
greater transparency Establishing lock-in or cooling off
periods to reduce switching in days leading up to failure
Incentivise operating via mandates Insolvency practitioners liquidating all
assets and shortfall shared equally Looking at inappropriate use of term
deposits by some firms
Reducing market impact
• Dislocate primary pooling event and firm failure to provide option of selling business rather than immediate pooling
• Get Client’s pre-consent to transfer their assets
Other changes to CASS: The mandate rules Clarifies mandate rules:
– Do not apply where firm holds client money or assets– Do not apply to operator of regulated collective investment scheme– Do not affect duties of another firm that holds client money or assets
Any means which a firm obtains in written form from (and with the consent of) the Client and subsequently retains, and which gives the firm the ability (without the client’s further involvement being necessary) to control the client’s assets or liabilities by: – Giving instructions to another person who holds an account for the Client– Giving instructions to another person who is responsible for holding the Client’s money– Giving instructions to another person who is responsible for holding the Client’s assets– Giving instructions to another person so that the Client incurs a debt or other liability
• Confirms that firm must establish and maintain adequate records and internal controls in respect of its use of mandates
Other changes to detail of CASS and CMAR Classification and oversight does not apply to firms that only arrange
custody Guidance from PS12/20 – will take effect on 1 January 2013
Impact on trading structures
Brokerage structures
Exchange
Client
Clearing Broker
Executing Broker
Introducing/Agency Broker
CCP
Direct Electronic/ Market Access
Sponsored and Naked Access
Give-up Agreement
• Ultimate trade obligations
• Initial trade obligations
• Means of getting trade executed
Trading venues
RegulatedMarkets (RMs)
- Non-discretionaryexecution of transactions
- Managed by marketoperator
-Operating is not an investmentactivity or service
Systems that bring together third partytrading interests and result in
contractsOrganised TradingFacilities (OTFs)
(Commission proposal)
- Discretion overexecution of transactions
- Investor protection, conductof business and best execution requirements
- Cannot trade against proprietary capital- Operating is an investment service
but can be operated by market operator
Multilateral TradingFacilities (MTFs)
- Non-discretionaryexecution of transactions
- Operating is an investmentservice but can be operated by
market operators- Few conduct of business rules apply
Organised Trading Facilities (OTFs)• Broadly defined: all types of organised execution and arranging of trading which does not correspond to
RM or MTF• Includes:
– Broker crossing systems which execute client orders against other client orders– Systems eligible for trading clearing-eligible and sufficiently liquid derivatives
• Does not include: – Facilities where there is no genuine trade execution or arranging taking place in the system, such as
bulletin boards, entities aggregating or pooling potential interests or electronic post-trade confirmation• There are two different levels of discretion:
– When deciding to place an order on the OTF or to retract it again– When deciding if, when and how much of two or more client orders it wants to match within the OTF
• Text now clarifies distinction between multilateral and bilateral systems• Parliament proposed to limit to bonds, structured finance, emissions allowances and derivatives and
Council has followed• Clarification that simultaneous matched principal trading is permitted subject to strong conflicts
management – UK govt agrees• Council text is more restrictive on what is permitted:
– Prior express consent of Client needed– Not derivatives declared subject to mandatory trading
No more OTC derivatives trading?Mandatory on-platform trading for derivatives
G20 commitment to have all standardised OTC derivatives traded on exchanges or electronic platforms
Derivatives that are subject to clearing obligation in EMIR which:–Are traded on at least one RM, MTF or OTF –Are considered sufficiently liquid to only trade on these venues
ESMA also has an own initiative power to identify derivatives for this purpose: Unclear whether this allows ESMA to include instruments which are not CCP cleared but this appears so
Must be traded on a RM, MTF, OTF or certain third country trading venues which Commission deems to be equivalent and where third country provides equivalent recognition for EU trading platforms
Same scope as EMIR in relation to counterparties:– Trades between financial counterparties and in-scope non-financial counterparties – Trades between an EU captured entity and third country entities that would be subject to EMIR– Trades between third country entities that would be subject to EMIR if they were established in the
EU where their transactions could have a direct, substantial and foreseeable effect within EU and this is necessary to avoid evasion
– Excludes certain intra-group transactions
Algorithmic trading and direct electronic access • Parliament amendments:
– Now a definition of high frequency trading and sponsored and naked market access
– Firms using a high frequency trading strategy must store raw audit trail of any quotation and trading activities performed on any trading venue
– Market makers must enter into a written agreement with the trading venue including terms and conditions on liquidity provision
– Investment firms shall not provide sponsored and naked market access to a trading venue
– Even more requirements on platforms for systems resilience, circuit breakers and electronic trading
• Council amendments:– New high frequency algorithmic trading
definition– Market making need only be carried out
during a specified portion of venue’s trading hours except under exceptional circumstances.
– Market making firms shall take into account sound operational, commercial and risk management practices, as well as liquidity, scale and nature of specific market and the characteristics of instruments traded
– New provisions for firms that engage in algorithmic trading pursuant to a market making strategy – I.e. a strategy, when dealing on own account,
that involves porting firm, simultaneous two-way quotes of comparable size and at competitive prices relating to one or more financial instruments on a single trading venue or across different trading venues, with the result of providing liquidity on a regular and frequent basis to the overall market
• Points to note– Many of these provisions reflect ESMA
Guidelines which are already effective– UK govt thinks more evidence of impact is
needed and is concerned about requirement to provide liquidity at all times
Pegasus: MiFID
OTC Oracle: EMIR
DisclaimerThe purpose of this presentation is to provide information as to developments in the law. It does not contain a full analysis of the law nor does it constitute an opinion of NRLLP on the points of law discussed.
No individual who is a member, partner, shareholder, director, employee or consultant of, in or to any constituent part of Norton Rose Group (whether or not such individual is described as a “partner”) accepts or assumes responsibility, or has any liability, to any person in respect of this presentation. Any reference to a partner or director is to a member, employee or consultant with equivalent standing and qualifications of, as the case may be, Norton Rose LLP or Norton Rose Australia or Norton Rose Canada LLP or Norton Rose South Africa (incorporated as Deneys Reitz Inc) or of one of their respective affiliates.