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EMIR frontloading offloaded?

ESMA has published the EC’s response to its own letter of 8 May regarding the frontloading requirement for OTC derivatives under EMIR. Michel Barnier’s letter makes the EC’s position uncharacteristically clear- hurry up and adjust the maturity threshold.

The frontloading obligation requires the clearing of outstanding swaps. Cleared and uncleared swaps have widely different capital and margin characteristics, likely resulting in two different pricing curves, making a simple transition to cleared status economically material. An uncleared IRS € swap, collateralised by $ at inception, would have to be re-collateralised in € for acceptance at a CCP. Overnight discount rate uncertainty does little to aid pricing clarity, consistency and ultimately, market liquidity. Frontloading potentially begins with the authorisation of a CCP, market participants are only informed of the need to frontload after ESMA has decided whether the particular CCP’s products will be cleared, creating a potentially 16-month long period of pricing uncertainty. ESMA’s 8 May letter proposed the exclusion from frontloading of all swaps that fall between a CCP’s authorisation date and the entry into force of the relevant RTS (Period A). Those swaps that are traded between the RTS’s entry into force and the date of application of the clearing obligation (period B)[1] would be subject to a minimum maturity threshold. Swaps traded during period B will have a definite clearing start date, but the final choice of CCP would remain unknown at inception and a client could choose to clear before the cut-off date; both decisions may retroactively impact pricing.

Barnier’s letter implicitly argues for (and to an extent authorises) the effective removal of the frontloading requirement for period B. He highlights the possible negative effects of frontloading on market function, financial stability and systemic risk; stating that EMIR allows adjustment of the obligation to ensure a level playing field, without undermining the systemic risk reduction imperative. The letter concludes “the Commission is of the view that the frontloading of OTC derivatives should be avoided in cases where it would not ensure the achievement of those objectives.”

Frontloading was a regulation made in fear, politicians foresaw a plethora of bank-led clearing-avoidance schemes; given the long lead times of the CCP\product approval process, frontloading would always have suffered from a practicality deficit. With the proposed exclusion of period A swaps, ESMA have already acceded to the removal of a large percentage of frontloading-induced uncertainty. The EC’s tacit approval would make it surprising if they do not conclude that period B maturity thresholds should be set at a height to effectively exclude the frontloading requirement.

 

[1] As it applies to different counterparty classes- yet to be decided.

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