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Frontloading on the Backburner?

On 8 May 2014, ESMA wrote a letter to the EU Commission, seeking its views on a possible solution to the thorny issue of frontloading.

The frontloading requirement is triggered by the authorisation of a CCP under EMIR (of which there are now four).  If ESMA concludes that any of the products offered by that CCP are suitable for mandatory clearing, the frontloading requirement demands that all trades executed since the authorisation of the CCP (and not just the decision regarding suitability) be subject to mandatory clearing requirements.

It is generally accepted that the frontloading requirement creates uncertainty from a legal, operational and financial point of view.  This is particularly the case during the period[1] from the initial notification of the classes of transaction that may potentially be subject to a clearing obligation[2] to the entry into force of the EMIR regulatory technical standards (RTS) which confirm the classes of trades which will actually be subject to the clearing obligation (referred to as “Period A” by ESMA in its letter).  The lack of certainty as to:

  • whether a particular transaction will be subject to clearing;
  • the date from which an obligation to clear may take effect; and
  • the identity of the CCPs which may clear the product(s) in question

can increase compliance costs and adversely impact the way in which a transaction is collateralised and priced.  ESMA’s concern is that the net effect of this uncertainty will be to operate as a disincentive for counterparties to manage risk (in order to avoid the requirement to frontload), which may ultimately increase systemic risk and reduce market stability.

ESMA’s proposed solution is to distinguish “Period A” from the immediately following period – which commences on entry into force of the relevant RTS and ends on the date on which the requirement to clear a particular transaction actually takes effect (referred to as “Period B” by ESMA in its letter).  The frontloading requirement would not apply to transactions executed within Period A.  In contrast, frontloading would apply to transactions executed within Period B, but even then may be subject to a minimum maturity threshold[3].  This is regarded by ESMA as a reasonable compromise due to the fact that at the start of Period B, counterparties would have clarity on the three points of uncertainty referred to above.

ESMA’s proposal has the makings of a viable solution and in that sense it is welcome ideed.  However, as always, the devil will be in the detail.  Specifically, firms will require a reasonable transitional period within “Period B” in order that they can build the infrastructure necessary to facilitate frontloading.  It would not be reasonable to expect them to build during “Period A” i.e. simply on the basis of what might be.

 

 


[1] Which may last between 8 and 15 months

[2] i.e. the date of the CCP EMIR authorisation

[3] Previously, there was talk about the maturity threshold being as high as 30 years, which would have rendered the frontloading requirement effectively stillborn.  The exact impact of ESMA’s proposed solution on that 30-year maturity threshold is as yet unknown.

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