06 January 2014

Risk.net: Frontloading fears remain despite ESMA guidance

Despite new guidance provided by ESMA, dealers say they still do not know how to price swaps that could be caught by so-called frontloading requirements in Europe - under which a trade that has already been executed may have to be sent to a clearing house months or years later.

The guidance came in the form of ESMA's periodically updated Q&As on the European Market Infrastructure Regulation (EMIR). It clarifies what would happen in two specific scenarios, but does not go far enough, dealers complain. A spokesman for ESMA says the regulator recognises the problem and will be returning to it. "It's an issue we're fully aware of and we're working on providing a bit more guidance. When exactly is difficult to say, but as soon as possible, either in a Q&A or in the clearing obligation technical standards", he says.

The problem for dealers is that clearing imposes a very different cost structure versus uncleared trades - the funding requirements are different, as are the capital requirements. If a dealer enters into a 20-year inflation swap after a CCP receives authorisation to clear those trades, and the clearing determination arrives months later, it could mean the transaction has been significantly mispriced, banks claim.

The new ESMA Q&A indicates that risk remains, but another danger has been taken off the table. Banks were unsure what would happen if the clearing obligation is applied to a class of product years after an initial decision not to do so - either because ESMA exercises its own authority to apply the mandate under the top-down approach to the clearing obligation, or because a second CCP is authorised to clear the products some time after an initial applicant. Either situation might arise if the market for a product becomes more liquid or if CCPs have more time to prove the service is effective. Dealers warned this would extend the frontloading window indefinitely, magnifying the pricing headache.

In the first case, frontloading would not apply, the Q&A says - the requirement hinges on CCP authorisation, so if ESMA itself decided to slap a mandate on a type of product, it would not have retrospective effect. In the second case, the frontloading window would start from the date of the second CCP's authorisation, rather than the first, ESMA says.

It's an important clarification, dealers concede, but even if the period of uncertainty is now shorter, products could still be dragged into clearing more than a year after they have been executed.

The timeline also remains unpredictable. EMIR requires ESMA to submit any clearing determination to the EC within six months - including a public consultation. The EC then has up to another three months to decide whether to endorse it, before the parliament and council are offered the chance to review it. If the EC makes any changes to the original technical standards, this review process can take up to an extra six months. The final rules are then published in the official journal, and come into force 20 days later.

Hester Serafini, global co-head of OTC clearing at JP Morgan in London, hopes the Q&A will pave the way to a clearer understanding of the regulation in future. "ESMA clearly recognises this is an important issue, and rightly so, because the market is looking for clarity on what should or shouldn't be cleared and within what time period. The sooner clients understand their obligations, the quicker we will see derivatives markets settle into a ‘new normal' way of functioning", she says.

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ESMA-Q&A

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