23 October 2013

Risk.net: CCP frontloading - The pricing nightmare

The gap between the two could be anywhere from nine months to just under two years, according to regulatory estimates, and that is creating uncertainty about how bilateral over-the-counter derivatives trades should be priced, dealers say. Should they be treated as wholly cleared trades, as uncleared trades, or somewhere in between? Many bankers aren’t sure.

All in all, it could mean the first clearing obligation comes into force between nine and 16 months after ESMA is notified by a national authority it has approved a class of derivatives – and even longer if ESMA decides to include a phase-in period. Under the frontloading requirement, any transaction executed in that class of derivative during that period would need to be loaded to the CCP once the clearing obligation starts.

That creates some real pricing headaches, say banks. For a start, it’s uncertain exactly how long the gap between a CCP authorisation and the clearing obligation will be. That largely depends on how quickly legislators endorse the proposal, but ESMA also has the ability to add a phase-in for certain counterparty types, which won’t be disclosed until the draft regulatory technical standards are published, potentially months after the CCP authorisation.

Meanwhile, it’s not clear what would happen if ESMA decides not to apply a clearing obligation immediately to a class of product authorised for clearing by a national supervisor – perhaps because there are some doubts about the ability of a single clearing house to handle the volumes that would result from a clearing obligation (see box). Once another CCP is authorised to clear that class of instrument, the whole ESMA consultation process would start again. If that second review process results in a clearing obligation, users are unclear whether the frontloading period would be deemed to have started when the first CCP was authorised, or after the second authorisation. 

The lack of certainty, and the impact it may have on derivatives pricing, has been recognised by some European legislators. The EC’s original EMIR proposals contained a backloading clause, requiring participants to load all outstanding, historical trades to the clearing house. The European Parliament backed away from that proposal, settling instead on frontloading – essentially a limited form of backloading.

Having included it, legislators recognise that market participants need as much certainty and transparency about the timelines as possible. “We’re trying to build in a whole heap of safeguards to the provisions, so that when frontloading is applied, ESMA actually has to take into account market conditions and effectively be fair to the market and provide transparency in how things will be done. In particular, people need to understand when timelines are in play - then when they’re entering into a contract, they at least know there is a risk that frontloading might be applied", says Kay Swinburne, a member of the European Parliament.

“The need for time to bring competition should be balanced with the fact that ESMA cannot delay too much the [clearing obligation], which is one of EMIR’s pillars to reduce systemic risk", ESMA writes. Therefore, giving extra time would only seem relevant in cases where there are other CCPs that clear the same asset class or similar classes and which are likely to upgrade their services quickly, it adds.

Full article (Risk.net subscription required)

© Risk.net