Asset ManagementAdviserNews and analysis for the asset management industry January 2013

OTC derivatives: United States vs. European UnionThis discussion outlines the similarities and differences between the treatment of over-the-counter (OTC) derivatives in the United States’ Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) versus the European Union (EU)’s Regulation on OTC Derivatives, Central Counterparties (CCPs) and Trade Repositories (EMIR) — collectively, the acts. Both the Dodd-Frank Act and the EMIR are designed to standardize OTC derivatives, make them more transparent, and subject them to regulation by a governing authority. The new regulations will have a direct effect on counterparties that offer OTC derivatives to hedge funds. In response to stricter regulation, asset managers may begin using other hedging instruments.

U.S. and EU regulators are still adopting many of the rules required to implement their respective Acts EU and U.S. regulators have been slowed in their progress because of the margin rules for uncleared derivative transactions pending

the outcome of the BCBS-IOSCO consultation on common international standards. Various rules and standards must be adopted before the acts can become fully effective. And these rules and standards will have a significant impact on how the acts function in practice.

In response to G-20 commitments, the EU and the United States have adopted legislation requiring that all OTC derivative transactions be cleared through CCPs and reported to trade repositories. The EMIR and the Dodd-Frank Act impose similar — but not identical — requirements on OTC derivative markets. Some of the major similarities and differences:

• Bothactsimposeclearingandreportingrequirements on a broader class of OTC derivatives. This more generalized approach will give regulators the final say on when the clearing obligation applies. Furthermore, registration, business conduct, and margin and other capital requirements will apply to major swap participants under the U.S. legislation. The EU applies responsibilities even more broadly. The EMIR requires all financial and nonfinancial counterparties to perform risk mitigation activities, and any counterparty whose transactions exceeds a specified clearing threshold must conduct daily valuations and exchange collateral.

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• Theactsrequirecounterpartiestomaintain records of all derivatives, and each transaction must be reported to the appropriate trade repository. Mandatory margin rules covering unsettled derivative transactions are expected to be put in place.

• Theactsencouragemoreflexibilityin clearing by allowing nondomestic CCPs to participate. However, proposed legislation with regard to trade repositories differs. The United States only accepts the use of domestic repositories as being valid, while the EU will likely recognize the use of international repositories. (This portion of the EMIR is contingent on the conclusion of a treaty.)

• TheDodd-FrankActrequiresOTCderivative transactions to be subject to the clearing obligation on a swap execution facility or designated contract market (if such a facility or market makes the swap available for trading). This requirement facilitates real-time post-trade transparency with respect to position limits and cleared derivative trades. In the EU, these issues are being addressed in separate legislative proposals that would replace the existing Markets in Financial Instruments Directive.

The EMIR proposes a departure from ring-fencing as it relates to derivatives and retail banks. As a result, the European Commission has appointed an expert board to review the configuration of the EU’s banking sector. In the United States, the Volcker rule separates investment banking, private equity and proprietary trading (hedge fund) sections of financial institutions from their consumer lending arms. Banks are not allowed to simultaneously enter into an advisory

and creditor role with clients, such as with private equity firms. The Volcker ruleaimstominimizeconflictsofinterestbetween banks and their clients through separating the various types of business practices financial institutions engage in. • TheEMIRcontainsexemptionsfrom

both the clearing obligation and the margin and other risk mitigation rules for transactions between affiliates. There are no corresponding provisions in the Dodd-Frank Act, but the Commodity Futures Trading Commission has proposed rules exempting transactions between affiliates from the clearing obligation. These exemptions would be subject to a number of conditions, including variation margin requirements, when both affiliates are financial entities.

• TheUnitedStatesandtheEUtakedifferent approaches to the application of rules outside their jurisdictions. In the United States, the proposed rules would impose U.S. swap dealer requirements on non-U.S. persons that execute any swap transaction exceeding a specified threshold, barring a few exceptions. In contrast, the EU considers a transaction to be in compliance with the clearing, reporting and risk mitigation requirements of counterparties in non-EU jurisdictions if those jurisdictions apply their regulatory policies in a manner that the European Commission believes to be just and fair.

Notably, the United States plans to implement rules concerning derivatives long before the EU does so. A significant part of the Dodd-Frank Act may be in force well in advance of the corresponding EU rules.

As discussed above, the derivatives guidance proposed by the United States and the EU is far from identical. However, it articulates two common goals: promoting transparent pricing and clearing processes and standardizing electronic trading for OTC derivatives. The road to the implementation will not be free of obstacles before the guidance of the United States and the EMIR can become fully effective. •

OTC derivatives: United States vs. European Union (continued)

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