Actions Required Under Derivatives Reforms

The first wave of financial regulatory change affecting banks, brokers and their users is in the field of derivatives. Various deadlines for new reporting, clearing and conduct of business requirements are imminent. The manner in which financial institutions deal with their clients and take collateral will undergo significant structural change. Hedge funds and corporates will need new operational processes and documentation in the short term and may also want to reconsider corporate structuring. This note discusses what companies and hedge funds, which use derivatives in their businesses, should be doing to ensure compliance.1

Mandatory Reporting

In Europe, EMIR2 requires counterparties to report all derivative contracts (OTC and exchange traded) to a trade repository. Counterparties are also required to maintain a record of their derivative contracts until at least five years after a contract has terminated. The reporting start date under EMIR is dependent on registration of a trade repository for each particular asset class. The European Securities and Markets Authority ("ESMA") has recently signified that mandatory reporting will start around 1 January 2014 for credit derivatives and interest rate derivatives. The reporting start date for all other asset classes, including equities, FX and commodities is currently also scheduled for 1 January 2014 but this is dependent on a trade repository being registered by 1 October 2013 for the relevant asset class.

In the US, the Dodd Frank Act ("Dodd-Frank") imposes real time price and regulatory reporting and recordkeeping obligations on market participants. Hedge funds and corporates, however, will rarely be required to act as the reporting party. When an end user's counterparty is a Swap Dealer or Major Swap Participant ("MSP"), almost all of the reporting burden for execution data is shifted to the end user's counterparty. However, when a swap is cleared and exchange traded, most of the reporting requirements will be dealt with by the derivatives clearing organisation and/or swap execution facility itself. Similar to in Europe, end users must retain records (in either paper or electronic form) of every swap until five years after the swap has terminated.

There are some substantive differences between EU and US reporting requirements. For example, regulations made under EMIR require information on the collateral for derivatives transactions to be reported, but this is not required in the United States. Various industry solutions nonetheless appear to be emerging. For example, DTCC will be offering reporting for both EU and US purposes through similar technology interfaces which report to its US and EU based repositories. In addition, the exchange and clearing groups ICE and CME are both establishing repositories in the US and EU which will report trades executed on their exchanges or cleared through their clearing houses.

It is vital that buy-side participants and corporates ensure that they are members of the relevant repositories. Appropriate legal entity identifier (LEI) codes will be needed for all companies and funds in a group which are party to derivatives trades.

Conduct of Business Standards for Derivatives

In Europe, EMIR requires that counterparties entering into OTC derivative contracts have appropriate procedures and arrangements in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least: (i) timely confirmation, where available electronically, of the terms of the OTC derivative contract; and (ii)...