regulating otc derivatives - transatlantic (dis)harmony after emir and dodd-frank

7/31/2019 Regulating OTC Derivatives - Transatlantic (Dis)Harmony After EMIR and Dodd-Frank

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THE COLUMBIA JOURNAL

OF EUROPEAN LAW ONLINE

REGULATING OVER-THE-COUNTER DERIVATIVES IN THE EUROPEAN

UNION TRANSATLANTIC (DIS)HARMONY AFTER EMIR AND DODD-

FRANK: THE IMPACT ON (RE)INSURANCE COMPANIES AND

OCCUPATIONAL PENSION FUNDS

Jan D. Lu et tri nghaus*

I. INTRODUCTIONDerivatives have a particularly bad reputation ever since Warren Buffet characterized them as

financial weapons of mass destruction carrying dangers that () are potentially lethal.

1

It is aless well known fact that regulators have been aware of the potential threat to systemic stabilityposed by these financial instruments long before this warning was uttered.2 But in the UnitedStates, for example, early attempts by the Commodities and Futures Exchange Commission(CFTC) to oversee the entire spectrum of derivatives in the late 1990s were met with furious

opposition.3 Whereas exchange-traded derivatives were thoroughly supervised, the importantmarkets for over-the-counter (OTC) derivatives continued to elude regulatory control. However,in the aftermath of the global financial crisis and following a joint resolution of the G20 at thePittsburgh summit in 2009, lawmakers on both sides of the Atlantic took regulatory action.

This paper analyzes the rationale for supervising OTC derivatives markets (Section I) and

examines the new EMIR-framework4

for OTC derivatives, central counterparties and traderepositories in the European Union (Section II). Considering the international character of the

majority of derivatives transactions, the paper then explores potential disharmonies between theregulation in the European Union and in the United States (Section III). Against this background,the paper will ask to what extent the present legal framework may achieve the initial objectives ofregulating derivatives in an internationally consistent way and points to some possible challengesin the future (Section IV).

* PhD, LL.M. Columbia, Senior Research Fellow at the Max Planck Institute for Comparative and

International Private Law; Lecturer in Law at the University of Hamburg School of Law.1 WARREN BUFFET,LETTER TO BERKSHIRE HATHAWAY SHAREHOLDERS (February 21, 2003), available athttp://www.berkshirehathaway.com/letters/2002pdf.pdf (last visited: April 18, 2012).2See as to the various regulatory initiatives e.g. CHRISTOPHER L.CULP,RISK TRANSFERDERIVATIVES INTHEORY AND PRACTICE, XVII (2004).3See e.g. the concept release by the CFTC,OVER-THE-COUNTER DERIVATIVES (May 6, 1998), available athttp://www.cftc.gov/opa/press98/opamntn.htm (last visited: April 18, 2012). See as to the variousregulatory initiatives and the counteraction to this crusade on derivatives CULP,supra note 2, at XVII.4 Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, centralcounterparties and trade repositories of 4 July 2012, O.J. 2012 L 201/1.


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II . THE RATIONALE BEHIND REGULATING OVE R-THE-COUNTER DERIVATIVESDerivatives are commonly defined as contracts whose payoffs are based on the future status orperformance of a specific underlying, e.g. an asset, reference index or the solvency of a debtor.5OTC derivatives are versatile, tailor-made financial instruments that may be used for, inter alia,hedging, investing and speculating. A credit default swap (CDS), for example, allows companies

to buy credit protection on their business partners. But since a CDS does not require actualexposure of the protection buyer to the risk which is subject to the protection agreement, investorsmay use these instruments for speculation. Instead of gaining credit exposure to a certaincompany by purchasing or selling its bond physically, an investor may use a CDS to achieve thesame economic effect.6 Against the backdrop of these various usages of OTC derivatives, the total

outstanding notional value of $707 trillion prima facie dwarfs even the bond market. However,the gross exposure resulting form OTC derivatives, i.e. the total value of all contracts closed outand settled simultaneously, amounts to roughly $20 trillion and therefore represents but a tinyfraction of the notional amount. Moreover, the actual gross counterparty credit risk exposure, i.e.

the amount remaining after netting all claims of the various counterparties, amounts to only $3trillion.7

Still, OTC derivatives pose a potential threat to financial stability because they may lead

to an opaque migration of risk in the financial system due to the bilateral nature of these privatelynegotiated contracts. Whereas standardized exchange-traded derivatives contracts are transparentwith regard to pricing, volume, the parties involved and their respective positions, the presentOTC derivatives markets provide only little information to other market participants andregulators.8 Hence, supervisors can neither monitor the nature or level of risks nor may they fully

assess the potential for contagion resulting from the multiple interdependencies between thecounterparties.9 Unlike their exchange-traded cousins which are subject to initial and variation

margin requirements,10 the collateralization of OTC derivatives transactions is left to individualnegotiation and often provides no reliable safety net.11 Counterparty credit risk is therefore amajor concern in OTC derivative contracts. Finally, OTC derivatives are (iii) often highly

leveraged as they usually involve no or only minor upfront payments and may exacerbate losses

5 E.g. CULP, supra note 2, at XIII; CHRISTOPH KUMPAN, FINANCIAL INSTRUMENTS, IN:BASEDOW/HOPT/ZIMMERMANN (EDS.),THE MAX PLANCK ENCYCLOPEDIA OF EUROPEAN LAW,697et seq.(2012).6 CULP,supra note 2, at XV.7 All of these figures refer to the first half of 2011, see BANK FOR INTERNATIONAL SETTLEMENTS,INTERNATIONAL BANKING AND FINANCIAL MARKET DEVELOPMENTS,BISQUARTERLY REVIEW DECEMBER

2011, 23 et seq. (2011), available at http://www.bis.org/publ/qtrpdf/r_qt1112.pdf (last visited: April 18,2012).8See as to the negative consequences of decentralized trading e.g. ANDREAS M.FLECKNER AND KLAUS J.HOPT, STOCK EXCHANGE LAW CONCEPT, HISTORY, CHALLENGES, 39 et seq. (2012) available athttp://papers.ssrn.com/sol3/papers.cfm?abstract_id=2068574 (last visited: May 31, 2012).9 Recital (4) EMIR.10 Initial margin is an up-front deposit that serves as collateral against potential future losses, see Art. 41EMIR. In addition, variation margin is calculated and exchanged between the counterparties on a dailybasis by marking-to-market all outstanding positions at the end of the trading day.11Cf. Recital (4) EMIR.


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2012 LUETTRINGHAUS 21

in times of declining or soaring markets. The financial meltdown of 2008, and, in particular, thefate of the OTC derivatives operations of AIG demonstrated the dangers inherent to the

imprudent use of these financial instruments.12

In light of these challenges, the G20 leaders agreed at the 2009 summit in Pittsburgh toimpose clearing, reporting and risk mitigation requirements for OTC derivative contracts in order

to enhance transparency and to reduce systemic risk.13

III. EMIR AND THE REGULATORY FRAMEWORK FOR DERIVATIVES IN THE EUThe European legislator has created a new market infrastructure for OTC derivatives in therecently adopted EMIR-Regulation on OTC derivatives, central counterparties and trade

repositories.14 This Regulation complements the existing legal framework established by, mostnotably, the Directive on markets in financial instruments (MiFID) which is supposed to be

overhauled and complemented by the recent MiFiD 2- and MiFIR-proposals.15

Thecornerstones of EMIR are clearing and reporting obligations as well as risk managementrequirements for uncleared OTC derivatives.

A. Clearing ObligationEMIR imposes clearing requirements for certain standardized OTC derivative contracts enteredinto by financial and, to a certain extent, non-financial counterparties. However, the clearing

obligation is subject to several exceptions, e.g. with regard to intra-group transactions andpension funds.

1. General Clearing Obligation for Financial Counterparties

12Seewith regard to AIGs exposure following the excessive signing of unhedged CDS and the companyssubsequent inability to fulfill its obligations to post collateral following a veritable flood of margin callsJEFFREY GORDON AND CHRISTOPHERMULLER,AVOIDING EIGHT-ALARM FIRES IN THE POLITICAL ECONOMYOF SYSTEMIC RISK MANAGEMENT, 20 and 24, ECGI - FINANCE WORKING PAPERNO. 277/2010 (March

2010), available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1553880 (last visited: April 18,2012).13 Recital (5) EMIR.14 Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives,central counterparties and trade repositories of 4 July 2012, O.J. 2012 L 201/1.15 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets infinancial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/ECof the European Parliament and of the Council and repealing Council Directive 93/22/EEC, O.J. 2004L/145, as amended. See alsothe European Commissions proposals on MiFID 2 COM(2011) 656 final,and on MiFIR COM(2011) 652 final.


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EMIR defines financial counterparties as, inter alia, (re)insurers, occupational pension funds,investment firms, credit institutions, and certain investment undertakings.16 Whenever these

financial entities enter into an eligible OTC derivative transaction, Art. 4 EMIR requires them toclear the contract in an authorized clearinghouse referred to as central counterparty (CCP).17 The

European Commission has defined clearing as (t)he process of establishing settlement positions,possibly including the calculation of net positions, and the process of checking that securities,cash or both are available.18The CCP interposes itself between the counterparties becoming the

buyer to every seller and the seller to every buyer.19 It manages the derivative contract for itsentire duration and guarantees that the transaction is settled even if one of the parties defaults. 20According to Art. 2(3) EMIR, the CCP establishes the outstanding positions between the parties,calculates the net obligations on a daily basis, and ensures that sufficient collateral (i.e. initial and

variation margin) is available to secure the respective exposures.21 To access a CCP, thecounterparties must either become clearing members or clients, or have to establish arrangementswith a clearing member.22 Admission to the CCP is to be granted in a non-discriminatory andtransparent way.23

In order to guarantee the execution of all trades even in difficult market conditions, theCCP is obliged to (i) keep segregated accounts,24 (ii) manage its liquidity and credit exposures,25and to (iii) impose margin requirements on a value-at-risk (VaR) basis.26 Furthermore, the CCP isobliged to construct buffers against unexpected losses consisting of (iv) a default fund,27 (v) other

financial resources,28 and, finally, (vi) own funds.29 If a clearing member defaults, the various

funds available to the CCP are used in the order established by the default waterfall in Art. 45

16 Art. 2(8) EMIR.17 Art. 4(1) and (3) EMIR. The CCP has to be authorized under Art. 14 EMIR, or, in case of a third-country

CCP recognized under Art. 25 EMIR, to clear the particular class of OTC derivatives.18 COMMISSION SERVICES WORKING DOCUMENT ON DEFINITIONS OF POST-TRADING ACTIVITIES, 9 (2005),available at http://ec.europa.eu/internal_market/financial-markets/docs/cesame/ec-docs/20051027_definitions1_ en.pdf (last visited: April 18, 2012).19 Art. 2(1) EMIR.20 See generally CHRYSSA PAPATHANASSIOU, CENTRAL COUNTERPARTIES AND DERIVATIVES, IN: KERNALEXANDER AND RAHUL DHUMALE (EDS.), RESEARCH HANDBOOK ON INTERNATIONAL FINANCIALREGULATION, 217 et seq. (2012); Joanne P. Braithwaite, The Inherent Limits of Legal Devices: Lessonsfor the Public Sectors Central Counter-Party Prescription for the OTC Derivatives Markets, 12 Eur. Bus.Organization L.Rev. 87 (2011).21 Art. 41 EMIR.22 Art. 4(3), Art. 39 and Art. 48 EMIR.23 Art. 7 EMIR.24

Art. 39 EMIR.25 Art. 40 and 44 EMIR.26 Art. 41 EMIR.27 Art. 42 EMIR.28 Art. 43 EMIR.29 Art. 16 EMIR requires the CCP to hold an initial minimum capital of7.5 million, and, moreover, tomaintain enough additional capital to cover its risk exposure. See as to the final Draft regulatory technicalstandards ESMA DRAFT TECHNICAL STANDARDS UNDER THE REGULATION (EU) NO 648/2012 OF THEEUROPEAN PARLIAMENT AND OF THE COUNCIL OF 4JULY 2012 ON OTCDERIVATIVES,CCPS AND TRADEREPOSITORIES (FINAL REPORT), ESMA/2012/600 of September 27, 2012, Annex IV.


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EMIR.30 The default fund and the other financial resources alone must enable the CCP towithstand the insolvency of its two largest clearing members.31 In sum, central clearing in CCPs

therefore minimizes the credit exposure compared to purely bilateral OTC trades. And from aprudential standpoint, the reduction of systemic risk through netting in CCPs is by far the most

important feature.

Yet, the clearing obligation in Art. 4(1) EMIR only applies if the contract at hand belongsto a class of eligible standardized OTC derivatives. The clearing eligibility is determined inaccordance with the procedures set out in Art. 5 EMIR, which include both a bottom-up and atop-down approach. In the bottom-up approach, a competent national regulator notifies theEuropean Securities and Markets Authority (ESMA) that it has authorized a CCP to clear a

particular class of OTC derivatives.32 After a public consultation, ESMA develops and submitsdraft regulatory technical standards to the European Commission for endorsement. In the topdown approach, by contrast, ESMA identifies the eligible classes of OTC derivatives on its owninitiative.33 ESMA evaluates the clearing eligibility of particular OTC derivative classes based on,

inter alia, standardization, market pricing and liquidity and will keep a public register identifyingthe classes of eligible derivatives that are subject to the clearing obligation.34

2. Clearing Threshold for Non-Financial CounterpartiesWhile non-financial counterparties generally do not have to clear their OTC derivative contracts,

the exposures of these entities might also be of systemic relevance once they reach a certainvolume. Moreover, a complete exemption of non-financial counterparties regardless of the riskthey take on in their OTC contracts could open the floodgates to regulatory arbitrage. Against thisbackground, Art. 10(1) EMIR subjects these firms to the clearing obligation when their average

positions exceed a predefined clearing threshold over a 30-day horizon. The clearing thresholdswhich have recently been proposed by ESMA will be set by a European Commission DelegatedRegulation and are to reflect the systemic relevance of the sum of net positions and exposures percounterparty and per class of OTC derivatives.35 However, the use of derivatives for mitigatingcommercial risks in the context of normal business activities does not count towards the

threshold: Art. 10(3) EMIR excludes all hedging efforts that are objectively measurable asreducing risks directly relating to the commercial activity or treasury financing activity of thenon-financial counterparty or of that group. Since this wording does not provide any clear-cutdefinition, ESMA has recently developed a set of criteria for establishing which OTC derivativecontracts are objectively reducing risks.36

30Seeid., at 43 et seq. and Annex IV Art. 35 et seq.31 Art. 43(2) EMIR.32 Art. 5(2) EMIR.33 Art. 5(3) EMIR.34 Art. 5(4) EMIR. According to Art. 6 EMIR the register is to be publicly available on ESMAs website.35 Art. 10(4)(b) EMIR. See also ESMA DRAFT TECHNICAL STANDARDS, supra note 29, 18 et seq. andAnnex II Art. 10.36 ESMADRAFT TECHNICAL STANDARDS, supra note 29, Annex II Art. 9. Cf. Art. 10(4)(a) EMIR.


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3. Exemptions for Occupational Pension Funds and Intra-GroupTransactions

Unlike the initial proposal of the European Commission,37

the final text introduces importantexemptions from the clearing obligation. First, Art. 89(1) EMIR states that occupational pensioninstitutions are to be exempt from the clearing requirement for three years after the entry intoforce of the Regulation. This special treatment is motivated by the fear that forcing these entitiesto clear OTC derivatives could have a negative impact on retirement benefits since these fundsmight have to divest some of their assets to secure cash in order to meet the marginrequirements.38 The clearing obligation should therefore only take effect when a suitable

technical solution for the transfer of non-cash collateral as variation margins is developed byCCPs to address this problem.39 This special carve-out is questionable since occupationalpension funds are not the only important retirement benefit providing entities faced with this

challenge: annuities underwriters and life insurers, for example, could basically make the sameclaim.40 Experience in other clearing sectors, e.g. in the futures markets, shows that non-cashcollateral such as high-rated government securities may, in fact, be used, albeit with somehaircuts. Furthermore, ESMA has already expanded the range of eligible collateral underthe EMIR framework.41 Second, Art. 4(2) and Art. 3 EMIR permanently exempt intra-group OTCderivatives contracts from the clearing obligation. This exception applies to both financial andnon-financial counterparties, provided that all parties belong to the same group where they areincluded in the same consolidation and subject to centralized risk management. 42 But while they

are exempt from clearing, the counterparties still have to fulfill the other requirements such as the

reporting and risk mitigation obligations.

B. Report ing Obli ga tions and Tr ade Reposi to ri esIn the EMIR framework, trade repositories are charged with centrally collecting and maintainingthe records of OTC derivative transactions.43 According to Art. 9(1) EMIR, the counterparties to

OTC derivatives contracts must report all relevant details of the transaction to an authorized traderepository. The reports must at a minimum disclose the parties to the contract and/or thebeneficiaries, the main characteristics of the transaction such as the type of contract, underlying,maturity, notional value, price, and settlement date. The information must be provided to the trade

repository no later than the working day following the conclusion, modification and termination

37 COM(2010) 484 final.38 Recital (26) EMIR.39Id.40Cf., however, the narrow rule in Recital (28) EMIR.41See ESMADRAFT TECHNICAL STANDARDS, supra note 29, at 45 et seq. and Annex IV Art. 37 et seq.42 Art. 3(1) and (2) EMIR.43 Art. 55 et seq. EMIR.


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of the contract.44 Further details have been specified by ESMA in draft technical standardspursuant to Art. 9(5) EMIR.45

The reporting obligation applies regardless of the nature of the contract, i.e. customizedand hence uncleared OTC transactions have to be reported just like standardized contracts whichare subject to the clearing requirement. The reporting burden for non-financial parties increased

substantially in the final version of EMIR given that Art. 9 EMIR no longer distinguishesbetween the different categories of counterparties.46 Non-financial parties will therefore have toreport all transactions including commercial hedging activities whereas the initial proposal

subjected the reporting obligation to an information threshold.47 Recital (37) EMIR clarifies

that this comprehensive scope is indeed intended by the legislator.48 It is moreover noteworthy

that the reporting obligation has retroactive effect: it applies not only to OTC derivativestransactions initiated after the coming into force of the Regulation but also to contracts whichwere entered into well into the past but are still outstanding on that date.49

C. Ri sk Management Requ ir ement s fo r Uncl eare d Deri vat iv esCustomized OTC derivative contracts for which no secondary market and hence no pricinginformation exists will continue to be traded bilaterally. But these illiquid, tailor-made OTCderivatives may entail significant exposures. Art. 11 EMIR seeks to minimize the risk inherent toOTC derivatives not cleared by CCPs and imposes comprehensive risk mitigation obligations for

financial and non-financial counterparties. The parties must implement risk mitigation systemsassuring the timely confirmation of the terms of the OTC derivative contract as well as audible,robust and formalized processes allowing portfolio reconciliation, risk management, disputeresolution, and monitoring of the outstanding contracts.50 Moreover, all counterparties are obligedto mark-to-market the value of outstanding contracts daily or to use prudent marking-to-models.51

In addition, financial as well as non-financial counterparties exceeding the clearing thresholdhave to establish risk-management procedures assuring a timely, accurate and appropriatelysegregated exchange of collateral (i.e. margining).52 Finally, financial counterparties are alsosubject to capital requirements under EMIR,53 thus necessitating a careful coordination with the

44 Art. 9(1) EMIR.45

ESMADRAFT TECHNICAL STANDARDS, supra note 29, 54 et seq. and Annex VI.I.46See as to the initial approach Art. 6 and 7 COM(2010) 484 final.47

Art. 7(3)(a) COM(2010) 484 final.48 Recital (37) EMIR requires a reporting obligation to the largest possible extent, for both financialcounterparties and non-financial counterparties. However, non-financial parties are not required to reporte.g. collateral or mark to market, see ESMADRAFT TECHNICAL STANDARDS, supra note 29, 54 et seq. andAnnex VI.I Art. 3(4).49 Art. 9(1)(a) and Recital (37) EMIR.50 Art. 11(1) EMIR.51 Art. 11(2) EMIR.52 Art. 11(3) EMIR.53 Art. 11(4) EMIR.


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standards set by the proposal on Prudential Requirements for Credit Institutions and InvestmentFirms (CRD IV).54

IV. TRANSATLANTIC (D IS )HARMONY?EMIR VS . TITLE VII OF THE DOD D-FRANK ACT

Notwithstanding the fact that EMIR and the regulation of OTC derivatives in Title VII of theDodd-Frank Act (DFA)55 are equally designed to meet the commitment made at the G20 summit,

their rules differ in some important respects. Disharmonies in cross-border transactions mightoccur given that both regulatory frameworks have extraterritorial effects. Mutual recognition and

substitutive compliance have already proven to be efficient tools for solving conflicts of laws inother fields of exterritorial financial regulation.56 Whereas these concepts are also part of thetoolbox of both EMIR and Title VII DFA, it is uncertain whether the much-neededcomprehensive mutual recognition may be achieved. This is particularly unfortunate since OTC

derivatives are international in nature: in the United States alone, an estimated 55 to 75% ofbanks total derivatives exposure is to foreign entities.

57 Moreover, 65% of all OTC foreignexchange (FX) derivative contracts were traded cross-border in 2010.58

A. Di ff erenc es Be tween EMIR and Dodd -Fr ank Tit le VI ISome of the differences between EMIR and DFA do not lead to immediate conflicts, but ratherthey create competitive disadvantages for entities from certain jurisdictions. For example, unlikeEMIR, the United States has implemented a push out-provision in Sec. 716 DFA barring

specific swap counterparties and dealers from, for example, benefitting from the Feds discountwindow or FDIC guarantees. This push-out rule as well as other unique features of Title VIIDFA, such as the Sec. 764 requirements for security-based swaps, cause undesirable friction ininternational transactions since EMIR adopts a different regulatory approach.59 The following

sections of the present paper, however, will focus on some other striking examples of

54 See as to the CRD IV-proposal COM(2011), 452 final. See also META ZHRES, DEUTSCHE BANKRESEARCH: OTC DERIVATIVES MARKET, 5 (2011), available athttp://www.dbresearch.com/PROD/DBR_INTERNET_EN-PROD/PROD0000000000280 806.PDF (lastvisited: April 18, 2012).55 Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173.56See generally Pierre-Hugues Verdier,Mutual Recognition in International Finance, 52 Harv. Intl L.J. 56

(2011); Edward F. Greene and Omer S. Oztan, The Attack on National Regulation: Why We Need a GlobalFramework for Domestic Regulation, 4 Capital Markets L. J. 6 et seq. (2008); Howell E. Jackson and EricJ. Pan,Regulatory Competition in International Securities Markets: Evidence from Europe in 1999-Part I,56 Bus. Law. 653, 661 et seq. (2001).57 Sally Davies, Cross-border derivatives exposures: how global are derivatives markets?, 31 IFC Bulletin,159, 160 (2009).58 BANK FOR INTERNATIONAL SETTLEMENTS,TRIENNIAL CENTRAL BANK SURVEY, 16 (2010), available athttp://www.bis.org/publ/rpfxf10t.pdf (last visited: April 18, 2012).59E.g. Benjamin M. Weadon,International Regulatory Arbitrage Resulting from Dodd-Frank DerivativesRegulation, 16 N.C. Banking Inst. 249, 259 et seq. (2012).


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disharmonies which could in fact pose a significant risk of regulatory arbitrage. Divergencepersists even when it comes to fundamental concepts such as the definition of OTC derivatives

and exemptions for both certain types of OTC derivatives and counterparties.

1. Diverging Definitions: The Case of (Re)InsuranceArt. 2(5) and (7) EMIR limit the notion of OTC derivatives to financial instruments as defined inthe MiFiD.60 By contrast, the definition in the DFA is far broader: Sec. 721 DFA, for example,

defines swaps as any agreement, contract, or transaction () that provides for any () payment

() that is dependent on the occurrence of an event or contingency associated with a potential

financial, economic, or commercial consequence.61 Unlike under the EMIR framework, the

definition provided in the DFA might therefore even include (re)insurance contracts. The finalrules developed by the CFTC and the SEC62 reveal that (re)insurance products are indeed notentirely excluded from the scope of Title VII DFA.63 Rather, these contracts are subject to non-

exclusive safe harbor provisions.64 This approach is motivated by the fear that the clearingobligation and other requirements might be circumvented by counterparties using functionallyand economically equivalent insurance products instead of OTC derivative contracts. 65 Hence,

Title VII DFA introduces the so-called product test which ties the safe harbor for (re)insurancecontracts to the existence of an insured interest.66 Moreover, the Commissions have introduceda list of enumerated products67 including various types of insurance contracts which have to

satisfy an additional Provider Test.68 However, the distinction between swaps and insurance

products could prove problematic in cross-border contracts because the tests focus on concepts of

domestic law.69 Certain international transactions, such as life-settlements, might qualify as

trading of insurance policies separately from the insured interest under the CEA and the

Exchange Act:70

first, unlike the national insurance codes in the United States,71

importantEuropean jurisdictions do not at all require an insurable interest in life insurance contracts.72

60 Art. 2(5) and (7) EMIR.61 Sec. 721 DFA amends, inter alia, Sec. 1a(47)(ii) Commodity Exchange Act (CEA).62 CFTC AND SEC, Release No. 339338; 3467453; File No. S71611: Further Definition of Swap,Security-Based Swap, and Security-Based Swap Agreement; Mixed Swaps; Security-Based SwapAgreement Recordkeeping; Final Rule, Fed. Reg. 77 (2012), 48208-48366.63Id. at p. 48350.64 Sec. 1.3(xxx)(4)(i) CEA and Sec. 240.3a691(a) Exchange Act.65

CFTC AND SEC, supra Note 62, at 48212.66

Id. at p. 48212. See also Sec. 1.3(xxx)(4)(i)(A)(1) Commodities Exchange Act (CEA) and Sec.

240.3a691(a)(1)(i) Securities Exchange Act of 1934 (Exchange Act)67 Sec. 1.3(xxx)(4)(i)(C) CEA and Sec. 240.3a691(a)(3).68 Sec. 1.3(xxx)(4)(i)(B) CEA and Sec. 240.3a691(a)(2).69Id.70 Sec. 1.3(xxx)(4)(i)(A)(3) CEA and Sec. 240.3a691(a)(1)(iii) Exchange Act. See also CFTC AND SEC,supra Note 62, at p. 48214 et seq.71E.g. LEE R.RUSS,COUCH ON INSURANCE, 3rd ed. (2011), 41:20 and 41:1 et seq.72 See e.g. in Germany: Sec. 150 Gesetz ber den Versicherungsvertrag (Versicherungsvertragsgesetz -VVG) vom 23. November 2007, BGBl. I S. 2631, zuletzt gendert durch Art. 2 Abs. 79 des Gesetzes vom22. Dezember 2011, BGBl. I S. 3044; in France: Art. L132-1 et seq. Code des assurances, JORF du 21


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Second, foreign parties involved in these transactions might fail the provider test.73 It is thereforedoubtful whether the safe harbor for (re)insurance will always produce the desired results in

international cases. Rather than including (re)insurance contracts in the definition of swaps andproviding a seemingly comprehensive exemption, the concerns expressed by the regulators might

be better addressed by anti-evasion rules such as Sec. 1.3(6) CEA, pursuant to which atransaction that is willfully structured to evade anyprovision (...) shall be deemed a swap.74

2. Diverging Registration RequirementsUnlike the DFA, EMIR neither creates new categories of market participants such as (security-based) swap dealers or major (security-based) swap participants nor does it require thecorresponding entities to register or to comply with any special European regulatory framework.75Yet, since these entities may be subject to rules similar to those under DFA in their home

countries, this could nonetheless lead to double requirements in transatlantic OTC derivatives

trades.76

3. Diverging Exemptions: Occupational Pension FundsWith regard to the total volume outstanding, FX derivatives are by far the most important class ofOTC contracts.77 The United States Treasury, however, has recently proposed an exemption fromthe DFA clearing requirements for specific FX derivatives such as swaps and forwards. 78 Thisgeneral exemption is not reflected in EMIR, which only confers authority to ESMA to determinethe derivative contracts eligible for clearing whereby it may distinguish certain classes (e.g.

foreign exchanges) of OTC derivatives from other classes.79

However, ESMAs final drafttechnical standards still include clearing thresholds for FX derivatives.80

Conversely, and, as already discussed above, EMIR exempts intra-group trades from the

clearing requirement. On August 16, 2012, the CFTC decided in a narrow 3 to 2 vote to release aproposal that, at least in principle, allows certain intra-group trades to be exempted from the DFAclearing requirements. It remains to be seen whether regulatory harmony may be achieved in this

juillet 1976, p. 4341 (Version consolide au 7 juillet 2012); in Switzerland: Art. 16 Abs. 1 and Art. 74Bundesgesetz ber den Versicherungsvertrag (Versicherungsvertragsgesetz, VVG) vom 2. April 1908(Stand am 1. Januar 2011), 221.229.1.73See, however, CFTC AND SEC, supra Note 62, at 48218.74

Id. at 48350. See also Sec. 1.3(xxx)(6) CEA and Sec. 240.3a691(a)(2).75 EMIR only contains a registration requirement for trade repositories, see Art. 55 EMIR.76 For example, entities such as CCPs have to be authorized by national authorities, see Art. 5 EMIR. Seealso CFTC AND SECJOINT REPORT ON INTERNATIONAL SWAP REGULATION, 99 (Jan. 31, 2012), available athttp://www.cftc.gov/ucm/groups/public/@swaps/documents/file/dfstudy_isr_013112.pdf (last visited: Mar.24, 2012).77 BANK FOR INTERNATIONAL SETTLEMENTS (2011),supra note 7, at 24.78See CFTC AND SECJOINT REPORT, supra note 76, at 100.79 Recital (19) EMIR.80See ESMADRAFT TECHNICAL STANDARDS, supra note 29, Annex II Art. 10(d).


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field. However, friction persists as far as occupational pension providers are concerned. WhereasEMIR grants these funds an exemption form the obligation to clear their OTC derivative

contracts,81 no such exception may be found in the DFA framework.

4. Diverging Execution RequirementsTitle VII DFA introduces a general execution obligation, i.e. (security-based) swaps subject toclearing must be executed in special venues, such as a swap execution facility or a designated

exchange.82 By contrast, EMIR itself does not require the execution of eligible OTC contracts atexchanges or other types of trading venues. However, Art. 26 MiFIR gives ESMA authority todecide whether a specific class of contracts is sufficiently liquid to be executed at regulatedtrading venues, i.e. multilateral trading facilities (MTF) or organized trading facilities (OTF).83 In

view of these different approaches in Europe and the United States, it is likely that certain OTCderivative contracts subject to the execution obligation under Title VII DFA will not be required

to be traded on MTFs or OFTs in the European Union.84 This could create incentives forregulatory arbitrage.

B. Ex tr a-T er ri to ri al Ef fect s and Conf li cts of LawsSince EMIR and DFA both have extraterritorial effects, these conflicting regulatory regimes must

be coordinated in cross-border transactions. It remains to be seen, however, whether mutualrecognition and the substituted compliance provided for under EMIR and Title VII DFA arecapable of offering a viable solution to the various conflict-of-laws issues.

1. Extra-Territorial Effects of EMIR and Title VII DFAArt. 4(1)(a)(v) EMIR extends the clearing requirement to entities established in one or morethird countries that would be subject to the clearing obligation if they were established in theUnion, provided that the contract has a direct, substantial and foreseeable effect within the Union

81 Art. 4(2) and Art. 89(1) EMIR.82 Sec. 723(a) DFA amending Sec. 2(h)(8) CEA, and Sec. 763(a) DFA adding Sec. 3C(h) to the ExchangeAct. Depending on the nature of the financial instrument, the counterparties have to use different venues:

whereas swaps must be executed either at a swap execution facility (SEF) or a designated contract market(DCM), security-based swaps have to be traded on exchanges or at security-based swaps executionfacilities (SBSEF). This execution obligation applies to all swaps that are required to clear unless noauthorized venue trades the individual class of OTC derivatives.83Art. 2(7) MiFIR introduces OTFs as a new type of trading venue. See as to the execution obligation Art.26 and Recitals (7) and (21) MiFIR.84 See CFTC AND SEC JOINT REPORT, supra note 76, at 104; KERN ALEXANDER, THE EUROPEANREGULATION OF CENTRAL COUNTERPARTIES:SOME INTERNATIONAL CHALLENGES, IN:KERN ALEXANDERAND RAHUL DHUMALE (EDS.), RESEARCH HANDBOOK ON INTERNATIONAL FINANCIAL REGULATION, 244(2012).


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or where such an obligation is necessary or appropriate to prevent the evasion of any provisionsof this Regulation. In the same spirit, Sec. 722 DFA states that the provisions on swaps will

apply to activities outside the United States that either (i) have a direct and significant

connection with activities in, or effect on, commerce of the United States or that (ii) contravene

such rules or regulations as the Commission may prescribe or promulgate as are necessary orappropriate to prevent the evasion of any provision of this Act. 85 The CFTC has already releasedproposed rules regarding the cross-border application of certain swaps provisions of the CEA

including a broad definition of US persons applying to all entities that have an effect on UScommerce.86

2. Mutual Recognition and Substituted Compliance a Viable Solution?At least in principle, both EMIR and Title VII DFA provide for substituted compliance and the(mutual) recognition of foreign regulatory regimes.87 Sec. 752(a) DFA even obliges regulators in

United States to cooperate and coordinate with their European counterparts in order to achieveconsistent international standards for OTC derivative regulation.88 In this spirit, the CFTC hasrecently proposed a process for the recognition of substituted compliance based on its experience

in exempting foreign brokers.89 However, it remains to be seen whether a system of mutualrecognition and wide-ranging cooperation will take effect any time soon: neither Title VII DFAnor EMIR contains any clear-cut rules or define any process for attaining a truly comprehensivemutual recognition that could eliminate all potential regulatory conflicts in transatlantic OTC

derivative trades.

Moreover, negotiating treaties on mutual recognition with foreign regulators might prove time-consuming even when it comes to establishing partial equivalence for specific regulatoryquestions. This is best illustrated by the intricate and potentially drawn-out procedure for the

recognition of third-country CCPs by ESMA under Art. 25(1) EMIR90: First, the European

Commission must adopt an implementing act determining that the third countrys legal and

supervisory standards for CCPs are equivalent to those under EMIR and that the third countryalso has an equivalent system for the recognition of foreign CCPs in place (i.e. mutuality must be

established).91 Second, the CCP has to be authorized and supervised in the relevant third country

85See also Sec. 772 DFA which aims at preventing the evasion of the rules on security based swaps.86 CFTC, Cross-Border Application of Certain Swaps Provisions of the Commodity Exchange Act Proposed Rule, Fed. Reg. 77 (2012), 41218 et seq.87

E.g. Art. 13(2) EMIR, and, for example, Sec. 725(b) DFA amending Sec. 5b(h) CEA.88 By contrast, Art. 23 EMIR as the general provision on cooperation between regulators only addressescooperation between national regulators of the 27 European Member States as well as European authoritiessuch as ESMA.89 CFTC, supra note 86, at 41232 et seq.90See alsoESMADRAFT TECHNICAL STANDARDS, supra note 29, at 29 et seq. and Annex IV Art. 2.91 See as to this complex procedure Art. 25(6) EMIR and Art. 5 Regulation (EU) No 182/2011 of theEuropean Parliament and of the Council of 16 February 2011 laying down the rules and general principlesconcerning mechanisms for control by Member States of the Commissions exercise of implementing

powers, O.J. 2011 L 55/13.


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on an ongoing basis. Third, ESMA must have signed cooperation arrangements with all relevantcompetent authorities of the third country. Fourth, the third country is required to have, inter alia,

equivalent anti-money laundering standards. And throughout the entire assessment andrecognition processes ESMA must consult all competent authorities of the 27 EU Member States

in which (i) the CCP intends to provide clearing services, (ii) the three largest contributors to theCCPs default fund are established, (iii) the third country CCP intends to serve trading venues,

(iv) other CCPs are established that have signed interoperability arrangements with the foreign

CCP.92 Moreover, ESMA has not only to cooperate closely with all relevant national members ofthe European System of Central Banks but also with the central banks that issue the most relevantcurrencies of the financial instruments cleared by the CCP.93 Detailed technical standards arecurrently being developed by ESMA that will add to the already existing complexity. 94 In sum,

the aforementioned approach is likely not only to produce objections and demands by variousregulators but also likely to be rather time consuming for CCPs since these entities will have tocomply with supranational as well as with multipleand in the extreme case up to 27 nationalregulatory standards in the European Union.

As substantial disharmonies between certain parts of the respective regulations persist, it is far

from certain that DFA and EMIR will be considered equivalent or at least comparable in

every respect.95 Still, EMIR has already come into force in mid-August 2012 and thecounterparties on both sides of the Atlantic are facing clearing obligations as soon as 2013.96 This

raises the question whether regulators in the United States and the European Union will be able toestablish a viable cooperation in such a short time.97 An agreement between regulators in theUnited States and the European Union on a comprehensive mutual recognition of all regulatorystandards is more likely to take years if it can be reached at all.98 Yet, if mutual recognitionremains fractional, there is a considerable risk that transatlantic trades will be subject to

duplicative requirements.99 This would increase the costs of these transactions and would make itmore difficult to trade with foreign counterparties.

V. CONCLUSION AND OUTLOOKEMIR creates a European framework for OTC derivative contracts in line with the global movetoward central clearing and enhanced transparency of the formerly opaque OTC markets. Still,

92 Art. 25(3) EMIR.93Id.94

Art. 25(2)(8) EMIR.95 CFTC, supra note 86, at 41232 et seq.96 According to Art. 51 EMIR, the Regulation, published on July 27, 2012, entered into force on the 20thday following its publication in the Official Journal of the European Union.97 Leonard Ng, Third country issues in current EU financial services regulation, 27 Butterworths J IntlBanking&Financial L 287, 289 (2012).98Id.99See CFTC AND SECJOINT REPORT,supra note 76, at 99 et seq. See also ROBERT L.D.Colby and AndrewS. Fei, Potential Extraterritorial Application of Regulations issued under Title VII Dodd-Frank Act, 31(6)Futures&Derivatives L.R. 1 et seq. (2011).


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shifting the bulk of OTC transactions to central counterparties might also create a new source ofsystemic risk. First, under the EMIR rules, the default of clearing members may eventually lead

to a mutualization of risk when the CCP has to reach into the pockets of other members to

cover unexpected losses.100 Second, the default of an important CCP with a high degree of

interconnection and a large concentration of exposures could itself pose a threat to systemicstability.101

The objective of harmonizing the regulation of OTC derivatives might also be impairedby varying national approaches. Especially (re)insurance companies and occupational pensionfunds will be facing different rules in the United States and the European Union. This frictionranges from the potential inclusion of certain (re)insurance products in the definition of swap tothe exemption of pension funds from the clearing requirement under EMIR.

Even though many OTC derivative contracts are international in nature, there is a lack ofcoordination when it comes to regulatory conflicts in cross-border transactions. Since EMIR and

Title VII DFA both have extraterritorial effects, regulators on either side of the Atlantic are wellaware that this may result in two or more jurisdictions asserting authority ... with thecounterparties potentially facing conflicting or duplicative regulatory requirements.102 Untilnow, however, the rules in both EMIR and Title VII DFA on mutual recognition and substituted

compliance remain incomplete.

Since the counterparties to transatlantic OTC derivative trades will be facing clearing obligationsas of 2013, regulators in the United States and the European Union are under pressure to establish

a system for cooperation, coordination and recognition as soon as possible. This is easier saidthan done given that substantial differences between the regulatory approaches under EMIR andTitle VII DFA persist. In fact, regulators are facing a dilemma: if mutual recognition remains

fractional, this could burden OTC derivative transactions with duplicated requirements andtherefore prove disruptive for transatlantic trades. But if, on the contrary, the varying rules are

deemed fully equivalent, this could open the floodgates to regulatory arbitrage. Finally, marketparticipants might also take a different road and shift some of their operations to otherjurisdictions, e.g. to Asia.103In any event, the G20s ambitious project of creating a global levelplaying field for OTC derivatives is soon likely to be put to the test.

100

See CRAIG PIRRONG,THE ECONOMICS OF CLEARING IN DERIVATIVES MARKETS:NETTING,ASYMMETRICINFORMATION, AND THE SHARING OF DEFAULT RISKS THROUGH A CENTRAL COUNTERPARTY, 53 et seq.(Jan. 8, 2009), available athttp://www.cba.uh.edu/spirrong/clearing_organization.pdf (last visited: March28, 2012); ZHRES, supra note 54, at 9.101E.g. THE ECONOMIST, CENTRALLY CLEARED DERIVATIVES PLUMBING PROBLEMS (April 3, 2012),available at http://www.economist.com/blogs/schumpeter/2012/04/centrally-cleared-derivatives (lastvisited: April 14, 2012). See also ZHRES, supra note 54, at 9.102 CFTC, supra note 86, at 41235.103 However, in some cases, this would be considered an evasion of DFA or EMIR provisions, cf. suprasection III B.

regulating otc derivatives - transatlantic (dis)harmony after emir and dodd-frank

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