Regulating OTC derivatives: The CCP's role and the EMIR

In the wake of a series of financial crises occurring between 2007 and 2009, there has been a political consensus, at a global level, on various regulatory reforms after the G20 Pittsburgh Summit 2009. The regulatory reforms were aimed at the shadow banking system (SBS) through an enhanced market transparency and regulation of over-the-counter (OTC) derivatives. These two objectives are not mutually exclusive. From a regulatory standpoint, they are relative. This chapter analyses these two objectives in the contextual framework of the European Market Infrastructure Regulation (EMIR). The analysis focuses on the reporting obligation to the trade repository (TR) and the clearance obligation of designated OTC derivatives through the central counterparty (CCP). The chapter argues that while these two obligations can functionally transform shadow banking into a resilient market-based finance, the regulatory framework also creates an exchange platform that transforms the OTC derivative contracts into the fungible securities. The transformation is manifested in the functional role of the CCP as both the buyer and the seller to all CCP participants. By interposing the CCP in between counterparties, OTC contracts have the same counterparty. The counterparty substitute is achieved by novating their original contracts. The CCP becomes a static counterparty to all OTC derivatives contracts. Consequently, all contracts are novated with same counterparty – the CCP. The substitution and novation transform these contracts into futures contracts or fungible securities. In doing so, the legal process also shifts the bilateral counterparty risk to the CCP. When the CCP takes over the counterparty risk, the risk is reduced through a centralized process of net-off that results in a single net payment or no payment to a participant in the CCP. The role of the CCP also transforms the legal bilateral obligations and rights analogous to multilateral set-off with the resultant recipient of a single net payment. The economic advantage is that in the event of a party’s insolvency, the non-faulting party reduces the totality of its claim against the insolvent party. The CCP also deals with the potential systemic instability triggered by the breach of contractual obligation of a financial institution. These coincide with the stability objective in the Markets in Financial Instruments Directive (MiFID) and the Dodd–Frank by bringing derivatives ‘on exchange’ so as to enhance the transparency of the market. By regulating the OTC contracts from the outset as a securities product, the EMIR facilitates the market participants with a platform that makes the OTC derivatives ready and transferrable as a thing. The private-law technique becomes a tool for ‘public regulation’ and is justified by the transaction cost analysis for the ‘public good’, but there is a subtle evolution in the way that law recognizes OTC derivatives as more than just about contractual obligations and rights.