Bail-in and the Central Clearing of Derivatives

Pursuant to Article 38(3) of the original EU Commission proposal for a EU Directive establishing a framework for the recovery and resolution of credit institutions and investment firms (the “RRD”), resolution authorities may exclude derivatives transactions from the scope of the Bail-in tool if that exclusion is “necessary or appropriate” to:

  • ensure the continuity of critical functions; and
  • avoid significant adverse effects on financial stability.

Much has already been written as to whether derivatives should be in- or out-of-scope as far as the Bail-in tool is concerned.  The practical difficulties of implementing bail-in in relation to portfolios of derivatives transactions is generally recognised.  In addition, whilst excluding derivatives from the scope of bail-in creates a clear regulatory arbitrage in the way in which deals can be structured between counterparties, this risk is mitigated by the fact that firms which are subject to the RRD will be required to maintain a minimum amount of bail-inable debt at all times.

In many ways, the greater risk lies not in whether derivatives themselves are in- or out- of scope, but in the fact that Member States are given discretion to choose whether they are or not.  The extent to which this is really consistent with the concept of a single market is unclear, and some commentators have questioned whether this aspect of the EU Commission draft would survive the EU trialogue process under which the EU Commission, EU Parliament and the Council of Ministers thrash out their differing opinions with respect to proposed legislation with a view to arriving at a compromise position.  However, this question was largely answered on 5 June 2013, when the EU Parliament’s Economic and Monetary Affairs Committee published a report which sets out the Parliament’s proposed amendments to the RRD, in anticipation of the beginning of the trilogue process.  Within the EU Parliament document, the concept of Member State discretion in determining whether derivative transactions are in- or out-of-scope for the purposes of the bail-in tool remains intact and so seems unlikely even to arise during the trilogue discussions.

Interestingly, the EU Parliament has taken matters a step further, suggesting a different amendment which would, if passed, require that cleared derivatives are treated as more senior than non-cleared derivatives in a bail-in situation.  In other words, non-cleared transactions stand to be bailed-in before cleared transactions.  This is understandable in the context of the drive towards central clearing.  However, it will potentially change the risk associated with counterparties which are subject to the RRD and are established in jurisdictions where derivatives are within the scope of the Bail-in tool.  It will also potentially impact on the price at which such trades are executed.  It remains to be seen just how this provision interacts with another exclusion from the scope of the Bail-in tool – that relating to secured liabilities.  It may be that only uncollateralised non-cleared transactions would be affected.  Moreover, in light of requirement to enact the BCBS/IOSCO “Margin requirements for non-centrally cleared derivatives” in Europe, there may not be much of this trading activity taking place in the future.  Of course, excluding secured derivatives from the scope of the bail-in regime would likely defeat the point of bailing in derivatives in the first place.  In this scenario the discretion afforded to Member States may be more illusory than real.  Either way, as we don’t currently have answers to any of these questions we’ll be monitoring how this conversation develops, so watch this space.

Defining the Clearing Threshold for Non-Financial Counterparties Under EMIR

If you have an interest in regulatory reform matters beyond simply RRP and CASS RP, you may be interested in a new post regarding the clearing threshold for non-financial counterparties under EMIR that has just been published on my other blog, which has been recently lauched – please see here.

All the best