The ESMA OTC Derivatives End User Carve Out

ESMA has released a Consultation Paper on the draft technical standards for trade repositories, OTC clearing and CCPs.

Discussion of non-financial counterparty exclusions begins on page 14.

OTC contracts that protect non-financial counterparties against risks "directly related to their commercial activities and treasury financing activities" are entirely excluded from a CCP clearing obligation.  OTC derivatives that do not protect against "directly related" risks but do not exceed clearing thresholds are also exempt from the clearing obligation.

To be "directly related" and therefore excluded from theshold computation, OTC derivatives contracts of a non-financial counterparty must be "objectively measurable as reducing risks directly related to its commercial activity or treasury financing activity or that of its group." There are two alternative tests for exclusion.  The first test is whether the OTC derivatives contract of the non-financial counterparty "individually, or in combination with other derivatives contracts", reduces "the potential change in the value of assets, services, inputs, products, commodities, liabilities that it owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs in the ordinary course of its business, or the potential change in the value of assets, services, inputs, products, commodities or liabilities referred to above, resulting from fluctuation of interest rates, inflation or foreign exchang rates."  The second test is whether the OTC derivatives contract qualifies for accounting treatment of a hedging contract under IFRS principles endorsed by the European Commission.  The rules are clear that whether the contracts consitute hedging under local GAAP rules is the standard, although ESMA expects most local GAAP treatment to meet the proposed definition.

Clearing thresholds are set by notional amount and by asset class, with 5 asset classes defined: credit, equity, interest rates, foreign exchange, and commodity & others.  Breaching the threhold for any one asset class subjects the non-financial counterparty to a clearing obligation for all derivatives for all asset classes thereafter.  The notional amount thresholds will be phased-in, and periodically reviewed.

Non-financial counterparties will have to confirm OTC derivatives contracts by the end of the second business day following the trade day.

Portfolio reconciliation must be daily if counterparties have more than 500 contracts between them, weekly if between 300 and 500 contracts, and monthly for less than 300 contracts.

Portfolio compression is mandated for all counterparties with more than 500 non-centrally cleared contracts to be done at least twice a year.

Capital treatment will be addressed in a separate set of regulations on Basel III and CVAs.  There is still a significant likelihood that exclusion from clearing will result in a requirement of higher bilateral margin and contract re-pricing to include the CVA.

Much more in there, but this hits the high points.