Risk Magazine is reporting that the International Swaps and Derivatives Association (“ISDA”) and the Futures and Options Association have finalised the long overdue standard “Client Cleared OTC Derivatives Addendum” (the “European Addendum”) designed to enable clearing members to sign up clients and so facilitate central clearing in Europe.
The European Addendum was originally due to be published in September 2012. However, despite the existence of the US “Cleared Derivatives Addendum” (the “US Addendum”) as a template, it has been delayed as a result of the need to reflect the different clearing model adopted in Europe (where clearing members act as principals to transactions) as opposed to the US (where Futures Commission Merchants act as agents for clients). Specific negotiation points have also resulted in delay, in particular the mechanism by which clearing members can close out transactions following a client default. Discussion has centred on whether clearing members should be required to establish equal and offsetting transactions with a clearing house with respect to every client trade being closed out. This approach is transparent and mirrors the default position under the US Addendum. However, dealers understandably prefer to retain the ability to macro hedge the exposure associated with defaulting client transactions at the portfolio level, believing this to be less cumbersome (particularly for large client portfolios) and able to deliver better results for clients. It seems that the compromise solution agreed with respect to the European Addendum was to find a balance between constraining what the clearing member can do (primarily by requiring it to conduct any liquidation in a commercially reasonable manner) whilst also giving it freedom to do what is in the best economic interests of the client.
The article also briefly discusses the cross-margining benefits associated with the European Addendum. If used in conjunction with a futures agreement which facilitates both futures and OTC derivatives trading, a firm will be able to benefit from any cross-margining services offered by European clearing houses. In contrast, if used in conjunction with an ISDA Master Agreement (which only applies to OTC derivative products) cross-margining will not be available. Apparently, ISDA intends to solve this problem by creating another document (which has not yet been drafted) that would enable firms to use the ISDA Master Agreement with the European Addendum and yet still link to existing futures contracts.
The article refers to concerns that persist about the European Addendum and the impact that this might have on its uptake. This stems mainly from the feeling that some of the compromises reflected in the drafting may prove too much for some buy-side firms to accept. More generally, given the current EMIR timeline, there is a thought that buy-side firms may show little interest in using the document until the end of 2013/beginning of 2014. Given that mandatory clearing in Europe seems likely to start in Q1/Q2 2014, the resources of even the largest dealers to negotiate documentation are finite and the European Addendum is over 40 pages long and documents a new way of doing business, any holding approach represents a high risk strategy. This document represents the ‘Plan A’ for central clearing in Europe that many dealers have been waiting for. Therefore, any firm truly wishing to avoid being frozen out of markets due to an inability to sign the necessary documentation under a “docugeddon” scenario needs either to get to grips with this document, or figure out their own ‘Plan B’, in the very near future.