EMIR Central Clearing Agreement: agree in haste, repent at leisure

This week’s authorisation of Nasdaq OMX as the first QCCP under EMIR should serve to concentrate the minds of the many firms who do not already have a client clearing agreement (CCA) in place. The client clearing document suite defines and governs the relationship between the client and their clearing broker. Mandatory clearing of certain contracts under EMIR may start as soon as December 2014, deadline-pressured firms already run the risk of non-compliance or being forced into an inflexible contract which may prove to be prejudicial to their interests. Time-constraints are exacerbated by the need to also appoint a “standby” clearing broker and by significant differences between CCPs’ own rules.

The broad categories of CCA are as follows:

• Industry-led
  • ISDA-FIA  Cleared Derivatives Addendum
  • FIA Clearing Module
  • Clearing-Rahmenvereinbarung (German clearing standard)
  • Update to the FBF agreement (French “ISDA Master”)  incorporating clearing
• Stand-alone CCP-led agreements eg. LCH Clearnet /SwapClear
• Stand-alone Clearing Broker-led agreements

While careful contractual scrutiny is imperative in the case of the various stand-alone agreements (not the least of which is verification of supporting legal opinion), it is perhaps too easy to accept the industry-led addenda to existing agreements as a quick-fix solution. Among these the ISDA-FIA contribution is most likely to become the de facto standard. The transposition of a simple futures-exchange model to the previously unregulated, bespoke OTC derivatives market has been fraught with difficulty and delay. Drafting an agreement that can satisfy both sides while adhering to the differing laws and bankruptcy codes of 27 member states is a non-trivial task and the ISDA-FIA addendum has been broadly welcomed.  However, it should be regarded as a template and framework for negotiation rather than a ready-made solution.

Irrespective of the particular CCA’s genesis, they all contain the following elements:

• A definition of the agreement’s scope- what transaction types and with whom
• A definition of CCA’s interaction with other applicable rules.
• A definition of the Events of Default relating to both clearing broker and client, compliant with the relevant CCP’s rules.
• A definition of collateral standards and terms. A definition of account type, client-asset segregation and porting ability.
• A definition of the link between the Client-Broker transaction and the mirror Broker-CCP transaction.

Even from these brief details and before the client’s specific needs are accounted, it is clear that there are a number of critical points that should be subject to bilateral negotiation:

• Pre-default porting- the exact conditions under which a client may exercise a right to transfer his trades to a more congenial Clearing Broker. It is vital that Clients understand and carefully negotiate this point and its interaction with the CCP rules to retain a degree of commercial freedom. They may also wish to assess its utility as a remedy, particularly in the context of collateral held in a net omnibus account.
• Events of Default or automatic termination triggers. The Client has no contractual nexus with the CCP and must rely on good faith and the CCP’s commercial sense. Any mismatch in the definition of trigger event between the ISDA Master and the CCP clearing agreement will introduce significant documentary basis risk.
• Termination amounts. The principal-to-principal schema of many agreements result in Client termination amounts that exactly match those of the CCP. Even in the case of Clearing Member default, the Client pays the spread.
• Optional termination. It’s inclusion and under what terms eg. bilateral, transaction specific, notice period etc.
• Collateral and margin terms eg. Collateral eligibility, applicable haircuts, variation margin, initial margin, CCP determination matching, notice period and settlement details. The practicalities of collateral arrangements are highly client-specific, but it is an area on which all sides will focus and is largely unresolved by the industry-standard agreements. The ISDA-FIA addendum for instance, simply disapplies any existing terms and substitutes a basic clearing-compatible CSA.
• Limitation of Liability/Indemnity eg. the scope of the clearing fails indemnity if included, the Clearing Broker’s role as intermediary.
• Commercial terms eg. pre-funding arrangements, position limits, fees, etc.

Although these agreements are typically not long, they are relatively complex and are compounded by the need to account for related factors such as CCP rules; the market as a whole is far from familiar with the questions they pose. Clients will have to invest significant resources in understanding the implications of and risks inherent in the agreement, deciding their own position before inevitably protracted negotiations can even begin. Excepting perhaps for their most favoured clients, Clearing Brokers will not be gearing up their negotiating teams to cater for a last-minute rush. Mandatory clearing under EMIR may begin as soon as the year end, the time to put a clearing agreement in place is now.

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