Regulation of Financial Market Infrastructures under the preliminary draft for a Financial Market Infrastructure Act

As the consultation period for the preliminary draft of a Financial Market Infrastructure Act (E-FinfraG) reached its term, we survey the proposed regulation of providers of financial market infrastructure services. This new framework complements the regulation of over-the-counter derivatives described in previous articles (see CapLaw-2014-5 and CapLaw-2014-6).

By Rashid Bahar/Roland Truffer (Reference: CapLaw-2014-13)

1) Overview of the E-FINFRAG

In addition to the regulation of derivatives trading, the preliminary draft seeks to provide for a comprehensive regulatory framework for financial market infrastructures (FMI) in line with the Principles for Financial Market Infrastructures (PFMI) issued by the Committee on Payment and Settlement Systems of the Bank for International Settlements and by the Technical Committee of the International Organization of Securities Commissions (IOSCO) in April 2012 and with the EU’s “EMIR” Regulation of 2012. This legislation distinguishes several types of FMIs, namely, trading venues such as stock exchanges, multilateral trading platforms and organized trading platforms, central counterparties, central securities depositories, payments systems and trade repositories.

With the exception of the regulation of stock exchanges which is already covered by the Stock Exchange Act, the draft bill marks a departure from current laws and regulations in terms of the normative density. Instead of five articles spread throughout the Banking Act, the Stock Exchange Act and the National Bank Act (article 1bis BankA, article 10bis SESTA, article 19-21 NBA), the draft bill envisages to regulate FMIs with more than 80 provisions, which will need to be implemented through ordinances of the Federal Council, FINMA and the SNB. Even so, the draft bill remains to a large extent in line with current legislation, except for a limited number of important changes in specific areas, which will be the focus of this article.

2) General Licensing Requirement

Under the draft bill, FMIs are subject to licensing by FINMA (article 3 (1) E-FinfraG). Ongoing supervision over such institutions will be exercised by FINMA (article 75 (1) E-FinfraG) and, in the case of systemically relevant institutions, additionally by the SNB (article 75 (1) E-FinfraG).

As a matter of principle, an FMI is entitled to a license if it satisfi es the general and specific licensing requirements for the relevant type of FMI (article 4 (1) E-FinfraG).

The general licensing requirements for FMIs mirror, to a large extent, the existing provisions under the BankA, SESTA and CISA regarding the licensing of other financial institutions.

However, the draft bill provides for certain novel requirements for FMIs. In a signifcant departure from the universal banking model that prevails in Switzerland, the draft bill provides that a given legal entity can only run one FMI with an exception for central depositories who can run a securities settlement system and a central securities depository (article 8 (1) E-FinfraG). A group of companies further remains free to hold several FMIs. Moreover, the rules encourage ring-fencing financial market infrastructures by allowing FINMA to impose specifi c organizational measures or require additional capital or liquidity from a FMI who would be engaged in an ancillary business that is not regulated (article 8 (3) E-FinfraG).

Furthermore, the draft bill includes new provisions on internal organization of FMIs. For example, it requires for the outsourcing of essential services the prior approval of FINMA, who, in connection with systemically relevant FMIs, must consult the SNB (article 9 (1) E-FinfraG). It provides also for specific requirements on business continuity and IT Systems (article 11 and 12 E-FinfraG).

Finally, the draft bill includes additional requirements specifi cally crafted for FMIs, such as the requirements to ensure an open access to their services on a non-discriminatory basis (article 16 E-FinfraG) and to ensure the validity and enforceability of their contractual arrangements under all applicable laws (article 17 E-FinfraG). Finally, the draft bill provides for extensive documentation and retention rules (article 18 E-FinfraG) and a generic obligation to publish important information for participants and the public generally (article 20 E-FinfraG).

3) Regulation of Stock Exchanges and Trading Platforms

Regarding trading venues, the draft bill distinguishes between stock exchanges (which list securities), multilateral trading platforms (which, without listing securities, enable trading in securities on an organized basis following non-discretionary rules), and organized trading platforms (which are governed by discretionary rules), the latter being regulated only if they allow multiple participants to trade with each other, thus leaving systematic internalizers, in principle, out of scope of the regulation unless the purpose of the law requires otherwise (article 3 (2) E-FinfraG).

Overall, the draft bill consolidates to a large extent the existing rules on stock exchanges, but expands their scope to apply to other trading venues without leaving FINMA any discretion to tailor the regulation to the risk profi le of each specific institution (see article 3 (4) SESTA and article 16 SESTO). Under the draft bill, the same set of rules apply to the organization and supervision of trading with differences among

types of trading venues appearing only for the admission of participants and securities (see article 33 (2) E-FinfraG, comp. article 34 f. E-FinfraG). As is currently the case for exchange transactions, parti ci pants to all types of platforms will be required to record their transactions (article 38 E-FinfraG) and report them to the trading platform (article 39 E-FinfraG).

Similarly, the draft bill proposes to extend the model that is currently applicable for the licensing of foreign participants in stock exchanges to all regulated Swiss trading platforms and to do the same with respect to the recognition of foreign trading platforms (see articles 40 and 41 E-FinfraG).

4) Regulation of CCPs

As with EMIR, the regulation of central counterparties (CCPs) is one of the cornerstones of the draft bill. In line with the current regulation of securities settle ment systems under the current National Bank Ordinance (NBO), central counter-parties are required to limit their risks by requesting collateral from participants, as well as contributions to a default fund, and to take further measures to limit credit and liquidity risks in connection with the default of a participant (article 44 and 47 E-FinfraG). In particular, CCPs will be required to defi ne the ‘waterfall’ of collateral and other buffers in the event of a default (article 47 (2) E-FinfraG). In this respect, the draft bill provides for a less detailed regulation than the NBO or EMIR which both prescribe high-level provisions on the order of the waterfall, which need to be implemented through technical guidance.

The main challenge for CCPs, in particular in an environment mandating the use of exchange traded derivatives and/or of CCPs for OTC transactions, is that they concentrate risks around the CCP and its direct participants. To counteract this effect, the draft bill requires CCPs to segregate their assets from those of parti cipants (article 48 (1) E-FinfraG) and allows the latter to open segregated accounts in the books of the CCP for some or all clients (article 49 (1) E-FinfraG) and, in turn, requires participants to inform clients of their right to request this set-up without imposing it (article 53 E-FinfraG). However, it is worth stressing that while segregation may help operationally to distinguish client assets from proprietary assets of participants, it does not per se have any legal effect.

Furthermore, to extend the benefi t of CCPs from direct participants who legally face the CCP to non-clearing exchange members and ultimate clients, the draft bill requires CCPs to provide for porting of positions and collateral and, thus, ensure that, in the event of a default of a direct participant, collateral, rights and obligations that the direct participant holds for indirect participants can be transferred to another direct participant designated by the indirect participant (article 49 E-FinfraG). However, but for the insolvency law rule discussed in further detail below (see section 8 below), the draft bill does not provide for any detail on how to achieve such porting and ensure its effectiveness.

To ensure an effective competition among CCPs, the draft bill, following EMIR, allows CCPs to enter into interoperability agreements allowing members of two different CCPs to clear transactions through their own CCP (article 50 (1) E-FinfraG) and even requires CCPs to accept requests to enter into such arrangements unless they would endanger the security and effi ciency of the clearing (article 50 (2) E-FinfraG). However, to ensure that such agreements do not compromise the stability of the system, they are subject to the approval of FINMA (article 51 (1) E-FinfraG) and, when a systemically relevant CCP is involved, the SNB (article 51 (3) E-FinfraG).

An important aspect of the regulation, in this respect, will be the regime for foreign CCPs. They will, as a matter of principle, be required to be recognized by FINMA before allowing direct participation of Swiss entities, providing services to a Swiss FMI or entering into an interoperability agreement with a Swiss CCP (article 54 (1) E-FinfraG). This recognition will be granted if, in addition to the usual conditions for cross-border business (e.g., appropriate regulation in the home country and no objection by the home country regulator to doing business in the host country), the home country regulator of the foreign CCP agrees to inform FINMA of any breach of laws or incident relating to a Swiss participant and will provide administrative assistance to FINMA (article 54 (2) E-FinfraG).

5) Regulation of Central Securities Depositories

Under the draft bill, a central securities depository (CSD) can either run a securities settlement system or a central depository, or both (article 55 (1) E-FinfraG, see also article 8 (1) E-FinfraG). CSDs act as the guardians of the intermediated securities system: they are responsible for defi ning rules and procedures to ensure the appropriate and legally compliant custody, booking and transfer of securities (article 56 (1) E-FinfraG) and for preventing participants from overdrawing their securities accounts (article 56 (2) E-FinfraG).

As with other FMIs, CSDs must ensure that they have appropriate measures in place to cover credit risks and that they can both deal with risks arising out of the default of a participant (article 59 and 61 (1) E-FinfraG) and segregate their own assets from those of participants (article 63 (1) E-FinfraG). Furthermore, as with CCPs, CSDs must offer the possibility to segregate client assets from proprietary assets of a direct participant (article 63 (2) E-FinfraG) without however imposing such segregation.

Finally, the draft bill includes provisions on connections between CSDs to enable clearing and settlement between several CSDs or to allow a CSD to participate directly or indirectly in another CSD. In essence, such interconnections are possible, but require the prior approval of FINMA who will ensure that connections among CSDs do not compromise the safety of the system and participants (article 65 (2) E-FinfraG).

6) Regulation of Trade Repositories

The requirement of transaction reporting to trade repositories is one of the financial infrastructure requirements at the core of the draft bill, in the same way as it is one of the priorities pursued under EMIR. The main function of these institutions is to ensure further transparency of the derivatives markets, by centralizing all data on OTC transactions and retaining such data for ten years (article 67 E-FinfraG). This data will need to be published in an anonymized statistical form covering at least open positions, trade volumes and value for each relevant category of derivatives (article 68 E-FinfraG).

Another purpose of trade repositories is to give regulators full access to relevant data. Under the draft bill, they will need to provide access to all trade data to Swiss financial market regulators, including FINMA, the SNB, and other financial market supervisory authorities (which term is construed to include the Competition Commission when it investigates these markets for anti-competitive collusion, article 69 E-FinfraG), and also, subject to the satisfaction of certain safeguards, to their foreign counterparts (article 70 (1) E-FinfraG), who will also have direct access to such data, including the name of counter-parties to a given trade.

The draft bill also provides for a regime to recognize foreign trade repositories, which is comparable to the one applicable to foreign CCPs (article 72 E-FinfraG; see above section 4).

7) Regulation of Payment Systems

The regulatory regime for payment systems is probably the lightest of the regimes applying to licensed FMIs under the E-FinfraG. Payment systems will be subject to regulations and licensing requirements as a financial market infrastructure under the E-FinfraG only if they act on the whole-sale market among financial institutions (article 73 E-FinfraG). Moreover, the statute does not formulate any specific licensing requirements, except for any that would be required by the Federal Council following a development of international standards, or by the SNB in the case of systemically important payment systems (article 74 E-FinfraG).

8) Insolvency Rules for Infrastructures and Participants

Swiss FMIs will generally be subject to the special insolvency regime applicable to banks and securities traders, which has been repeatedly amended and refined in the years following the financial crisis (see amendments to the Banking Act effective 1 September 2011 and 1 March 2012; Banking Insolvency Ordinance of the FINMA (“BIO-FINMA”) of 30 August 2012). Explicit reference is made to the rules of the Banking Act for this purpose (article 79 E-FinfraG). Thus, failing market infrastructures will be subject to the various innovative resolution tools developed in connection therewith, such as the facilitated transfer of clusters of legal relationships to a third party in order to ensure continuity of particular services (article 30 para. 2 BankA) or the bail-in of debt (article 31 para. 3 BankA, articles 48 ff. BIO-FINMA), although the former seems of greater relevance in the case of FMIs as compared to the latter.

While the insolvency of a market infrastructure itself should remain an unlikely event, the draft bill also includes a number of rules that would apply in the insolvency of an infrastructure’s participants. For example, existing rules inspired by the EU Settlement Finality Directive and aimed at the protection of settlement systems, which provide for the timely information of the system on any insolvency action taken over its participant and for the finality of instructions emanating from it, will be moved from the Banking Act to the new Act (article 80 E-FinfraG). The draft bill further proposes a new provision aimed at facilitating ‘porting’ solutions in the case that a central counterpart’s direct participant defaults (article 84 E-FinfraG). The proposed rule appears, however, overly ambitious in that it purports to install a statutory mechanism for the transfer, by operation of law, of collateral, claims and obligations, which may not interlock smoothly with a specifi c (potentially foreign) CCP’s own rules governing such cases. A better approach would be for the Act to provide that the operation of contractual ‘porting’ arrangements of a CCP shall not be affected by Swiss insolvency proceedings in respect of a participant.

The draft bill also takes some of the instruments and safeguards of existing bank insolvency law a step further. Thus, the ancillary tool of a stay of termination rights in case of a transfer of contracts, currently provided in the BIO-FINMA for ‘financial contracts’ of a bank, is extended to all types of contracts that a FMI enters into (article 82 E-FinfraG). Several provisions across the draft bill (article 80 (4), article 83, article 102 (3) E-FinfraG) aim to protect netting arrangements and rights of private sale of collateral in particular insolvency situations. It would seem preferable to such a piecemeal approach, however, to address this evergreen topic of insolvency regulation in a comprehensive and principled manner in the Banking Act (and possibly in the Debt Enforcement and Bankruptcy Act for application in general insolvency law), as its importance is not limited to FMIs. A respective statutory provision could afford equal legal protection to various accepted instruments of risk mitigation (as defi ned, e.g., in article 61 of the Capital Adequacy Ordinance), including not only specifi c posted collateral and close-out netting arrangements, but also other forms of contractual or indeed statutory set-off.

In the interest of Switzerland remaining a step or two ahead of its peers in this particular field of banking regulation, as it has been for some time, it is hoped that the consultation procedure and further legislative process will result in a number of further refinements in the respective draft provisions. Meanwhile, the regulatory process in the European Union is ongoing (with formal promulgation of the Bank Recovery and Resolution Directive, which its Parliament passed on 15 April 2014, expected shortly and member states having to implement its requirements into their national laws by the end of 2014, the bail-in tool, however, not becoming universally available to resolution authorities until 2016), and may be expected in turn to produce new food for thought.