New legislation protecting holders of derivatives positions against bankruptcy of an intermediary
In May 2015, the Dutch Minister of Finance sent a legislative proposal for an Amendment Act Financial Markets 201618 to Parliament (the Amendment Act).
This Amendment Act includes new rules regarding asset separation for Dutch investment firms, banks and clearing institutions that act as intermediaries in derivatives transactions. The proposal will amend the Dutch Securities Book-Entry Transfer Act (the Act).
Under current Dutch legislation, there is no protection for holders of derivatives positions against the bankruptcy of a bank or another intermediary through which the client has entered into derivatives transactions (the intermediary). The Act currently only provides such protection to the holders of securities. Although article 13(7) of the Markets in Financial Instruments Directive (MiFID)19 introduced rules for the protection of client assets20 in 2007 and while these rules were implemented in Article 4:87 of the Dutch Financial Supervision Act, it is in practice not possible for banks and intermediaries to comply with the rules in relation to derivatives products under current Dutch legislation. A change in law is required to make this possible.
Next to the rules on asset protection introduced by MiFID, the Amendment Act also takes into account certain aspects of the European Market Infrastructure Regulation (EMIR)21 that entered into force in 2012. EMIR requires, amongst others, that central counterparties (CCPs) have legally enforceable procedures in place for the transfer of the assets and collateral that a clearing member (CM) holds in relation to a derivative entered into for a client, to another CM in case of a bankruptcy of the CM. Under current Dutch insolvency laws, such a transfer requires the cooperation of the trustee in bankruptcy making any procedure of a CCP in the Netherlands at the moment not enforceable. The Amendment Act aims to bring Dutch legislation into line with this EMIR requirement.
The Amendment Act – key provisions
The Amendment Act introduces a new chapter into the Act which applies to both listed and OTC derivatives. Under the new legislation, all derivatives positions entered into by an intermediary with a third party (CCP or another intermediary) in connection with a derivative position of a client, and all related rights and obligations arising from the exchange of collateral, are separated from the other assets and liabilities of the intermediary. If the intermediary becomes bankrupt, these separated assets will fall outside the bankruptcy estate.
However, with regard to the exchange of collateral, the new legislation does not introduce full protection for the clients with derivative positions. This is because, in general, intermediaries require clients to provide more collateral to the intermediary than the intermediary is required to provide to the third party under the corresponding transactions. If the collateral under the corresponding transactions, which has been separated from the other assets of the intermediary under the Amendment Act, is not sufficient to cover the claims of the clients, the available collateral will be divided pro rata between the clients of the intermediary (unless individual client segregation has been agreed with the intermediary). The clients will then need to claim the shortfall in the collateral from the bankruptcy estate of the intermediary.
The protection for the holders of derivatives positions only applies in relation to intermediary risk. If a bank is acting as a principal in the derivative transaction with the client, there is no protection under the Amendment Act, subject only to an exception if the bank is acting as a principal in a back-to-back transaction with a third party on exactly the same conditions as in the transaction with the client. In this case the client is protected. The Decree on Market Conduct Supervision of Financial Institutions will be amended to include a new requirement for intermediaries to inform their derivatives clients whether they are acting as intermediaries or whether they are acting for their own account in relation to a derivatives position (and thus whether protection under the Amendment Act arises).
The Amendment Act also provides that, in the case of the bankruptcy of an intermediary, the trustee in bankruptcy is required to appoint an expert approved by one of the Dutch regulators, the Dutch Central Bank (if the intermediary is a bank or a clearing institution) or the Netherlands Authority for the Financial Markets (if the intermediary is an investment firm). That expert will manage the derivatives positions and related collateral under the supervision of the trustee in bankruptcy. The trustee in bankruptcy is also required to cooperate with a CCP in the transfer of the derivatives positions and the related collateral of the bankrupt intermediary to another intermediary as required under EMIR. In addition to the EMIR requirement that only requires the transfer of the derivatives positions of the bankrupt CM and the related collateral to another CM, the Amendment Act also requires the transfer of the corresponding client positions and the related collateral to the new intermediary. If the transfer to the other intermediary under the CCP procedure is not successful, the trustee in bankruptcy may transfer the positions and collateral (and the corresponding client positions) to another intermediary. In order to facilitate the transfers, intermediaries are required to have adequate administration in place to be able to easily identify, at any given moment, the corresponding transactions with a third party (and the related collateral) for each client derivative position. Having such adequate administration in place will also become a requirement for obtaining a licence to act as an intermediary in relation to derivatives transactions.
The Amendment Act is planned to enter into force at the beginning of 2016.
18 Wijzigingswet financiële markten 2016.19 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial instruments amending Council Directives 85/611/EEC and 93/6/EEC and Directive 2000/12/EC of the European Parliament and of the Council and repealing Council Directive 93/22/EEC.
20 An investment firm shall, when holding financial instruments belonging to clients, make adequate arrangements so as to safeguard clients' ownership rights, especially in the event of the investment firm's insolvency, and to prevent the use of a client's instruments on own account except with the client's express consent.
21 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.