Major swaps dealers began the controversial concept of ‘frontloading’ this week, a unique requirement to Europe’s approach of migrating derivatives trades from bilateral to central clearing.

The rationale behind frontloading is that certain OTC derivatives trades can be captured under the clearing scope as soon as possible, even before new clearing rules under European Market Infrastructure Regulation (EMIR) apply in practice.

Hannah Meakin, partner at Norton Rose Fulbright LLP, explains that “relevant OTC derivatives entered into or novated from the frontloading date will have to be cleared through a central counterparty (CCP) once clearing obligations take effect if the derivative has a certain minimum remaining maturity – however, in practice, counterparties may opt to start clearing these derivatives during, or even before, the frontloading period”.

Several classes of interest rate OTC derivatives denominated EUR, GBP, JPY and USD will soon start to shift to a centrally cleared model using authorised CCPs. Interest rate derivatives in certain other EEA currencies and some classes of credit derivatives are expected to follow soon.

‘Category 1’ firms - counterparties which are CCP members, have now started the ‘frontloading’ process ahead of mandatory central clearing rules which will apply from June.

Contracts entered into between major banks and broker-dealers, for example, will now have to be cleared with a qualifying CCP, such as LCH.Clearnet or Eurex, if they have at least 6 months remaining maturity on 21 June.

The US regime has not yet been deemed equivalent for this purpose.  

For ‘category 2’ businesses, which include asset managers and hedge funds with derivative exposure above a certain threshold, frontloading will apply from 21 May, ahead of central clearing commencing on 21 December 2016.

While the requirement appears simple, a significant amount of uncertainty has existed for those affected.

Issues have ranged from the actual derivatives within a class that will be subject to frontloading; the CCPs mandated to clear which classes of derivatives and the start date and duration of the frontloading period.

Jamie Gavin, head of OTC clearing sales, EMEA, for Societe Generale Prime Services says: "This uncertainty around the rules has encouraged many clients to delay securing a clearing broker and start getting ready for clearing.  Where we are in a situation with limited brokers and limited clearing capacity, some clients have a significant amount of work to do to comply by their deadline."

ESMA has sought to address uncertainty in consultation papers and updated a Q&A last week, clarifying how clearing obligations should apply to swaps, including during the frontloading period.

In broad terms, central clearing obligations form a major part of European Market Infrastructure Regulation (EMIR), the post-crisis derivatives regulation aiming to reduce systemic risk in the financial system.

This follows the G20 commitment to clear certain OTC derivatives through central counterparties (CCPs).