EMIR - A giant stride forward but further work to do

The European Markets Infrastructure Regulation (EMIR) has passed a significant milestone. Agreement between the European Commission, the European Parliament and the European Council (the so called ‘trilogue’ process) means we are close to the end of lengthy negotiations and are starting a process that will significantly alter the structure of OTC derivative markets.

EMIR is a cornerstone of the post-crisis reform agenda and will introduce requirements aimed at reducing counterparty risk and improving transparency within OTC derivative markets. In the EU, EMIR will also provide the framework for implementing the G20 commitment that ‘All standardised OTC derivative contracts should be....cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories....’

Whilst the Commission’s legislative proposal in September 2010 set the general framework and direction of travel for these new requirements, firms now have a higher degree of certainty as to their shape and form. Further clarity on the expected detail of the requirements is offered by the recently published discussion paper from the European Securities and Markets Authority (ESMA) on ‘Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories’.

The largest participants in these markets started implementation projects some time ago. For those that have not yet done so, it is now essential that they step up implementation plans at both the strategic and operational level.

This briefing note sets out the key requirements that firms will have to meet in this area. Where possible it draws parallels with the provisions under Title VII of the Dodd-Frank Act which sets the framework for the reforms to US markets and will affect firms with US-based clients. Importantly, we identify some of the key issues that firms should be addressing now to ensure that they are well placed to meet these sweeping changes.

Summary of new requirements

Clearing obligation: Scope
Firms will need to clear all OTC derivative transactions for the products where ESMA has determined a clearing obligation will apply. This will have far-reaching implications and will fundamentally shift the way counterparty risk is managed. In general terms the scope of the clearing obligation will apply across the five main derivative asset classes (interest rate, equity, credit, commodity and foreign exchange) and with the publication of its Discussion Paper ESMA has now publicly started work to determine the specific products covered.

The scope of the clearing requirement will apply to all financial counterparties transacting in OTC derivatives. In practice this will cut across banks, insurers and asset managers, although some important exemptions have been secured. Most notably, corporate clients who use derivatives for hedging purposes or who have a small degree of non-hedging business have been carved out of scope. By end-September 2012, ESMA will need to determine where the threshold for non-hedging business should be set as well as the criteria for determining if a derivative is for hedging purposes. Whilst of comfort to some corporate clients this will not be without challenges as the threshold will be calculated on a rolling basis and so firms could drop in and out of scope although in practice we expect firms to monitor and manage their activity so as to preserve their exemption status. In addition, some intra-group transactions are exempt and pension funds will have a three-year transitional period to allow for central counterparties (CCPs) to provide a solution which specifically caters for the funding needs of pension funds. This will remain under subsequent review by the Commission.

Clearing obligation: Process
In determining whether a clearing obligation should apply ESMA will, in the first instance, need to consider the liquidity, standardisation and the volume of transactions executed of the instrument and pay regard to a variety of factors including the number of active counterparties in the market and the ability of CCPs to clear the product. This decision-making process will either be via a ‘bottom-up’ approach (whereby a CCP already offers the product for clearing) or via a ‘top-down’ approach (whereby no CCP offers the product but due to systemic risk concerns a clearing obligation is deemed appropriate). In practice we expect the majority of clearing obligations will be determined under the ‘bottom-up’ approach as regulators will be reluctant to force a CCP to clear a product when the ability to risk-manage that particular product may be less than certain.

Policymakers and legislators have listened to industry concerns, from both a cost and practical perspective, regarding the treatment of outstanding contracts; these will not need to be moved in their entirety to clearing. However, in future when a national regulator notifies ESMA of a proposed clearing obligation the market will effectively be ‘put on notice’ that a clearing obligation could apply at some point thereafter. If ESMA subsequently decides that the particular product should be cleared this will apply from the date of the original notification and will affect all contracts concluded since then as well as new business going forward. ESMA will also determine the deadline for moving outstanding contracts to clearing.

This will be an on-going process. We expect ESMA to make determinations throughout the course of next year and thereafter when new products are launched or regulators identify products which in their view should be subject to mandatory clearing. In our view, ESMA will closely monitor global developments to inform their decisions.

Approach for non-cleared trades
Despite the desire of regulators and policy makers to move more business on to central clearing, there will always be a universe of products whose bespoke nature and reduced levels of liquidity mean that they will never be suitable for clearing. The Regulation recognises this and so will introduce extensive requirements that will strengthen the risk management of non-cleared trades. The most significant change will be the requirement for participants to exchange collateral on their non-cleared trades. Working with the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA) ESMA will, by end-September 2012, determine the form this will take. It remains to be seen whether this will follow an ‘initial margin’ and ‘variation margin’ type approach. This will present firms with significant challenges as they will have to source highly liquid collateral to cover the position across the duration of the contract - a potentially lengthy period of time with major implications for liquidity.

In addition firms will need to make changes to ensure they are operationally strong and have the capability to mark their positions to market on a daily basis; to confirm their trades electronically; and to perform a variety of risk management functions including trade compression and portfolio reconciliation activities.   

Reporting to trade repositories
In order to address concerns that regulators do not have a full picture of the exposures of the firms they regulate and the possible systemic implications these may pose, a number of trade repositories (essentially a central database) have been established (and others are in the process of being established) where information on positions is collected. Unlike the EU transaction reporting regime, the primary objective is not to combat market abuse but instead to identify pockets of potential systemic risk either at a firm- or a product-specific level and take action to address these. Trade repositories also facilitate the reporting of some aggregate data to the public. Currently there are operational trade repositories for credit, equity and interest rate derivatives with plans underway to establish ones for foreign exchange and commodity derivatives. Some of the largest banks active in these markets are already reporting some data to trade repositories but all firms will now need to consider how they will meet the requirements outlined below, especially as some firms will be brought within the scope of regulatory reporting requirements for the first time.

EMIR will require all derivative transactions (OTC and exchange traded) entered into by EU counterparties to be reported within one day of the execution of the contract to an EU registered or a third country recognised trade repository. This will apply across all participants so the exemptions to the clearing obligation outlined above will not apply. Modifications and terminations of contracts are also caught. Both counterparties to the transaction will need to report although firms will be able to do so on behalf of their clients. In addition all contracts that were executed prior to the entry into force of the Regulation and remain outstanding will need to be reported. If no trade repository exists firms will need to report the details of their trades to ESMA - the now designated supervisor of trade repositories located in the EU. In practice we think direct reporting is unlikely as ESMA will be keen to avoid building a system for what would most likely be a relatively short period of time given that plans are underway to establish trade repositories in the asset classes where trade repositories are not yet operational.

This will lead to significant systems changes for firms and will come at a time that other pieces of EU legislation, namely the amendments to the Markets in Financial Instrument Directive (MiFID) and the Market Abuse Directive (MAD), will require additional reporting. The exact data fields will be determined by ESMA and at a minimum will contain information on the parties to the transaction and the main characteristics of the contract including the type, maturity and notional value. The ESMA Discussion Paper builds on this and highlights at least 30 data fields that may need to be reported. ESMA is also seeking views on more ambitious requirements such as capturing data on exposures and collateral.

Framework for CCPs
The Regulation not only introduces far-reaching requirements for market participants but will also, for the first time, introduce harmonised requirements for the supervision and authorisation of CCPs. These will span both conduct (e.g. record keeping and account segregation requirements) and prudential requirements (such as default fund contributions and financial resource requirements). Of particular interest is the requirement for national regulators to establish a college when considering an application to authorise a CCP, including when an authorised CCP launches a new product and the process for resolving the differing views of college members.

Third country issues
The approach for non-EEA CCPs and trade repositories providing services in the EU has proved a contentious issue during the negotiations, with policy makers keen to support a competitive market but mindful of the potentially protectionist provisions included within Title VII of Dodd-Frank. EMIR will allow ‘third countries’ to provide clearing and trade repository services in the EU provided the legal and supervisory regime in their country provides for an effective equivalent system for the recognition of CCPs under foreign legal regimes. In our view, the text leaves ESMA sufficient leeway to take a hard line if other countries do not offer a similar approach for EU firms seeking to access their markets. Whilst the agreement makes clear this should not set a precedent we expect to see further politically-charged discussions on similar provisions in the MiFID proposal.

Comparison of key requirements under EMIR and Title VII of the Dodd-Frank Act

Markets are global as are many of the largest participants which are active in both the EU and US OTC derivative markets. The table below sets out a summary of the key requirements under EMIR and the corresponding requirements or approach that will be imposed under Title VII of the Dodd-Frank Act.

Whilst the frameworks under EMIR and Title VII of Dodd Frank are broadly similar we expect there will be important differences between the EU and US implementing measures.

These are likely to include areas such as:

• the products subject to a clearing obligation and/or bilateral collateralisation requirements
• the shape and form of ‘margins’ for non-cleared trades
• the data reported to trade repositories
• account segregation requirements
• the approach to third countries

Therefore an assumption that implementing Dodd-Frank will satisfy EU requirements (and vice versa) is misguided. Whilst some of these issues may not in practice lead to significant differences in impact, in our view the implementing measures for non-cleared trades (especially those for foreign exchange derivatives where the US proposes an exemption) should be monitored closely as a significant difference in approach could lead firms to relocate their activities accordingly.

The largest banks and investment banks are well advanced in their preparations and have increasingly stepped up the volumes of cleared trades as CCPs increase their offerings in this space. And for some asset classes good progress has been made towards reporting to trade repositories. However, other participants are less advanced and overall we expect the requirements relating to bilateral collateralisation will pose challenges for all.

External drivers
As we digest the impact of these new requirements it is clear that the market will undergo a period of significant change.

Firms should now be thinking about wider impacts on their collateral management strategy. Greater use of clearing will mean that firms will need to be able to respond to intraday margin calls with highly liquid assets. The funding implications will be more far-reaching than for the clearing of more ‘traditional’ products such as equities, since the duration of derivative contracts are typically much longer and firms will need to consider how margin will be funded over a potentially much longer time horizon.

In parallel non-cleared trades will also have to be collateralised. Whilst the shape and form of the collateral may be different to that for cleared trades, firms should consider their strategy to ensure optimal allocation of collateral within their firm.

Increased flows of business to clearing houses will in themselves pose regulators with a new set of challenges. Work is already underway at the international level through CPSS-IOSCO to propose a set of principles for the supervision of market infrastructure which take into consideration the changing business of CCPs. We agree with regulators that CCPs will need to meet stringent standards so as to mitigate what will essentially be a significantly increased concentration of risk at the clearing house level. This should include the need for CCPs to have a recovery and resolution plan (and EU legislative proposals are expected in this area later this year) but acknowledging that this is likely to differ in some ways from banks.

In our view the greatest scope for regulatory arbitrage relates to how OTC derivatives are traded. This is in part because the trading proposals in MiFID are at an early stage and there is expected to be a delay in implementing these proposals in the EU compared to the US where legislation is further advanced. As a result, we may see global firms taking steps to benefit from differences, if albeit temporary, between the two approaches.

Next steps and implementation
Whilst this agreement is a significant step forward it is in practice one piece of a complex jigsaw. The baton now passes to ESMA which has the daunting task of developing binding technical standards in more than 25 areas by end-September 2012. Whilst some of the legwork has been done, the formal process has commenced with the publication of the ESMA Discussion Paper on OTC derivatives, CCPs and Trade Repositories. We expect two further discussion papers to be published shortly. One in conjunction with the EBA and EIOPA covering risk mitigation techniques for non-centrally cleared derivatives and one in conjunction with the EBA on capital requirements for CCPs. This will be followed in the summer by a consultation on the draft technical standards. Firms therefore still have the opportunity to engage and look to influence the debate, especially on some of the more technical aspects.

However, the path to implementation is less than clear. In reality many of the technical standards are linked and so a staged timeline for full implementation is expected. By way of example, ESMA will now have to determine which products will be subject to a mandatory clearing obligation. Only once this universe of products is identified can firms be under an obligation to move their business to clearing. Notwithstanding this, regulators will be mindful of the looming G20 deadline and we expect there will be a strong push to see concrete steps by all market participants to clear and report at least some of their derivatives business by the end of this year.

But EMIR is only one important part of a three-pronged approach to improving the resilience of OTC derivative markets in the EU. The revisions to MiFID will introduce requirements for the trading of derivatives on ‘organised markets’ as well as a harmonised and mandatory approach for pre- and post- trade transparency. And in terms of capital, CRD IV will set the risk weights for cleared and non-cleared trades and for the treatment of contributions to CCP default funds. When taken in aggregate these proposals will dramatically change the way markets currently operate and will mean firms will need to make important strategic choices as to how they manage their business.

In our view the aggregate impact of this package of regulation will significantly alter the structure of OTC derivative markets. This will not only be in terms of risk management practices, but also in terms of the way derivatives are traded and priced. This will ultimately drive the shape of product offerings to be more standardised in form. Over time, as the market digests these implications, there may also be location considerations for the most active firms in these markets.

As part of our on-going drive to provide our clients with insight into the impacts of regulation the Centre for Regulatory Strategy will, in the coming months, publish our analysis of what the broader impacts for capital markets might be.

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