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All clear? EU introduces clearing and reporting regime for OTC derivatives
EMIR May 2012
EU introduces Securing your access clearing | OTC and reporting derivatives regime and central for OTC clearing derivatives
Contents
Executive summary EMIR introducing an EU regime for OTC derivative trading International mandate for reform of OTC derivatives market EMIR requirements Overlap with US Dodd-Frank Act Who is subject to EMIR? Requirements for cleared contracts Bilateral trading and cleared trading comparison Risk management requirements for uncleared contracts Reporting obligations Coordination with other legislative initiatives Third country issues Key issues for firms How we can help Contacts
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Executive summary
On 29 March 2012 the European Parliament (Parliament) approved the EMIR text, paving the way for its passage by the European Council of Finance Ministers (Council) this spring. We expect the reporting requirements to become effective by early 2013 and for clearing requirements to be phased in from spring 2013. The version passed by the Council contained few significant changes from prior versions, except that the clearing requirement was expanded to include certain OTC derivative trades conducted between counterparties located outside of the EU. The requirement is stated in extremely broad terms and the European Securities and Markets Authority (ESMA) is required to develop meaningful criteria to refine it.
While the text of EMIR is near-final at this stage, regulators still need to produce twenty-five sets of regulatory technical standards (RTS) defining some of the key requirements and their effective dates. Notably, RTS will clarify which OTC derivative contracts are subject to mandatory central clearing, define the reporting requirements and establish margin and collateral standards for CCPs.
EU introduces Securing your access clearing | OTC and reporting derivatives regime and central for OTC clearing derivatives
The OTC derivatives market will evolve into a two-tier market for centrally cleared and bilaterally cleared trades. Firms will face increased costs from clearing fees and additional reporting requirements. Both clearing brokers and trading firms will need to make operational changes to ensure compliance with the new regulations. Firms are also likely to face higher capital charges and will need to post margin in cash or other designated eligible securities, in relation to contracts which are not continually cleared. The narrowing of eligible collateral requirements may result in a shortage of such assets, giving rise to a growth in collateral trading and related services.
The demand for clearing services over the next twelve months may exceed supply and operational capability of CCPs to on board clients, with the result that central clearing may not be immediately available to all those entities captured by the scope of EMIR. In the short-term, trade volumes may decrease while market participants assess the costs of hedging risks, the challenges of matching risks to standardised products and the overall costs of OTC derivative maintaining OTC derivatives positions.
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EU. The enhanced transparency is expected to help regulators better spot threats to financial stability that may arise from derivatives trading. The new rules also create the market infrastructure to support this regime by introducing common authorisation and operational requirements for CCPs and registration and supervision requirements for TRs by European regulations.
would be traded on-exchange or through electronic trading platforms, cleared through CCPs (or subject to appropriate credit risk management rules) and reported to TRs. G20 countries are making progress in achieving four basic OTC derivative reform objectives: mitigating credit counterparty risk reducing operational risk increasing transparency enhancing market integrity. In the United States (US), the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) introduced OTC derivative clearing requirements which, like EMIR, apply to non-financial firms as well as to regulated financial firms. For the EU, EMIR creates the clearing and basic reporting infrastructure. The EU plans to introduce exchange trading requirements and market disclosure requirements for derivatives through revisions to the Markets in Financial Instruments Directive (MiFID), which are currently being negotiated in Brussels.
EMIR requirements
EMIR sets out the following requirements in relation to OTC derivative trading: clearing obligation for eligible OTC derivative trades reporting obligation for all derivative trades measures to reduce counterparty credit risk and operational risk for OTC derivative trades which are bilaterally traded rules for the authorisation and operation of CCPs rules on the interoperability between CCPS rules for the registration and operation of TRs. The new rules will improve market stability by replacing individual market participants counterparty risk management processes with standardised CCP requirements. Most importantly, EMIR will interpose the CCP between counterparties thus reducing potential credit default contagion between firms and markets. The new reporting requirements will apply to all derivative trades and aim to ensure that regulators can monitor the build-up of systemic risk through excessive risk concentrations. Risk concentration within the CCPs themselves will be addressed through strict requirements covering issues such as governance, capital requirements and default funding mechanisms. EMIR requirements apply to trading in derivative contracts, as defined within MiFID. The EMIR mandatory clearing and reporting requirements set the scene for the new exchange-trading and pre-and posttrade transparency requirements that will apply under proposed revisions to MiFID (MiFID II). The EU is also amending its market abuse regime to cover trading in OTC derivatives and to seek to bring more integrity to OTC derivative trading practices and conduct of business.
However, the Dodd-Frank Act rules on OTC derivatives go further, capturing nonfinancial firms in the scope of authorisation requirements, imposing new conduct of business rules on dealers, creating position limits and position management rights, and mandating exchange trading. Further, the controversial Volker rule under the DoddFrank Act contains a swap push out rule which requires the legal separation of swap trading operations from certain other firm activities. Thus far, the EU has not sought to require legal seperation of derivative trading activites.
However pension scheme operators will still be subject to reporting requirements and collateralisation requirements. Other similar schemes such as those generating retirement income or schemes operated by life insurance companies may also qualify for this exemption if certain conditions are met.
Who is a financial counterparty under EMIR? This term is defined widely under EMIR to include MiFID investment firms, credit institutions, non-life insurers, life assurance firms, reinsurers, undertakings for collective investments in transferable securities (UCITS) and their managers, occupational pension schemes (IORPs) and alternative investment fund managers (AIFMs).
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Foreign exchange swaps and forwards pose particular challenges under EMIR. Legislators rejected proposals to exempt FX derivatives from the scope of EMIR. However, EMIR recognises that derivatives exposed primarily to settlement risk, as in the case of FX derivatives, may not be suitable for the same treatment as those exposed primarily to counterparty risk. ESMA will make the final determination, but EMIR states that the regime for such contracts should rely notably on preliminary international convergence and mutual recognition of the relevant infrastructure. As a first step, firms will need to prepare a clearing plan for all OTC derivative contracts they trade which are likely to be deemed clearing eligible. Firms will need to assess the costs and operational and commercial considerations of becoming a CCP clearing member or becoming a client of another CCP member firm. Then firms will be able to assess how the collateral requirements of their CCP or clearing firm differ from the current OTC collateral requirements that they operate, for
example to comply with International Derivatives and Swaps Association (ISDA) master agreements which are widely used by most derivative counterparties. Under CCP clearing, firms will have the option to maintain omnibus or individual client segregated accounts, against which collateral will be posted. Margin calls will be made intra-day, at least when pre-defined thresholds are exceeded. Legislators and commentators have fiercely debated the type of collateral required for CCP initial margin and variation margin. Table 1 below compares bilateral and cleared trading arrangements. Some stakeholders are concerned that new collateral requirements will be expensive and difficult to meet. In particular, there is a risk that OTC dealing firms may seek alternative and unregulated trading and hedging techniques, to avoid CCP requirements that they deem too expensive or difficult to fulfil.
Commission proposal in relation to central securities depositories, the European Central Banks Target2Securities initiative, and the SEPA regime for payments. These initiatives seek to improve clearing and settlement systems resiliency and efficiency. From a trading perspective, EMIR is closely linked to the proposed MiFID II and the Market Abuse Directive revisions which will require many OTC derivatives to be traded onexchange and will bring trading in these instruments into the scope of the EU market abuse regime. We are also awaiting proposals from the European Commission to amend the Securities Law Directive to address investor rights and safekeeping issues. Developing deep regulatory reforms like EMIR poses significant challenges maintaining coherence and consistency with the reforms mentioned above and the wider prudential reform agenda, including CRD IV and Solvency II is essential, and further work on EMIR may be required to ensure we achieve that. These factors reinforce the complexity of the current regulatory environment and the need for firms to assess regulatory change as a package of reforms, not as isolated sets of requirements.
Reporting obligations
Firms and CCPs are required to report all OTC derivative contact transactions to a TR (or ESMA in the absence of TR arrangements) no later than one working day following the conclusion, modification or termination of the contract. This requirement will apply to all existing on-exchange derivatives trading as well as all cleared and uncleared OTC dealing. Firms must keep records of trades for five years from the date of the termination of the contract. ESMA will develop data and format requirements through RTS.
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presented by each option. Clearing brokers need to consider how to set margin requirements to ensure that they are consistent with those of different CCPs and incorporate those costs in their commercial clearing rates. Transition to standardised collateral requirements. In addition, RTS will specify the types of assets which meet CCP initial and variation margin requirements. These requirements are expected to have a dramatic effect on firms collateral funding abilities, and in turn could also impact other commercial activities, such as securities lending. Further, the standardisation of collateral requirements and loss of re-hypothecation opportunities may result in a shortage of high quality collateral. Application of intra-group exemptions. RTS will also clarify how intragroup exemptions within groups of financial and non-financial firms will apply. Those exemptions will not be automatic, they will require pre-approval by regulators. Establishment of reporting arrangements. New reporting requirements will apply to all derivative transactions including those which remain bilaterally traded. This requirement will put more demands on firms data management and reporting systems, particularly on client onboarding and data capture processes.
EMIRs passage and implementation dates will arrive quickly during the next year. Firms which have not already developed reporting and clearing strategies, budgets, IT and resourcing plans must do so as a matter of urgency. We advise firms to monitor the final stages of the legislative process and draft their project plans around the requirements in late stage proposals, but be prepared to accommodate any late legislative changes.
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Table 2: List of RTS that ESMA has to submit to the European Commission by 30 September 2012
1 Criteria for transactions conducted by counterparties outside the EU which are subject to EMIR clearing requirements, types of indirect contractual arrangements that do not increase counterparty risk and ensure adequate protection Details in notifications from competent authorities about OTC derivative contracts approved for clearing Classes of OTC derivatives to be cleared on EU-wide basis and date(s) from which clearing obligation takes effect Details to be included in public register Notion of liquidity fragmentation Details of trade reports Format and frequency of reports, dates for commencement of reporting Criteria for which derivative contracts qualify as hedge contracts, value of clearing thresholds for intra-group transactions that trigger clearing requirements (European Securities Authorities) Procedures for approving counterparty risk management, including mark to market techniques, intra-group exemption notice information requirements, contracts considered to have a direct, substantial, foreseeable effect within the Union or cases where it is necessary or appropriate to prevent the evasion of any provision of EMIR (European Banking Authority) Risk management procedures, including levels and types of collateral and segregation arrangements, level of capital required for compliance, procedures for counterparties when applying for exemptions, and criteria for what is prompt legal transfer of own funds (European Banking Authority) Rules regarding capital and retained earnings and reserves of a CCP Conditions under which Union currencies are relevant to assessment of which central banks should be included in EMIR colleges CCP information that applicant 3rd country CCP shall provide ESMA in application CCP minimum contents of corporate governance arrangements CCP record keeping requirements CCP BCP and disaster recovery plans CCP appropriate percentage and time horizons for the liquidation period and the calculation of historical volatility to be considered for different classes of instruments CCP framework market conditions to be used to define size of default fund and other financial resources CCP liquidity fund framework CCP methodology for calculating and maintaining CCP own resource to be used CCP highly liquid collateral standards, haircuts and conditions under which commercial bank guarantees may be accepted as collateral CCP highly liquid financial instruments, highly secured arrangements and condensation limits CCP stress testing requirements TR application standards TR frequency and content of data to be shared among regulators to aggregate and compare data
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The ESAs are tasked with drafting some 25 RTS and must submit these to the Commission by 30 September 2012. The European Commission has up to three months to endorse the RTS, and then the Council and European Parliament have a further three months to review the finalised versions. Thus, the final RTS may be in place by March 2013.
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Contacts
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This publication has been prepared for general guidance on matters of interest only, and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is given as to the accuracy, or completeness of the information contained in this publication and, to the extent permitted by law, PricewaterhouseCoopers LLP, its members, employees and agents do not accept or assume any liability, responsibility or duty of care for any consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it. 2012 PricewaterhouseCoopers LLP. All rights reserved. In this document, PwC refers to PricewaterhouseCoopers LLP (a limited liability partnership in the United Kingdom), which is a member firm of PricewaterhouseCoopers International Limited, each member firm of which is a separate legal entity. ML1-2012-04-19-18 03-MF