The Commissioner of the European Commission, Michel Barnier, announced late last week that the European Parliament has decided not to object to the proposed technical standards to implement new rules relating to derivatives. Standards can now enter into force 20 days after their publication in the Official Journal of the EU, anticipated mid-March.
On 19 December 2012, the European Commission adopted nine regulatory and implementing technical standards (TS) enhancing the current EMIR obligations which came into force on 16 August 2012. The adoption of these new standards finalises requirements for the mandatory clearing of ‘standardised’ OTC derivatives and reporting of transactions in line with the EU’s G20 commitment.
The adoption of the TS highlights a significant move in the regulation of OTC derivatives by focusing on the financial soundness, structure, operations and required use of both Central Counterparties (CCP) and Trade Repositories (TR). This focus creates direct and indirect obligations on both financial counterparties (FC) and non financial counterparties who fall under the scope of EMIR.
Who will this impact?
The TS will impact both financial counterparties (including MiFID Investment Firms, Credit Institutions, UCITS, Insurance and reinsurance undertakings and Alternative Investment Funds managed by AIFMs) and non financial counterparties (segregated between those non financial counterparties whose positions in OTC derivatives pass a clearing threshold (known as NFC+) and those who do not pass this threshold (NFC)). Territorial scope extends beyond EU entities to include third country firms that would be subject to the obligations if they were established in the EU for any transaction with an obligated EU entity. Territorial scope is further extended by including any transaction where the contract has a direct, substantial and foreseeable effect within the EU.
When will this apply?
Following the adoption of the TS on 19 December 2012, the European Council and Parliament had a period of two months (extended by one month owing to the December holiday period) to exercise their right of scrutiny. As announced last Thursday, there have been no objections meaning the TS are expected to be published in the Official Journal of the European Union imminently. They will enter into force 20 days later meaning an expected implementation date around mid March 2013.
Assuming TRs complete the required registration process, implementation of the reporting obligation will be staggered. Credit and Interest Rate derivative trade reporting is scheduled to commence around 1 July 2013 and other asset classes around 1 January 2014. There is also a requirement to back report all derivative contracts that were entered into on or after 16 August 2012 once a TR gains recognition. Firms will therefore need to ensure they archive all trade and reference data.
Points of particular interest
Clearing and risk mitigation
Core elements of the regulatory TS specify the prudential requirements of CCPs, specifically concentrating on their capital requirements. This has been accompanied by various other financial obligations including capital reserve and retained earning requirements. The associated implementing TS specify practical responsibilities such as record keeping formats.
The TS also stipulate obligations for OTC derivative contracts not cleared by a CCP which aim to limit the additional risks posed by non cleared contracts through higher margin requirements. The additional margining required is likely to add an additional capital burden to some current portfolios and trading strategies. As such, it will be important to assess the financial impact on affected portfolios. Various additional risk mitigation obligations will impact both buy and sell-side firms including timely trade confirmation requirements, dispute resolution procedures relating to collateral valuations, appropriate usage of mark-to-market models and also portfolio recognition and compression processes.
The introduction of CCPs will mean new relationships between both the CCP and the counterparty and the counterparty and their “indirect” clearing members. Both buy and sell-side firms will need to consider their connections to a CCP as either direct or indirect members. An assessment of the impacts on technology, margining, communication and compliance will be required.
The TS place detailed rules on the structure and functions of TRs. Minimum data details to be reported and publication of and access to data are also defined, as is the application process for registering as a TR.
Unlike Transaction Reporting under MiFID, where the Approved Reporting Mechanism applies to the local Competent Authority for approval, EMIR requires firms to apply directly to ESMA to obtain TR status.
There are ongoing discussions over who will apply and whether some will only apply to become a TR for OTC or Listed derivatives or certain asset classes. Firms who are planning to use a single TR will need to monitor and communicate with the selected repository regarding its application.
Further divergence from transaction reporting involves the reporting responsibility. Transaction Reporting has traditionally been linked to the sell-side given portfolio managers have often relied on reporting exemptions under FSA’s SUP 17.2.2G and TRUP 9.7. Under this reliance regime, portfolio managers do not need to report if a third party, typically a broker, has a reporting obligation. However, under EMIR all counterparties to a transaction will be required to report. Although there is opportunity to delegate trade reporting to a third party, responsibility remains with the counterparty. This appears to restrict the opportunity for portfolio managers to be exempt from reporting responsibility.
Internationally, one of the main differences between Dodd Frank and EMIR reporting is that Dodd Frank only requires the reporting of OTC derivatives, whereas under EMIR, both OTC and Listed derivatives are reportable. To date, sell-side firms have traditionally been geared up to report but given the complexity of the reporting requirements, compliance with the new reporting obligations will be a challenge for both buy- and sell-side firms.
To assist the industry, ESMA has agreed to publish a Q&A in March/April 2013 to address some of the outstanding questions around the technical standards, in particular around reporting protocol. Industry Associations plan to participate by submitting common questions and where possible propose industry solutions. With the implementation date looming, the industry is under increasing pressure to meet the deadlines.
What this means for the industry
Although the new TS focus on CCP and TR arrangements, all counterparties of eligible trades will be impacted differently dependent on their counterparty classification (FC/NFC/NFC+). As mentioned, all counterparties will be required to report but the clearing obligations mean that if a NFC does not pass the OTC derivative clearing threshold, it will be exempt from the clearing requirements. Furthermore, the risk mitigation techniques employed under the EMIR regime will mean non-centrally cleared eligible trades may be subject to higher capital requirements for FCs. This could affect the availability of capital and could potentially influence demand within the market as well as meaning less flexibility over margining arrangements for OTC contracts given the emphasis on central clearing
In addition to the impacts directly stemming from the new regime, a wave of additional requirements are likely to be experienced when firms attempt to adapt and integrate the changes to their existing flows.
Counterparties will need to revisit their OTC trading arrangements to ensure they are fully compliant with the use of CCPs for eligible contracts. This will require a suitable process of periodic review to ensure that compliance is maintained as further CCPs gain authorisation within different jurisdictions.
Robust procedures will need to be developed to ensure margin calls are dealt with efficiently and reporting obligations/data access are suitably addressed, whilst IT systems to handle these processes will need to be constructed and tested accordingly.
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