This update relates to the risk mitigation obligations under EMIR and specifically the timely confirmation and mark to market components.
15 March 2013 marks the entry into force of the European Markets Infrastructure Regulation (EMIR), a regulation introduced to help mitigate the risks posed to financial stability by OTC derivatives and improve the transparency of derivatives more broadly.
Although several obligations under EMIR may not be practicable until mid to late 2013 onwards, a number of obligations will take effect immediately. Within chapter 8 of the Technical Standards (TS) published in the Official Journal of the European Union (Volume 56) on 23 February 2013, articles 12, 16 and 17 will, in addition to other obligations relating to intra-group transactions, impact OTC derivative trading from 15 March.
These articles relate to the timely confirmation of OTC derivatives not cleared by a Central Counterparty (CCP) as well as usage of mark-to-market and mark-to-model techniques respectively. There is a link to the TS at the end of this alert.
What is the content of these Articles?
Article 12 requires the timely confirmation (with your counterparty) of OTC derivatives not cleared by a CCP by all Financial Counterparties and also Non-Financial Counterparties (above the clearing threshold – shown below). This is to ensure OTC contracts are confirmed, where available by electronic means, within the timeframes set below:
Credit and Interest Rate contracts concluded:
- up to and including 28 February 2014 by close of business T+2
- after 28 February 2014 by close of business T+1
All other OTC derivative contracts concluded:
- up to and including 31 August 2013 by close of business T+3
- after 31 August 2013 up to and including 31 August 2014 by close of business T+2
- after 31 August 2014 by close of business T+1
In addition, there is a requirement for Financial Counterparties (defined below) to have in place procedures to report to their relevant competent authority on a monthly basis the number of unconfirmed trades that have been outstanding for more than five business days.
Under the regulation, all Financial Counterparties and Non-Financial Counterparties (above the clearing threshold) must mark-to-market the value of outstanding contracts on a daily basis. Article 16 of the TS stipulates market conditions that prevent this mark-to-market process. Specifically, these situations include:
- when the market is inactive; or
- where the range of reasonable fair value estimates is significant (broad) and the probabilities of various estimates cannot reasonably be assessed
In instances where the above conditions prevent mark-to-market, mark-to-model techniques are to be used under EMIR by Financial Counterparties and Non-Financial Counterparties (defined below). Article 17 of the TS states the criteria for using mark-to-model. Specifically, all Counterparties shall have a model that:
- incorporates all factors that Counterparties would consider in setting a price, including using as much as possible mark-to-market information;
- is consistent with accepted economic methodologies for pricing financial instruments;
- is calibrated and tested for validity using prices from any observable current market transactions in the same financial instrument or based on any available observable market data;
- is validated and monitored independently, by a division other than the division taking the risk; and
- is duly documented and approved by the board of directors as frequently as necessary, following any material change and at least annually. This approval may be delegated to a committee.
Who will this impact?
In addition to the Financial Counterparties and Non-Financial Counterparties defined below, Paragraph 12 of Article 11 (Regulation (EU) No. 648/2012) states that the requirements ‘’shall apply to OTC derivative contracts entered into between third country entities that would be subject to those obligations if they were established in the Union, provided that those contracts have a direct, substantial and foreseeable effect within the Union or where such obligation is necessary or appropriate to prevent the evasion of any provision of this Regulation’’.
What do the Articles require in practice?
The timely confirmation requirement means that Financial Counterparties and Non-Financial Counterparties should now be in a position to confirm OTC contracts according to the timeframes and deadlines mentioned above. In this instance, EMSA has defined confirmation to mean “the documentation of the agreement of the counterparties to all the terms of an OTC derivative contract”.
How to report
It is also stressed that Financial Counterparties must have procedures in place to report on a monthly basis to the relevant Competent Authority the number of unconfirmed OTC derivative transactions that have been outstanding for more than five business days. The FSA has been proactive in preparation for this requirement by stating that Financial Counterparties under its supervision will be contacted individually to request that this report is submitted to the FSA. The FSA further clarifies their current stance by stating “Financial Counterparties do not need to submit a report unless it has been requested, but must have procedures in place to do so when requested”. Further details of this reporting procedure and other notifications and exemptions can be found at the FSA’s EMIR notifications page.
Financial and Non-Financial Counterparties above the clearing threshold should also be in a position to mark-to-market the value of outstanding OTC derivative contracts on a daily basis at this stage. If such mark-to-market valuations are not possible it is crucial that Financial and Non-Financial Counterparties are able to justify the market conditions preventing this valuation and revert to a mark-to-model process which incorporates the bullet points above.
References and definitions:
ESMA Technical Standards: http://eur-lex.europa.eu/JOHtml.do?uri=OJ:L:2013:052:SOM:EN:HTML
The clearing thresholds (gross notional value) for OTC derivative contracts are:
- Credit – €1 Billion
- Equity – €1 Billion
- Interest rate – €3 Billion
- FX – €3 Billion
- Commodity – €3 Billion
- Other contracts – €3 Billion
Financial Counterparties: includes banks, insurers, investment firms, fund managers, spread betting firms and pension schemes but specifically means:
- an investment firm authorised in accordance with Directive 2004/39/EC;
- a credit institution authorised in accordance with Directive 2006/48/EC;
- an insurance undertaking authorised in accordance with Directive 73/239/EE;
- Can assurance undertaking authorised in accordance with Directive 2002/83/EC;
- a reinsurance undertaking authorised in accordance with Directive 2005/68/EC;
- a UCITS and where relevant, its management company, authorised in accordance with Directive 2009/65/EC;
- an institution for occupational retirement provision within the meaning of Article 6(a) of Directive 2003/41/EC; and
- an alternative investment fund managed by AIFMs authorised or registered in accordance with Directive 2011/61/EU.
Non-financial counterparties: covers an undertaking established in the EU, other than those listed as a Financial Counterparty (see above).
Disclaimer: The opinions expressed herein are those of the authors and other contributors and do not necessarily reflect the views of the Firm. This is not intended as specific legal advice for any purpose.
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