EMIR: Collateralizing the swaps market

European Markets Infrastructure Regulation (EMIR) implements the G20 commitment to have all standardized OTC derivatives cleared through central counterparties (CCPs) by end 2012. The aim of the regulation is to reduce counterparty risk and increase transparency.

EMIR introduces a requirement on market participants to post collateral and segregate assets to ensure that CCPs have adequate margin to help prevent and contain the default of any single clearing member.

Each party to cleared OTC derivative contracts is required to post collateral with a CCP – Initial Margin (IM) and Variable Margin (VM). VM covers fluctuations in market value, while IM is a buffer for covering losses beyond those covered by the VM in the event of a clearing member’s default.

Exotic derivatives (all non-cleared contracts) will need to be bilaterally collateralized starting from 1 December 2015 and additional capital held against risks not adequately mitigated by the exchange of collateral. Collateral collected as IM must be fully protected and should not be re-hypothecated or re-used except under specific circumstances. This is likely to make trading exotic derivatives more costly. It has also been argued that higher costs of clearing might result in reduced market liquidity contrary to ESMA’s intentions.

Collateral that is posted as either IM or VM must be ‘highly liquid collateral’ with minimal credit and market risk. It includes either transferable securities or money market instruments, such as cash, high quality government, corporate and covered bonds, equities of major stock indices and gold.

The reporting obligation and the increase of collateral needs pose a number of challenges to the industry. Asset managers and management companies need to consider the following:

• Higher collateral requirements and increased complexity in oversight and controlling processes for both cleared and non-cleared transactions.

• High costs associated with posting collateral may result in decreased hedging activity.

• The obligation to report collateral information, unlike the trade reporting obligation, only applies to FC and NFC+, but not NFC-.

• Systems and processes in place to implement the new operational risk mitigation requirements.

• Assess collateral available to collateralize exotic derivatives.

EMIR also introduces reporting requirements on the collateral posted which commences on 11 August 2014, six months after the reporting start date of all derivatives on 12 February 2014, and must be reported daily thereafter where the valuation changes. This will entail reporting an up to date valuation of the contract and include how much collateral is posted against each exposure. The reason for this is to understand the net exposure. Custodians and depositaries may also be impacted by the collateral requirements as they will have increased requirements in terms of collateral segregation, transfer and settlement.