I would say that there are four main EMIR-driven challenges facing our industry in the immediate future: tight deadlines; a shifting regulatory framework; the compliance of legal documentation with EMIR provisions and substantial operational adaptations.
A fully formed holistic view is essential if the challenges are to be successful and the benefi t from the opportunities created by it maximised. Such is the level of complexity of the subject, and the extent of the fi ne detail, that familiarity, for once, does not breed contempt. We address the subject in fuller detail in our recent white paper entitled EMIR Latest News And Associated Changes For OTC Derivatives Users.
Most Global Investor/ISF readers will be perfectly well acquainted with the background, but there will inevitably be others who would benefi t from an occasional refresher course. This article seeks to remind readers of the essentials of EMIR, explaining its genesis, its purpose, its importance and an assessment of what the buy-side needs to do in response. It will do so by examining recent developments, considering future landmarks in the implementation timetable and assessing the implications for the investment world and service providers.
OTC derivatives EU implementation: The Story So Far
Although EMIR entered into force on August 16 2012, the fi rst set of three mandatory risk mitigation measures did not go live until several months later on March 15 2013. These initiatives are timely confi rmation, valuation by both parties and the obligation for non-fi nancial counterparties to notify their national authority should they exceed at least one clearing threshold.
A set of three further obligations came into force on September 15 2013 concerning the risk mitigation techniques for OTC derivatives contracts not cleared by a central counterparty (CCP): portfolio reconciliation, portfolio compression and the implementation of a dispute resolution mechanism. The preparations needed to meet these challenges successfully will vary from institution to institution.
Arguably, the most important factors in the current equation include demands relating to portfolio reconciliation and compression, the use of trade repositories and geographical variations. A number of key EMIR provisions, such as the clearing obligation for standardised contracts and collateral requirements for non-standardised OTC derivatives contracts have yet to be defi ned by Regulatory Technical Standards; these are needed for those obligations to take effect.
Another important subject relates to extra-territoriality and to the defi nition of the rules that will apply when entering into an OTC derivative contract with a counterparty outside the EU or to the rules that will apply to a transaction between two non-EU counterparties that might have a substantial impact in the EU.
Immediate priorities: Reconciliation and Compression
Portfolio reconciliation consists of undertaking a comprehensive review of a transactions portfolio as seen by the counterparty in order to promptly identify any misunderstandings of key transaction terms. Such terms should at least include the valuation of each transaction and may also include other details such as the scheduled maturity date, any payment or settlement dates, the notional value of the contract and currency of the transaction, etc.
Institutional investors, which are parties to an OTC derivatives contract, will agree in writing or by other equivalent electronic means with each of their counterparties on the terms on which portfolios will be reconciled, before entering into a contract. The European Securities and Markets Authority (ESMA) has defined mandatory reconciliation frequencies depending on risk profiles, as assessed by the number of outstanding contracts between two counterparties:
It is worth mentioning here the protocols developed by the International Swaps and Derivatives Association (ISDA), and in particular the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol. ISDA has developed this protocol to specifically address the portfolio reconciliation and dispute resolution agreement requirements of EMIR.
Adherence to this protocol enables institutional investors to agree on the portfolio reconciliation and dispute resolution terms with all their counterparties in a single process. Institutional investors will assess the effi ciency of trade portfolio reconciliation tools with regards to the terms that need to be reconciled along with the portfolio reconciliation frequency made mandatory by law. If need be, the task can be delegated to a third party.
ESMA requires that counterparties with 500 or more bilateral OTC derivative contracts with a specific counterparty, have procedures to regularly, and at least twice a year, analyse the possibility of conducting a portfolio compression exercise in order to reduce their counterparty credit risk and engage in the actual portfolio compression exercise.
Compression aims at reducing the overall notional size and number of outstanding contracts in an OTC derivative portfolio without changing the overall risk profile of the portfolio. In practice, other players - banks for instance – will be more concerned than the buy side, as few funds of asset managers have more than 500 OTC derivatives contracts with one single specifi c counterparty.
Trade Repository reporting: Which Way Next?
On July 5 2013, ESMA estimated that the earliest approval of a trade repository would be September 24 2013 and the earliest reporting deadline will be January 1 2014, for all asset classes. Under EMIR, all entities will report their OTC derivative and listed derivative trades to a trade repository (deadline delayed by one year for this latest category).
In the US, by contrast, only swap dealers and major swap participants will report. In practice, this means that fewer than 100 players will report to a trade repository in the US, but around 350,000 players will report to EU trade repositories. The reporting task can be delegated either to the counterparty or to a third party but without any transfer in terms of responsibility.
Those entities affected have an unenviable task. They are required to move forward in a context where no trade repository has yet been offi cially approved by ESMA and to deal with challenges that consist in gathering to a short deadline (trade date execution + 1 business day) frontoffi ce information such as execution time stamp and front-office trade references with middle/back-office information such as confi rmation timestamp. This implies the corresponding tight synchronisation of front and middle/back-office teams.
Regulatory confl ict between two different geographical territories can result in market distortions as well as regulatory arbitrage, as market operators favour the friendliest environment. It can also lead to market fragmentation, with entities ruled by different regulatory framework stopping trading with each other for not becoming liable of additional obligations and support the associated costs.
The Commodity Futures Trading Commission (CFTC) decision on the regime that will apply to foreign branches of US banks is a good example of this. In effect, CFTC decided that OTC derivatives contracts concluded between a European investor and a foreign branch of a US bank must be cleared, from October 9.
This is considered by European investors as a clear incentive to stop trading with such foreign branches in favour of European banks. Faced with the prospect of a consistent loss of market share, US banks have few options available to them.
The creation of affi liates (separate legal entities) protecting European funds from the clearing obligation could be a solution; but while this is easy to say, it is not so easy to implement, as existing trade inventory would have to be transferred. This is no small matter; a recent Reuters’ article suggested that firms such as JPMorgan have more than 10,000 clients booked through their UK branches.
Non-cleared trades: death reports premature
Against this backdrop, reports of the possible death of non-cleared trades have been greatly exaggerated. Even if they account for only a small proportion of total activity, non-cleared trades are certainly not going to die.
In effect, they are essential to a number of fi nancial and non-fi nancial players around the globe to hedge against certain risks: corporates hedge against currency and interest rate risks through non-cleared trades, pension funds enter into infl ation swaps to hedge their longterm liability exposure and banks hedge lending activities.
The key question is how to reduce the impact that non-cleared OTC derivatives could have on systemic risk. Appropriate margining practice—notably the systematic implementation of initial margin practice —has been part of the Working Group on Margining Requirements’ answer.
However, some market participants question its use. It is a fact; the payment of an initial margin—i.e. an additional collateral buffer, designed to cover the replacement costs in the event of a defaulting party—does really improve the situation of the non-defaulting party, and reduces the risk of default contagion across the system. However, under stressed market conditions, it can also represent a signifi cant cost and can substantially increase pro-cyclical effects, therefore reintroducing risk into the fi nancial system.
In conclusion: What the buy-side needs
We live in uncertain and ever-changing regulatory times. New requirements demand a new industry mindset. Traditional approaches to the conduct of business and the processing of operations need to be radically reviewed.
• Buy-side firms using OTC derivatives need to adapt their operational set-up in a number of ways: by developing TR reporting capabilities or mandating an asset servicer that can report on their behalf;
• by appointing at least one clearing broker (and sometimes more, for risk mitigation purposes, if they trade large volumes and wish to organise portability) and ensuring the required connectivity;
• by developing their collateral management infrastructure, with a view to exchanging daily collateral flows in the near future.
There is little doubt that the appointment of a well-equipped services provider can help OTC derivatives users, whether institutional investors or asset managers adapt to the new regulatory landscape quickly, cost-effectively and safely.