European Market Infrastructure Regulation (EMIR)
The European Commission adopted on 4th July 2012 nine regulatory and implementing technical standards to complement the obligations defined under the Regulation on OTC derivatives, central counter-parties (CCPs) and trade repositories, which constitute the European Markets Infrastructure Regulation (EMIR) and have been developed by the European Supervisory Authorities. They have been endorsed by the European Commission without modification and entered into force on 16th August 2012 as Level 1 text. The adoption of these standards follows the EU's G20 commitment made in Pittsburgh in September 2009.
ESMA (European Securities and Markets Authority) is “an independent EU Authority that contributes to safeguarding the stability of the European Union's financial system by ensuring the integrity, transparency, efficiency and orderly functioning of securities markets, as well as enhancing investor protection”.
The main general purpose of ESMA is to ensure the correct functioning across the financial markets in Europe by providing a consistent investor protection and international supervisory co-operation.
Specifically for EMIR, ESMA developed the “Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories” (Level 2 text) which are considered subordinate acts and executive measures giving effect to the substantive requirements (in this case to the Regulation (EU) No 648/2012), referred as draft regulatory (RTS) and implementing technical standards (ITS) in relation to several provisions of EMIR.
Why? The need for this Regulation.
The year 2008 was a landmark in the economy historical annals. The worst financial crisis since the Great Depression of the 1930s hit the world dramatically. The watershed moment – the collapse of Lehman Brothers (along with those of AIG and Bear Sterns) because it held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages (like CDOs …) and causing a liquidity issue, exposed the fragility of the OTC derivatives world, which constituted the cause of that disaster. Fundamentally, two are the main reasons: even if the OTC world accounts for around $27 trillion in terms of gross market value (for a more in depth analysis of the size of the OTC market, see http://theotcspace.com/2013/03/22/how-big-is-otc-really/), the potential losses that OTC derivatives can generate through “leverage” could be gigantic; and it demonstrated to be very opaque.
The following year in Pittsburgh at the G–20, a group of nations agreed on a set of rules to increase transparency and reduce systemic risk. The European Market Infrastructure Regulation (EMIR) represents the response to the commitments on behalf of the EU nations; with the same end, the US has enforced the “Dodd–Frank Wall Street Reform and Consumer Protection Act” (Dodd–Frank Act) and the Japanese Financial Service Authority (JFSA) had implemented similar requirements.
Who? The parties involved.
EMIR divides counterparties into the following four categories: Financial Counterparties, Non-Financial Counterparties, Central Counterparties and Trade Repositories.
The following are the general definition provided by EMIR, which will help you to identify what category you fall into.
Financial Counteparties (FCs), as defined in Article 2 (8) of Regulation (EU) No. 648/2012
- 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/EEC;
- an assurance undertaking authorised in accordance with Directive 2002/83/EC;
- a reinsurance undertaking authorised in accordance with Directive 2005/68/EC;
- a UCITS [Undertakings for Collective Investment in Transferable Securities] 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 [Alternative Investment Fund Managers] authorised or registered in accordance with Directive 2011/61/EU.
Non–Financial Counterparties (NFCs), as defined in Article 2 (9) of Regulation (EU) No. 648/2012
‘Non-financial counterparty’ means an undertaking established in the Union other than the entities referred to in points 1 (Central Counterparties) and 8 (Financial Counterparties).
For scoping purposes, NFCs are divided into those above the clearing thresholds (see below) and those ones below. Those ones that breach the threshold are considered as FCs and subject to the full extent of the regulation.
The clearing thresholds are defined in the Article 10 (3) of Regulation (EU) No. 648/2012 and are defined per asset classes: credit derivatives, equity derivatives, interest rate, foreign exchange and commodity and others, as follows:
- EUR 1 billion in gross notional value of OTC derivative contracts for each of the credit and equity derivative contracts;
- EUR 3 billion in gross notional value of OTC derivative contracts for each of the interest rate, foreign exchange, and commodity or others derivative contracts.
When one of the clearing thresholds is reached, the entity is considered as exceeding the clearing thresholds and therefore subject to the relevant EMIR requirement for all classes of OTC derivative contracts.
For additional information, ESMA created a document specifically for Non–Financial Counterparties: What does EMIR mean for Non-financial counterparties?
Central Counterparties (CCPs), are mentioned in Article 2 (1) of Regulation (EU) No. 648/2012
‘CCP’ means a legal person that interposes itself between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer.
Lastly, Trade Repositories (TRs), are outlined in Article 2 (2) of Regulation (EU) No. 648/2012
‘Trade repository’ means a legal person that centrally collects and maintains the records of derivatives.
Which? The financial products in scope.
The products are mainly divided into Derivatives and OTC derivatives and the difference between the two categories are defined by EMIR as below (for an extensive regression on Financial Products you can refer to our 'The Knowledge' page for Products).
Derivatives (Article 2 (5) of Regulation (EU) No. 648/2012)
‘Derivative’ or ‘derivative contract’ means a financial instrument as set out in points (4) to (10) of Section C of Annex I to Directive 2004/39/EC as implemented by Article 38 and 39 of Regulation (EC) No 1287/2006.
As point of reference, please see below the extract from the regulatory piece mentioned:
- Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash;
- Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event);
- Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF;
- Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in C.6 and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls;
- Derivative instruments for the transfer of credit risk;
- Financial contracts for differences.
Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls.
OTC Derivatives (Article 2 (7) of Regulation (EU) No. 648/2012)
‘OTC derivative’ or ‘OTC derivative contract’ means a derivative contract the execution of which does not take place on a regulated market as within the meaning of Article 4(1) (14) of Directive 2004/39/EC (see footer 3) or on a third-country market considered as equivalent to a regulated market in accordance with Article 19(6) of Directive 2004/39/EC.
It is considered a regulated market, "a multilateral system operated and/or managed by a market operator, which brings together or facilitates the bringing together of multiple third-party buying and selling interests in financial instruments - in the system and in accordance with its non-discretionary rules - in a way that results in a contract, in respect of the financial instruments admitted to trading under its rules and/or systems, and which is authorised and functions regularly […]".
What? General overview of the main requirements.
A matrix of the obligations based on product and type of counterparty can be found below as brief overview.
Central Clearing for certain asset classes of OTC derivatives
The process of central clearing can be defined as the interposition of a third party into a bilateral trade, in which the third party becomes the seller to every buyer and the buyer to every seller.
EMIR defines the criteria that ESMA shall adopt for determining what asset classes and OTC derivatives instruments should be subject to the obligation of central clearing. ESMA will publish a list of those OTC derivatives in scope for clearing, based on:
- Degree of Standardisation;
- Availability of reliable pricing.
There are few issues correlated with the (nonappearance) of the above criteria. Firstly, standardisation will attract a greater trading interest and the product will be more liquid. Liquidity not only has a great effect on the CCP’s Risk Management for the increased accuracy in valuation of positions but also it will impact the accuracy of time-series data by enhancing the processes of development, testing and calibration of risk models. Lastly, a liquid market allows the CCP to hedge the risk on defaulter’s portfolio by entering into an equal and opposite position in those contracts.
Two methods are to be used by ESMA during the selection process of the products: Bottom-up (according to which, when a competent authority authorises a CCP to clear a class of OTC derivatives, it will notify ESMA) and Top-down (according to which ESMA has to identify the classes of OTC derivatives that meet the same criteria specified below, but for which no CCP has received an authorisation).
On 12th July 2013, ESMA has published a Discussion Paper on “The clearing obligation under EMIR” with the main purpose of receiving feedback prior to the drafting of regulatory technical standards. All stakeholders are invited by the commission to respond with a Template for the Responses to the Discussion Paper on the Clearing Obligation under EMIR.
Application of Risk Mitigation Techniques for non-centrally cleared OTC derivatives:
In Art. 11 of Regulation (EU) No. 648/2012, the regulator outlines the minimum requirements for those not cleared trades “FCs and NFCs that enter into an OTC derivative contract not cleared by a CCP, shall ensure, exercising due diligence, that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least:
The timely confirmation, where available, by electronic means, of the terms of the relevant OTC derivative contract;
Formalised processes which are robust, resilient and auditable in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them, and to monitor the value of outstanding contracts”.
In addition, FCs and NFCs “shall mark-to-market on a daily basis the value of outstanding contracts” and “shall have risk management procedures that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative entered into or after 16th August 2012”.
Lastly “FCs shall hold an appropriate and proportionate amount of capital to manage the risk not covered by appropriate exchange of collateral”.
EMIR instructs ESMA to define intragroup exempt transactions and the details of the information on exempted intragroup transactions.
Reporting to Trade Repositories
The reporting requirement is outlined by the Art. 9 of Regulation (EU) No. 648/2012: “counterparties and CCPs shall ensure that the details of any derivative contract they have concluded and of any modification or termination of the contract are reported to a trade repository registered […]. The details shall be reported no later than the working day following the Conclusion, modification or termination of the contract.”
The reports must specify:
- The parties to the derivative contract and, where different, the beneficiary of the rights and obligations arising from it;
- The main characteristics of the derivative contracts, including their type, underlying maturity, notional value, price, and settlement date.
- In addition, “A counterparty which is subject to the reporting obligation may delegate the reporting of the details of the derivative contract”; however, “counterparties shall ensure that the details of their derivative contracts are reported without duplication.”
Application of organisational, conduct of business and prudential requirements for CCPs (only applicable to CCPs):
The Regulation (EU) No. 648/2012 includes the requirement for the application process and the standards for CCPs, as follows:
- Authorisation of a CCP and Supervision of a CCP (Art.14 – 24, including Capital Requirements, procedures for granting and refusing authorisation…);
- Requirements for CCPs (Art. 26 – 35, including General Provisions, Senior Management and the Board, Risk committee, Record keeping and Information to competent authorities, Conflict of Interest …);
- Conduct of Business Rules (Art. 36 – 39, including Participation requirements, Transparency, Segregation and Portability);
Prudential Requirements (Art. 40 – 50) are the following: Exposure management, Margin Requirements, Default Fund, Liquidity Risk controls,
Default Waterfall, Investment Policy, Default Procedures, Review of Models, Stress Testing and Back Testing and Settlement.
Application of Requirements for TRs, including the duty to disclose certain data available to the public and to the relevant authorities (only applicable to Trade Repositories):
Similarly to the CCP requirements, EMIR set out obligations and processes for TRs, as below:
- Registration and Supervision of Trade Repositories (Art. 55 – 77);
- Requirements for Trade Repositories (Art. 78 – 84) includes the following: General Requirements, Safeguarding and Recording, Transparency and Data availability
In particular, it is relevant to note that TRs are instructed to “regularly, and in an easily accessible way, publish aggregate positions by class of derivatives on the contracts reported to it”.
When? The timeline.
Table of EMIR indicative timeline (source: esma.europa.eu – updated on 13th September 2013)
The Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties (CCPs) and trade repositories (TRs) (EMIR) entered into force on 16th August 2012. Sequentially, the Commission Delegated Regulations (EU) No 148/2013 to 153/2013 of 19th December 2012 (supplementing EMIR) were published in the Official Journal on 23 February 2013 and entered into force on 15th March 2013.
The various deadlines are defined as follows:
Clearing: the deadline for clearing will depend on the CCP authorisation given by the national competent authorities (NCA). CCPs have a window of six months from 15th March 2013 to apply for the authorisation. Once the application has been submitted, the NCA will take an additional six months to authorise the CCP. Within six months after the first CCP authorisation, ESMA will submit a draft of Regulatory Technical Standards (RTS) on the clearing obligations.
Risk mitigation techniques: as far as the timely confirmation is concerned, such requirements apply from the 15th March 2013 (i.e. the date of entry into force of the Delegated Regulations); whilst the dispute resolution, portfolio reconciliation and portfolio compression obligations will take effect on 15th September 2013, with a delay of six months.
Reporting: the deadline for reporting is based on the Registration date of the first Trade Repository. TRs can send the application from 15th March 2013 and the registration will take place after sixty to sixty-five days, i.e. 23rd September. However, there has not been any registration yet and the earliest deadline as of today is set for 12th February 2013. An article published by Risk.net dares to suggest that the Reporting obligation may be delayed by ESMA until 2015 due to concerns over delegated reporting (Emir flaws could see futures reporting delayed till 2015).