EMIR : A Progress Report
The problem is that the rules jump straight to the solution rather than defining success criteria for reducing systemic risk in the global capital markets.
This article was first published in the magazine Calypso Intelligence and was a joint effort between OTC Space and Calypso.
The Original Intention
The European Market Infrastructure Regulation (EMIR) is a response to the G20 recommendations to regulate over the counter (OTC) derivatives in the wake of the 2008 financial crisis. In broad terms, the aim is to impose clearing, reporting and greater transparency obligations on a broad range of market participants. The problem is that the rules jump straight to the solution rather than defining success criteria for reducing systemic risk in the global capital markets.
Unlike in the US, EMIR will not be a ‘big bang’ event. The authorization and recognition of European central counterparties (CCP) will occur individually and on a separate timeframe. There are two major components of EMIR regulation – clearing and reporting – as well as additional components for non-cleared business and the improvement of operational behavior in the markets.
- The International Swaps and Derivatives Association (ISDA) report in February 2014 estimated that around 90% of clearable interest rate swaps were already being cleared by the end of the second quarter of 2013 ahead of the G20-inspired rules. The Dodd-Frank Act’s rules on central clearing came into effect on 11 March 2013, but the majority of buy-side institutions were required to comply with subsequent deadlines on 10 June and 9 September 2013. Europe is expected to require central clearing of OTC derivatives by January 2015. This then begs the question of whether the market needs to be mandated to clear at all? But the hazard of not doing so would allow an escape route for counterparty risk.
- The timetable leading up to mandated clearing in Europe has a sequence of events over the next nine to 12 months. It starts with European CCPs having to achieve both ‘completeness’ for their EMIR application and then ‘authorization’ as a fully approved CCP. Once this occurs for a first CCP, the European Securities and Markets Authority (ESMA) has six months to submit draft Recommended Technical Standards (RTS) to the European Commission for approval. Given the authorization of NASDAQ OMX on March 18th the prediction for this to occur is at the earliest November 2014 or at the latest around March 2015. The Commission and European Council have up to three months to review the RTS where the application process can include a phase-in period for specific products.
Implementation Challenges for Clearing Members
Firms implementing clearing will face new challenges both for their internal operations and systems and also from a regulatory point of view.
The new OTC workflow requires tight integration from front office to back office, with trades flowing from a SEF or OTF into a clearing house and achieving clearing finality within 10 seconds (at the CCP) in the US. The traditional workflow involving execution, confirmation and then clearing over a period of days is no longer allowed.
This means firms have no choice but to make use of processing platforms with good connectivity and workflow tools, to enable all steps of the process to be as seam-free as possible, including up-front credit line checks, routing to a CCP, responding to the novation step and then settling multi-laterally with each CCP.
Front Loading – Pay It Forward
Over the years the term ‘back-loading’ has come to describe the retrospective transfer of trades into clearing platforms. A new term which is causing concern is ‘front-loading’, implied by the way the clearing mandate in Europe is to be applied.
Two key dates define a front-loading period; the first is the date on which a CCP is authorized under EMIR and the second is the date when a product is mandated to clear by ESMA. In the time period between the two, any trades executed outside clearing, which would be then mandated to clear, will need to be back-loaded.
The gap between the two periods could be anywhere from nine months to just less than two years, according to regulatory estimates. This is creating uncertainty over pricing in the OTC markets because a trade executed outside clearing has different pricing from one inside, especially as the margin and capital requirements of the two are different. Banks will need to consider their approach to pre-mandate trading and may price trades as if they will be cleared, given that the initial mandate in Europe is likely to cover products already being cleared.
Front-loading is one reason why there has been a high uptake of clearing in advance of the mandate. Why allow the confusion of bilateral processing at cleared prices when you can already register trades for clearing now
CCP Clearing Volumes
Regional Clearing – Here to Stay?
Given the political push for moving OTC products into clearing, a business opportunity has arisen to capture domestic OTC business, which had previously been excluded from some CCPs due to membership requirements. For example, new regulations from the US caused the lowering of the CCP membership criteria, which used to include capital, credit rating, portfolio size and other measures.
Regulation has driven an upsurge in regional clearing with new OTC rates products being cleared in Poland, Hong Kong, Singapore and Australia. It is thought that CCPs in China, India, Korea, Chile and Brazil could follow suit. In credit products clearing, the current market leader in terms of notional cleared (see chart) is ICE with CME, Japan Securities Clearing Exchange and LCH.Clearnet capturing smaller amounts of the market.
From a clearing members’ point of view, the network of other CCP members is what makes the most difference – if it is a small firm and a local CCP offers to clear all trades, then the decision becomes a commercial one based on cost. If it is a small firm trading with large global counterparties, the network is bigger by far at LCH SwapClear and CME for example. The result is that margin calculation that will benefit from maximum netting, rather than splitting the portfolio between a local and global CCP.
Trade reporting – Early Signs of Chaos
Another operational component of EMIR is gathering data on all OTC and exchange traded derivatives inside newly-created trade repositories (TRs). The February 12 deadline passed with a flurry of commentary on the haphazard way this process has been conducted, with late requirements as well as authorization of TRs.
Stepping back and re-visiting the purpose of trade reporting, the aim is to give regulators the data they need to begin to measure the risks within and between users of derivatives and to proactively set targets for the reduction of systemic risks.
Looking at the 85 data fields requirements from ESMA, the end result is a set of fields to represent many OTC and exchange traded products in a smallest set of common fields possible. The point is that the most that can be learned from the current data being reported in these fields is who did the trade, roughly the size and maturity and ancillary details. It will in no way enable regulators to perform risk analytics on the data or validate the risk calculations of any reporting entity.
As of now, statistics seem to indicate that many firms have yet to request or receive a Legal Entity Identifier (LEI), which is fundamental to start reporting. The UK’s Financial Conduct Authority has already indicated it will observe a grace period before taking enforcement action against firms not actively reporting.
Non-Cleared Business – The enduring legacy
Meanwhile, it is easy to forget that the non-cleared business will be with us for many years to come. EMIR sets out a series of new operational targets for these trades including regular portfolio reconciliation, timely confirmation and an approach to dispute resolution.
Immediately before the Feb 12 reporting start date, ESMA published new guidance on trade reporting, including examples of how to construct a unique trade identifier (UTI). This has left the industry wondering how the incremental guidance fits in with any published implementation timeline or regulatory expectations.
To muddy waters further, ESMA has written to the Commission asking for clarification on whether certain FX and commodity products are in fact derivatives – the answer to which could cause more rework for the implementation of EMIR.
Much progress has been made towards moving the OTC market to a more organized basis, with all business labelled with a legal entity identifier and reported to a trade repository for regulators to learn from. Clearing has become a way of life for many firms, with smaller firms now having a matter of months to prepare for the clearing mandate.
Regulators have more work to do, in improving the effectiveness of trade reporting and considering the systemic effects of large scale clearing – but as with any large project, hindsight should inform new thinking and progress towards better market infrastructure.
Finally, and it seems early to consider this, but non-compliance with EMIR will eventually bring fines. However, given the current uncertain circumstances, it will be some time before firms needs to get their checkbook out.