May 8, 2014

EMIR Front-Loading Move From ESMA

Front-loading, the obigation to move trades into clearing retrospectively is a major problem for pricing OTC trades. ESMA has written a letter / proposal to the European Commission to try and defuse this unexpected consequence of EMIR.

Steven Maijoor the Chair of ESMA has written a letter to Michel Barnier at the European Commission suggesting a new approach to handling the period between a CCP being authorised and any mandated clearing. Previous coverage of the front loading issue by Jon Skinner is on the site here for background reading.

As a recap, Steven sums up the idea here:

The frontloading requirement is the obligation to clear OTC derivative contracts entered into after a central counterparty (CCP) has been authorised under EMIR and before the date of application of the clearing obligation. Therefore, the frontloading requirement implies that contracts concluded on a bilateral basis following the authorisation of a CCP might become subject to the clearing obligation before their expiration date. According to Recital 20 of EMIR, the objective of the frontloading requirement is to ensure a uniform and coherent application of EMIR and a level playing field for stakeholders when a class of OTC derivative contracts is declared subject to the clearing obligation.

In the PDF letter (attached below) one of the main issues identified by ESMA is:

The frontloading requirement poses a significant challenge from a legal, operational and financial point of view, mainly because of the uncertainty that it creates. Indeed, a transaction that is cen- trally cleared is subject to a different collateral regime than a transaction that is not, and this has a substantial impact on pricing. This pricing uncertainty may have a number of effects such as a widening of the bid-offer spreads, difficulties or dis-incentive for counterparties to appropriately manage their risks, which may eventually increase risks and reduce market stability.

The proposal from ESMA to the Commission, for which an early reaction would be greatly appreciated is to split the period in two like this:

This is a new indication of the length of time it will take Europe to mandate clearing, indicating that even if a product is mandated, the 'phase in' period could be 'several years'. ESMA suggests that front-loading would not apply in Period A, and only apply in Period B subject to a threshold of remaining maturity, yet to be defined.

This moves the problem back to point D2 on the chart, Mark Croxon at Nomura has pointed out that the same pricing issues still exist in Period B, but perhaps by then the timing of the clearing mandate may be more, clear, as it were.  Coverage from Risk is over at their site if you subscribe.

As of now, this changes nothing until the Commission respond and support ESMA in this approach. The source of the letter is over at the ESMA website:

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