The material impact for Swiss domiciled entities (banks, insurance companies, fund management companies, commodities traders, pharmaceutical and/or industrial companies) of the ESMA Final Draft OTC Derivatives Risk Mitigation Technical Standards on the risk mitigation measures that have to be implemented under EMIR and the Swiss Financial Market Infrastructure Act (FinfraG/ FMIA).
The European regulators (ESMA, EBA and EIOPA) have issued the final draft of regulatory standards on risk-mitigation techniques related to OTC derivatives trading.1 These provisions apply to most Swiss-domiciled entities trading in OTC derivatives with an EU-domiciled entity, and will (indirectly) also affect the implementation of the risk mitigation measures under FinfraG at Swissdomiciled entities falling within the scope of application of FinfraG/FMIA. The new standards will enter into force in the next couple of months, although they must technically still be approved by the European Commission. This newsletter gives a short overview of the main areas addressed by the new provisions.
What is the scope of application of the ESMA Final Draft Risk-Mitigation Technical Standards?
Under international standards, counterparties have an obligation to protect each other against credit exposures in OTC derivative contracts by collecting margins.2 The new technical standards regulate the risk mitigation measures under EMIR applicable to OTC derivative contracts entered into between Swiss- and EU-domiciled entities. In particular they encompass risk management procedures, including the levels and type of collateral, segregation arrangements, exchange of initial and variation margins, and collateral maintenance and protection.
Why are these provisions of importance to Swiss-domiciled entities? The new technical standards will be applicable to most trades in OTC derivatives falling within the scope of FinfraG/FMIA and/or EMIR and entered into between Swissdomiciled entities and EU-domiciled entities. The application of these requirements will have the following impacts on Swiss-domiciled entities trading in OTC derivatives:
- The Final Draft OTC Derivatives Risk Mitigation Techniques Standards under EMIR go way beyond the risk mitigation measures under FinfraG/FMIA, and apply to OTC derivative trades between Swiss-domiciled and EU-domiciled entities that are regulated by EMIR.
- In addition to OTC derivatives contracts as defined under EMIR, the new technical standards generally also apply to OTC derivatives contracts as defined under FinfraG/FMIA. For Swiss-domiciled entities falling within the scope of EMIR this means that OTC derivative contracts in scope are determined on the basis of EMIR and FinfraG/FMIA (OTC derivative contracts under FinfraG/FMIA and EMIR).
- Swiss-domiciled entities entering into cross-border derivatives trades with EU-domiciled entities have (at least theoretically) to implement two sets of risk mitigation measures; those required under EMIR, and those required under FinfraG/FMIA.
- For many Swiss domiciled entities, the implementation of two different sets of risk mitigation standards is not feasible from an operational point of view. This means that converging to the more complex and detailed EMIR standard is the only feasible implementation solution for many market participants.
- Even non-cross-border trades falling solely within the scope of application of FinfraG are affected. This is because the interpretation of the content and scope of the FinfraG risk mitigation measures will be influenced by the Final Draft OTC Derivatives Risk Mitigation Technical Standards because of the general principle that FinfraG must be interpreted in compliance with EMIR.
- On the basis of the FINMA position paper on the cross-border provision of financial services, Swiss-regulated financial market participants must apply the Final Draft OTC Derivatives Risk Mitigation Technical Standards, which are part of the standards of business conduct required of them.
What does this mean for a Swiss-domiciled entity trading in OTC derivative contracts as defined under EMIR and as defined under FinfraG?
Any entity domiciled in Switzerland that trades OTC derivatives cross-border with an EU-domiciled entity must generally implement the margin requirements under the new ESMA technical standards if it falls within the scope of application of EMIR. This obligation also applies to OTC derivative contracts as defined under FinfraG if the entity would be subject to margin requirements under FinfraG.
OTC derivative contracts as defined under EMIR have a different scope of application than OTC derivative contracts under FinfraG. An OTC derivative contract as defined under EMIR 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 or on a third-country market considered as equivalent to a regulated market in accordance with Article 19(6) of Directive 2004/39/EC”.3 Under EMIR, execution on MTFs is therefore still considered to be OTC execution. FinfraG considers execution on an MTF to be non-OTC. Under EMIR, execution on Swiss-regulated markets is still considered to be OTC, because Swiss stock exchanges have not yet been deemed equivalent to a regulated market as defined under EU law. The definitions of the financial instruments falling within the scope of application of EMIR are also different from those falling within the scope of application of FinfraG. They should be evaluated on a case-by-case basis.
This means that the new ESMA technical standards to FinfraG and EMIR OTC derivative contracts. Any Swiss-domiciled entity falling within the scope of application of EMIR and FinfraG will, for multiple reasons, have to decide whether to ‘upgrade’ all its risk mitigation procedures to the more stringent EMIR standard when implementing its FinfraG risk mitigation measures. Such considerations are even relevant if an entity domiciled in Switzerland is subject only to FinfraG, but not to EMIR. Most OTC derivatives transactions are done on a cross-border basis, and the entity could be subject to restrictions when entering into such business because of non-compliance with EU legislation.
Why and to what extent do Swiss-domiciled entities fall within the scope of the new technical standards?
Any Swiss entity entering into an OTC derivative contract with a counterparty domiciled in the EU falls within the scope of application of the new ESMA technical standards if it would be subject to these provisions if established in the EU.4 This means that any Swiss entity falling within the scope of EMIR and subject to risk mitigation measures − in other words many Swiss entities qualifying as NFC or FC under EMIR − must apply the new technical standards. The required risk mitigation measures are the exchange of an initial margin to cover current and potential future exposure due to the default of the other counterparty, a variation margin reflecting the daily mark-tomarket of outstanding contracts between the counterparties, and the maintenance and protection of collateral.
What are my margin requirements as a Swiss-based entity falling within the scope of application of EMIR?
All OTC derivatives contracts are subject to margin requirements as set forth in the new ESMA technical standards. OTC derivatives contracts as defined under FinfraG which do not meet the definition of an OTC derivative contract under EMIR are only subject to these margin requirements if they are also subject to margin requirements under FinfraG.5 Depending on the risk management procedures in place, however, Swissbased entities affected may enjoy certain exemptions, such as the following:
- Initial margins must not be collected with respect to certain foreign exchange forwards, foreign exchange swaps, and currency swaps.6
- Initial margins must not be collected if at the individual or group level the aggregate month-end average notional amount of non-centrally cleared derivatives for the months March, April and May of the preceding year are below EUR 8 billion.7
- Initial margins must not be collected if they do not exceed EUR 50 million in aggregate in stand-alone situations, EUR 50 million in aggregate in a group situation, and EUR 10 million in aggregate in an intra-group situation.8
- Initial and variation margins must not be posted for certain derivatives associated with covered bonds.9
- Certain OTC derivatives contracts entered into between Swiss-domiciled entities and EU-domiciled entities must not be secured with initial and/or variation margins if certain requirements are met.10
Any netting agreements in place between the Swiss-domiciled entity and the EU-domiciled entity must be compliant with the new ESMA technical standards.11
How are the initial and variation margins calculated?
The variation margin must be calculated at least on a daily basis12 and initial margins no later than on the business day following certain events.13 Initial margins can be calculated on the basis of a standardised approach or an initial margin model or a combination of both.14 The counterparties must in any case agree on the method each counterparty will use to determine the initial margin it has to collect. Margin models must be initially and periodically calibrated, account for diversification, hedging and risk offsets arising from the risks of OTC derivative contracts that are in the same netting set. They must also be stress- and back-tested, and are subject to an internal governance process.15
To what extent is the outsourcing of certain jobs and tasks possible?
The performance of various jobs and tasks to be fulfilled as part of the new ESMA technical standards can be outsourced. The initial margin model can be developed by third parties, but the counterparty subject to the OTC derivative contract remains responsible for the accuracy of the models and their compliance with the provisions of the new ESMA technical standards.16 The credit quality assessment can also be done by a recognised External Credit Assessment Institution (ECAI).17 Initial margin can be held by a third party holder or custodian.18
What are the requirements regarding the eligibility and treatment of collateral?
Asset classes are only eligible for collateral to be posted as initial or variation margin if the counterparty has access to the market or is unable to liquidate the collateral in a timely manner in case of default. Debt securities of the Swiss government, the SNB, cantons or municipalities are other high quality assets generally eligible for collateral.19 The posted collateral is subject to fairly extensive collateral management regulations and credit quality assessments.20 The risk management procedures must include the application of haircuts to the market value of collected collateral using either a very detailed standard methodology or the entity’s own estimates.21
What kind of operational procedural and documentary requirements exist?
There must be robust risk management procedures in place to ensure the timely exchange of collateral for non-centrally cleared OTC derivative contracts.22 The trading documentation required when counterparties enter into at least one OTC derivative contracts is comprehensive and must encompass all the main criteria of a trade. The Swiss counterparty must also perform an independent legal review of the legal enforceability of the bilateral netting arrangements and its compliance with the applicable provisions, as well as the continuous assessment of compliance.23 The initial margin must be segregated either in the books and records of the third party holder or custodian or via other legally binding agreements so that the initial margin is protected from default or insolvency.24
How are Swiss-domiciled entities part of a group treated under EMIR?
When in a group context one of the counterparties is domiciled in Switzerland, the group currently has to exchange (and where appropriate segregate) variation and initial margins for all the intra-group transactions with the subsidiaries in Switzerland. In other words, the intra-group exemption is currently not applicable to Swiss subsidiaries of groups subject to EMIR. The margin requirements will apply as long as an equivalence determination related to the Swiss regulatory system remains outstanding [or: as long as there is no equivalence determination with respect of the Swiss regulatory system??].25 They will, however, only enter into force after three years after the entry into force of the Final Draft OTC Derivatives Risk Mitigation Technical Standards.