The European Markets and Infrastructure Regulations (EMIR) is a body of European Union law which came into force on 16 August 2012. During the G20 Summit held in 2009 following the 2008 financial crisis, G20 leaders agreed that all standardised over-the-counter (OTC) derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by the end of 2012 at the latest. It was further agreed that OTC derivative contracts should be reported to trade repositories and non-centrally cleared contracts should be subject to higher capital requirements.
EMIR is a global regulatory reform designed to implement the G20 Summit measures and mirrors the United States Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Dodd-Frank was enacted to improve transparency and accountability in the market after the financial crisis of 2008. EMIR was given broader powers in 2011 by the addition of margin requirements for non-centrally cleared OTC derivatives.
EMIR aims to reduce the risks associated with derivative transactions. It is essentially a set of standards for the regulation of OTC derivatives, central counterparties and trade repositories.
EMIR has extra-territorial impact because it impacts market participants in the European Economic Area (EEA) and those outside the EEA trading with an EEA counterparty, whether they do so for trading purposes, to hedge themselves against interest rate or foreign exchange risk, or to gain exposure to certain assets as part of their investment strategy.
South Africa is a member of the G20 and began a process of implementing OTC derivatives markets reforms in 2012. This was done by establishing the necessary regulatory framework in the form of the Financial Markets Act, No. 19 of 2012 (FMA) which became effective on 3 June 2013, and by issuing the draft regulations regarding OTC derivatives in 2014. The draft regulations deal with:
- requirements for the regulation of unlisted securities, including the categorisation of OTC derivatives;
- securities services to be provided by an external central securities depository (CSD) and external clearing members;
- assets and resources requirements applicable to market infrastructures (a market infrastructure includes a licensed CSD, a licensed clearing house, a licensed exchange and a licensed trade repository);
- regulations applicable to the licensing of trade repositories; and
- assets and resources requirements and functions applicable to a clearing house that is a central counterparty (CCP).
The OTC derivatives market plays an important role in domestic financial markets and the economy, particularly as these institutions use derivative products primarily for risk-hedging. Domestic participants in the OTC market are mainly corporates and banking institutions.
South Africa has adopted a three-part phased approach to implementing the G20 obligations. National Treasury has constituted working groups co-chaired by the National Treasury, the Financial Services Board and the South African Reserve Bank which will make policy recommendations to the Minister of Finance. Further discussions are planned with all the relevant stakeholders as these entities undertake to refine and finalise the regulations. What is clear is that the FMA will regulate the OTC derivatives market and also provide for the establishment and licensing of a trade repository to which OTC derivatives trades will have to be reported and will be monitored by the regulators.
The market for OTC derivatives is significant and global by nature. The 2009 G20 Summit noted that OTC derivatives had contributed significantly to the global financial crisis and that certain features of the market had the potential to exacerbate systemic risk. In order to understand OTC derivatives, it is important to understand derivatives in general. Derivatives are defined as the type of security in which the price of the security depends or is derived from the price of the underlying asset. The most common underlying assets include bonds, commodities, stocks, currencies and interest rates. The common types of derivatives include forwards, options, futures, warrants and swaps.
OTC derivatives are traded between two parties (bilateral negotiation) without going through an exchange or any other intermediaries. The common types of OTC derivatives are interest rate derivatives, credit derivatives, commodity derivatives, forex derivatives and equity derivatives. EMIR requires the reporting of all OTC derivatives contracts to a trade repository.
EMIR requires market participants to centrally clear standardised and liquid OTC derivatives via a central counterparty (CCP). CCPs interpose themselves between involved parties in a contract to serve as the focal point of each trade. They have a pivotal role in reducing systemic risk through centralised risk management that contributes to reducing total counterparty risk exposure. A challenge for the South African market has been the general lack of market infrastructure to provide central clearing services for OTC derivatives to South African market participants. Accordingly, the draft regulations therefore introduce a rigorous framework for the regulation of CCPs, and contain stringent prudential, governance and conduct requirements. EMIR also requires risk mitigation techniques for derivatives not cleared via a CCP (for example, reconciling portfolios periodically and agreeing dispute resolution procedures between counterparties). There are also higher capital requirements for non-centrally cleared derivatives.
A trade repository (TR) is an organisation that is established to centrally collect and manage data and the records of OTC derivatives and trades on a secure and confidential basis, and is regulated under EMIR. The objective is to provide regulatory authorities with transparency in the derivatives markets to facilitate identification and mitigation of systemic risk.
In terms of the South African proposed reforms, the design of the TR must ensure that it operates with effective risk controls and can serve the important role of enhancing the transparency of information to relevant authorities and the public, promote financial stability, and support the detection and prevention of risk concentration and market abuse. There is currently little clarity regarding whether the TR will be a bank, a CSD or the Johannesburg Stock Exchange (JSE). Currently, for prudential regulation, the Reserve Bank requires banks to report the volume and value of their South African OTC derivatives transactions. The envisaged TR could assist by providing the Reserve Bank with information relevant to assess the build-up of systemic risks.
While no determination has been made to adopt and enforce trading on electronic platforms, going forward it is envisioned that a decision will be made whether or not to require OTC derivatives trades to move to exchange or electronic trading platforms, if authorities consider it appropriate, and will naturally evolve from the market review of the size and scope of the standardised OTC derivatives market.
Given that a significant share of South Africa’s OTC derivatives transactions are cross-border, it is important to be mindful of domestic and international economic developments to ensure consistency with international best practice.