The regulatory response to the credit crisis is having a profound effect on derivative markets. In this bulletin for corporate clients, we provide an update on three areas of change in derivative markets, primarily driven by regulatory reform, which will have an increasing effect on the way corporate clients use derivatives.
EMIR – seeing clearly?
The European Markets Infrastructure Regulation (EMIR), came into force on 16 August 2012 and introduces a new era in the European OTC derivative markets. Although most of the obligations under EMIR will only take effect during the course of 2013 and beyond, the recent publication of the technical standards which form the heart of the legislation means both the key concepts which EMIR seeks to establish and the detail of how they will be implemented in the future are clear, and some obligations under EMIR have come into effect already. In this article, we consider some of the main issues raised by EMIR for corporate end-users of derivatives. For further information on EMIR, please see our August 2012 and March 2012 briefings on EMIR for detailed background information on the Regulation. Please see our updated timeline detailing key dates related to the EMIR implementation process.
The CVA debate
Corporate clients may have noticed changes in the methodology used for pricing derivatives. There are various factors behind that change, but it can in part be attributed to the new regulatory capital requirements for financial counterparties, and specifically the imposition of a credit valuation adjustment (CVA) charge on derivative transactions. In this article we examine the background to the CVA charge, potential regulatory outcomes and ways in which that charge can possibly be mitigated.
As regulators increasingly mandate the exchange of collateral to minimise counterparty credit risk on derivative transactions, the legal basis under which collateral can be transferred between parties, and the ways in which that collateral can be protected from counterparty default, is again coming under the spotlight. In this article we consider the principal benefits (and drawbacks) of using a security transfer mechanism to transfer collateral compared to the traditional title-transfer mechanism.
EMIR – Seeing clearly?
The European Markets Infrastructure Regulation (EMIR), (formally known as Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC Derivatives, Central Counterparties and Trade Repositories), came into force on 16 August 2012, and introduces a new era in European over-the-counter (OTC) derivative markets. Although most of the obligations under EMIR will only come into effect during the course of 2013 and beyond, the recent publication of the technical standards which form the heart of EMIR means that both the key concepts which EMIR seeks to establish and the detail of how they will be implemented are clear. In this article, we consider some of the main issues raised by EMIR for corporate end-users of derivatives.
EMIR introduces significant changes to OTC derivative markets. It introduces the clearing obligation, which is an obligation for certain classes of counterparties to clear certain standardised trades on a central counterparty (CCP), where previously such trades were private, bilateral contracts. It also imposes a variety of stringent risk mitigation standards for non-centrally cleared contracts, including a requirement for the exchange of collateral for non-cleared transactions. There will also be wide reporting requirements. The clearing obligation will apply to both financial counterparties and non-financial counterparties who exceed certain thresholds (see further below), and will apply broadly to OTC derivative contracts, including interest rate, credit, equity, foreign exchange and commodity derivatives. Since EMIR takes the form of a regulation, it will not require implementation into national law but will be directly binding on all Member States. The requirements to clear eligible trades on a CCP and collateralise uncleared trades will pose a significant burden on affected market participants, as the requirements to provide collateral on a previously largely uncollateralised derivative portfolio will impose higher prices and a potential liquidity drain.
EMIR sets out the broad framework for the new regulatory regime, however the detailed aspects of EMIR are contained in the regulatory technical standards (RTS) the majority of which came into effect in March 2013, and it is these RTS which will largely determine how EMIR will apply in practice. Following the publication of these RTS, ESMA continues to consult on certain aspects of EMIR which have not yet been finalised (such as the extraterritorial effect of the legislation and collateral requirements for non-cleared trades) and intends to publish further RTS during 2013 and beyond to address these aspects of EMIR. Below we consider some of the key aspects of EMIR and the RTS that are most relevant to corporate end-users of derivatives.
The clearing threshold
EMIR imposes the clearing obligation on two classes of EU established entities, financial counterparties (broadly defined as investment firms, credit institutions, insurance companies, reinsurance companies, UCITS and their managers, pension schemes, and alternative investment funds), regardless of the size of their portfolio, and non-financial counterparties (entities which are not financial counterparties) whose derivative portfolios exceed a certain threshold. The level of the threshold is therefore crucial to the very large number of end-users of derivatives who trade infrequently or use derivatives to hedge their business risks. ESMA has set the clearing threshold at a low level, arguing that a large number of OTC derivative transactions by non-financial counterparties will be exempt by virtue of the hedging exemption (see further below). The following clearing thresholds (calculated on a rolling 30 day average) therefore apply per asset class:
Click here to view table.
The thresholds apply at a group level, rather than per entity, and operate so that when one of the clearing thresholds for an asset class is exceeded, the non-financial counterparty is subject to the relevant EMIR clearing requirement for all classes of OTC derivative contracts. EMIR uses a very broad definition of group, which includes group companies established both inside and outside the EU, and also captures intra-group transactions for the purpose of assessing whether the clearing threshold has been breached. The value of the clearing thresholds is set by reference to the notional amount of the derivative portfolio, rather than a net exposure approach per counterparty and irrespective of the mark-to-market value of transactions. This approach has the advantage of being simple for end-users to monitor, but ignoring the mark-to-market value arguably does not reflect the true risk of the portfolio. Corporate end-users of derivatives should be aware that the requirement to monitor whether the threshold has been breached remains with the corporate user, and that when the threshold is breached in one asset class, the requirement to clear applies across all asset classes.
Initial reactions to the legislation are that the thresholds are set comparatively low in comparison to the useage of derivatives by some classes of non-financial counterparties (particularly for certain asset classes, such as commodity derivatives and for transactions hedging the risk of outstanding debt). ESMA has acknowledged that it received insufficient data during the consultation process on the useage of derivatives by non-financial counterparties, and therefore intends to regularly review the thresholds set under EMIR to determine their effect on non-financial counterparties. The level of the thresholds was also subject to some dispute between the European Commission and the European Parliament during the final implementation of the RTS, as the European Parliament had noted that EMIR required the level of the threshold to be set by reference to net rather than gross notional value; the proposed challenge was nevertheless dropped by the European Parliament and, although it seems likely that the thresholds will be revisited in due course, the levels set out above are final.
The hedging exemption
As noted above, EMIR exempts from the clearing threshold trades entered into by non-financial counterparties for hedging purposes, or those trades that can be "objectively measurable as reducing risks directly linked to the commercial activity or treasury financing activity" of the counterparty. This exemption to the clearing threshold is therefore vital to end-users of derivatives, the majority of whom use derivatives to hedge risks associated with their business.
The RTS state that a derivative contract entered into by a non-financial counterparty would fall within the exemption when it (whether individually or in combination with other derivative contracts) meets any one of the following conditions:
- it covers the risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal course of its business;
- it covers the risks arising from the potential indirect impact in the value of assets, services, inputs, products, commodities or liabilities referred to above, resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk; or
- it qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS) adopted in accordance with Article 3 of Regulation (EC) N0 1606/2002.
However, an OTC derivative which is used for a purpose in the nature of speculation, investing, or trading may not benefit from the hedging exemption.
A number of important clarifications to the above have been included in the RTS for the determination of the hedging exemption.
- With respect to (3) above, a recital to the RTS states that the accounting definition may be used by counterparties even though they do not apply IFRS rules, and ESMA have also stated that, for those non-financial counterparties that use local accounting rules, most of the contracts classified as hedging under such local accounting rules would fall within the general definition of contracts reducing risks directly related to commercial activity or treasury financing activity provided for in (1) above.
- The recitals to the RTS further state that both proxy hedging trades (i.e. where a non-financial counterparty uses a closely correlated instrument to hedge a particular risk where there is no directly related instrument available) and portfolio hedging (i.e. where a single entity in a non-financial group enters into trades to offset risks of other entities in the group) can be considered as hedging for the purposes of EMIR.
- The recitals to the RTS also include a provision that where a non-financial counterparty seeks to reduce exposure under an existing trade by entering into an offsetting trade, the offsetting trade can also be considered as hedging activity for the purposes of EMIR.
Risk mitigation for non-cleared trades
In addition to the clearing obligation, EMIR provides for a number of risk mitigation requirements for trades which cannot be cleared through a CCP. For these purposes, EMIR makes a crucial distinction between non-financial counterparties above the clearing threshold (NFC+) and therefore subject to the clearing obligation, and non-financial counterparties beneath the clearing threshold (NFC-) and therefore not subject to the clearing obligation. A number of the risk mitigation requirements apply to both NFC+ and NFC-, however NFC+ are generally subject to the more stringent requirements to reduce counterparty credit risk and operational risk for non-cleared trades, and it is therefore vital for non-financial counterparties to continuously monitor their derivative portfolios to determine whether the above thresholds have been breached.
The risk mitigation measures for non-cleared trades included in EMIR and further described in the RTS include:
- Record keeping: Counterparties are obliged by EMIR to keep a record of any derivative contract entered into (including both exchange traded and OTC derivative transactions), together with any modifications, for at least five years following the termination of that contract. The record keeping obligation has been backdated so that it applies to both (i) any derivative contracts entered into prior to 16 August 2012 and which remained outstanding on that date and (ii) any derivative contracts entered into after 16 August 2012.
Timely Confirmation: From 15 March 2013, transaction confirmations must be exchanged within the following minimum timeframes (and where possible, by electronic means):
- for CDS and IRS trades between financial counterparties and NFC+, within two business days if executed before 28/02/2014, and within one business day if executed thereafter;
- for all other trades between financial counterparties and NFC+, within three business days if executed before 31/08/2013, within two business days if executed from 31/08/2013 to 31/08/2014, and within one business day if executed thereafter;
- for CDS and IRS with NFC-, within five business days if executed by 31/08/2013, within three business days if executed from 31/08/2013 to 31/08/2014, and within two business days if executed thereafter; and
- for all other trades with NFC-, within seven business days if executed before 31/08/2013, within four business days if executed from 31/08/2013 to 31/08/2014, and within two business days if executed thereafter.
Portfolio Reconciliation: From September 2013, counterparties must maintain, robust, resilient and auditable processes to reconcile portfolios, within the following minimum timeframes:
- for financial counterparties and NFC+, each business day for a portfolio of 500 or more trades, weekly for a portfolio of less than 500 but greater than 50 trades, and quarterly for a portfolio with 50 or less trades; and
- for NFC-, quarterly for a portfolio greater than 100 trades, and annually for a portfolio of 100 trades or less.
- Portfolio Compression: From September 2013, counterparties with more than 500 trades must establish procedures to regularly (and at least twice a year) analyse the possibility of conducting portfolio compression in order to reduce counterparty risk, and engage in such a portfolio compression exercise. Financial Counterparties and NFC must also ensure they can provide a reasonable and valid explanation for concluding that a portfolio compression exercise is not appropriate.
- Dispute Reconciliation: From September 2013, counterparties must also have agreed detailed procedures in relation to the identification, recording and monitoring of disputes relating to trade valuations and collateral exchange (such procedures to at least record the counterparty, duration and value of the dispute), and the resolution of disputes in a timely manner for disputes outstanding for five business days or more.
Finally, and perhaps most importantly for financial counterparties and NFC+, EMIR requires procedures that provide for the timely, accurate and appropriate exchange of collateral between financial counterparties and NFC+. The European Banking Authority (EBA), EIOPA and ESMA (jointly, the European Supervisory Authorities (ESAs)) are charged by EMIR with determining what the level of collateral for non-cleared trades should be, and issued a joint discussion paper on 6 March 2012 stating their view that to meet this requirement there should be, at a minimum, a daily exchange of variation margin by both counterparties. The ESAs continue to consider a further requirement to exchange, post or collect initial margin. This key future requirement for the market will be delayed until mid-2013, as the ESAs have obtained a postponement of the original deadline of 30 September 2012 to deliver their proposal until the BCBS and IOSCO have issued guidance on a parallel report on margin requirements for non-centrally-cleared derivatives. BCBS and IOSCO recently issued a proposal for that report, which recommended that non-financial counterparties be exempt from the collateral requirement, however the final guidance on this issue remains outstanding.
With an aim to increase transparency in the OTC derivative market, EMIR also requires that all derivative contracts (including both exchange traded and OTC transactions) and any modifications thereof (including novation and termination) are reported by the parties to the trade to trade repositories (TRs) no later than the working day following the conclusion, modification or termination of a contract, without duplication. This reporting obligation applies to all market participants, irrespective of clearing thresholds, and the RTS states the significant detail to be reported to the TR (including details as to the parties to the contract, the beneficiary of the rights and obligations arising from it, and the main characteristics of the contract including the type, underlying, maturity, notional value, price and settlement date). Although many market participants will delegate their reporting obligation to others (e.g. to dealers, prime brokers or asset managers), it is worth noting the scale and scope of the reporting obligation as set forward in the RTS, as the prescriptive nature of the requirements and the detailed data formatting combine to provide a significant data mapping and reporting obligation. For example, the RTS contain the obligation to report data on exposures, including position and collateral data, in order to allow regulators to monitor concentration of exposures and systemic risk. Corporate end-users of derivatives should also note that, whilst the obligation may be delegated, responsibility for compliance with the reporting obligation remains with the corporate end-user itself.
The timing for the reporting obligation to commence is contained in the RTS and is as follows:
- for CDS and IRS, 1 July 2013, if a TR for that derivative class has been registered before 1 April 2013, or if no TR is registered by 1 April 2013, 90 days after the registration of a TR for that derivative class; and
- for all other derivative contracts, 1 January 2014, if a TR for that particular derivative class has been registered before 1 October 2013, or if no TR has been registered for that particular derivative class by 1 October 2013, 90 days after the registration of a TR for that particular derivative class.
As at 01 April 2013, no trade repositories have been registered with ESMA.
The reporting obligation has also been backdated so that it applies to both (i) any derivative contracts entered into prior to 16 August 2012 and which remained outstanding on that date and (ii) any derivative contracts entered into after 16 August 2012.
It is clear that the profound changes which EMIR brings to derivative markets will impact on market standard documentation. Corporate clients can expect that the market standard documentation used to document derivative transactions will evolve and adapt to meet the new regulatory regime, with the sell side of the market requiring enhanced status and purpose representations from non-financial counterparties, as well as written agreements to comply with requirements such as the risk mitigation techniques for non-cleared transactions. The first examples of these changes have already come to market (such as the ISDA 2013 EMIR NFC Representation Protocol), and clients can expect that their sell side counterparties will insist that similar initiatives are incorporated into documentation to ensure compliance with the new global regulatory regime, both in the EU and beyond. Clients will want to ensure that they understand and are aware of the implications of these changes to documentation, as well as ensuring that they themselves are compliant with regulatory obligations, before making these amendments to existing agreements.
EMIR heralds a new era as it brings about major structural reforms to the OTC derivatives market.With various aspects of EMIR now in effect and entering into force during 2013, including some which will affect all users of derivatives (including corporate end-users), clients have much to do in terms of understanding the impact of EMIR on their individual businesses, choosing clearing members and CCPs, organising reporting, and amending their documentation and policies.