Although the Regulation on OTC derivatives, central counterparties ("CCPs") and trade repositories (commonly known as EMIR) entered into force on 16 August 2012, many of its obligations have so far had limited practical effect as they require the implementation of level 2 technical standards, to be produced by the three European Supervisory Authorities (ESAs) and then approved by the European Commission. On 27 September 2012, the European Securities and Markets Authority (ESMA) published its final level 2 technical standards on most of the issues it was required to develop under EMIR. These technical standards incorporate some of the changes proposed by market participants during the consultation period, and the European Commission has three months to decide whether to endorse them.
Whilst the final technical standards cover a broad range of issues, including the authorisation and supervision framework for CCPs and trade repositories, this FM Alert focuses on the technical standards that: (a) provide clarity on the application of the clearing obligation; (b) specify some of the risk mitigation techniques for OTC derivatives which are not centrally cleared; and (c) lay down conditions for the exemption of non-financial counterparties and intragroup transactions.
Issues that the ESA's are still to provide technical standards on include: (i) the extra-territorial application of EMIR; (ii) details relating to certain risk mitigation techniques (e.g. capital requirements and exchange of collateral) which are to be developed jointly by ESMA with the other two ESAs; and (iii) CCP interoperability. The European Commission has yet to set a deadline for the submission of technical standards on these issues.
Indirect clearing arrangements
Under EMIR financial and certain non-financial counterparties will be required to clear certain classes of OTC derivatives (yet to be determined by the Commission) through a CCP. To meet this obligation, counterparties will have to: (a) become clearing members of a CCP; or (b) become a client of a clearing member of a CCP, who will act as its clearing broker; or (c) establish indirect clearing arrangements with a client of a clearing member. In order to facilitate access to CCPs, ESMA previously proposed that clearing members would be required to offer indirect clearing services; and guarantee the trades of 'indirect clients' for at least 30 days following the failure of a direct client. However, following feedback from market participants who complained that these provisions were 'unworkable', these proposed requirements have been dropped. Indeed, the imposition of the 30-day requirement would have given indirect clients a greater degree of protection than direct clients and would not have been consistent with EMIR which simply required EMSA to ensure that both groups of clients were protected by equivalent safeguards.
ESMA has clarified, however, that clearing members who are willing to provide indirect clearing services must do so on a reasonable commercial basis. Nevertheless, the removal of the mandatory requirement to provide indirect clearing services is likely to mean that some market participants may have difficulty accessing CCPs.
Clearing obligation procedure
EMIR introduced two approaches for assessing the eligibility of a class of OTC derivative contracts for mandatory clearing (known as the 'top down' and 'bottom up' processes). The final technical standards do not provide much that is new on the clearing obligation procedure, although following feedback from market participants ESMA has attempted to make the "bottom up" process more transparent by confirming that member state notifications which may trigger potential future clearing obligations will be made available as soon as possible and on ESMA's public register. Less helpful is ESMA's comment that it will not publicly notify the market of a negative assessment (i.e. where ESMA is not minded to recommend to the Commission that a clearing obligation should apply to a particular class of derivatives). Rather under the bottom up process, market participants will have to keep a close check on ESMA's public register and should assume that ESMA has made a negative assessment in the absence of a public consultation being launched and/or draft technical standards being published within the required 6 month period (from the date that ESMA is notified by the national regulator that it has authorised a CCP to clear certain OTC derivatives). It is puzzling why ESMA is unwilling to publicise details of a negative assessment at an early stage in the process as it seems likely to create uncertainty for market participants.
Clearing obligation calculation
Non-financial counterparties are subject to the "clearing obligation" if their positions in eligible derivative contracts exceed certain thresholds. However, OTC derivative contracts that are "objectively measureable as reducing risk directly related to its commercial activity or treasury financing activity or that of its group" ("hedging contracts") can be excluded by a non-financial counterparty when calculating whether its OTC derivative positions exceed the relevant clearing threshold.
In the final technical standards ESMA confirms that proxy hedging (e.g. where an instrument to carry out a direct hedge is not available), portfolio hedging and OTC derivative contracts that offset hedging contracts may qualify as 'hedging contracts' for these purposes. Equally, OTC derivatives relating to employee benefits, such as stock options, and OTC derivative contracts which are considered to be 'hedges' under IFRS rules may also be treated as hedges for EMIR purposes and thus be excluded for the purposes of the clearing threshold calculation. However, ESMA clarifies that the exemption does not include contracts considered to be 'hedges' solely under local accounting rules.
ESMA acknowledges that it does not currently have sufficient data on the use of OTC derivatives by non-financial counterparties. In light of this, ESMA has adopted a phase-in approach whereby it will set clearing thresholds at a level that can be adjusted once more data becomes available. It is intended that the thresholds will also be reviewed on a regular basis.
ESMA has set the following clearing thresholds: (i) Euro 1 billion for credit derivatives and equity derivatives, and (ii) Euro 3 billion for interest rates, FX and commodity derivatives. ESMA clarifies that the thresholds operate so that when one threshold is breached for an asset class the non-financial counterparty is subject to the EMIR clearing obligation in respect of all classes of derivatives into which they enter.
ESMA confirms in the final technical standards that the clearing thresholds are set by reference to the gross notional amount of OTC derivative contracts. Clearing thresholds are therefore set at a "high" level. ESMA has clarified that this is to accommodate non-financial counterparties that may not have sophisticated IT systems to calculate net exposure.
Intra-group transactions exemption
The intra-group transactions exemption in EMIR does not apply automatically to transactions within its scope – rather financial and non-financial counterparties that wish to use it must apply to their home state regulator for approval. The final technical standards contain details of the information that counterparties must provide to their home state regulator. ESMA has confirmed that intragroup credit limits need not be disclosed and legal opinions to support the intra-group exemption application will only be required on request from the national regulator.
Counterparties that are exempted must publicly disclose details of the exemption. However, in response to feedback concerning the disclosure of commercially sensitive information, ESMA stresses that any quantitative data that must be disclosed in this respect will be in aggregate and limited and therefore not commercially sensitive. Technical standards that will set out the criteria to assess the applicability of the intragroup exemption are to be developed jointly by the ESAs at a later date (yet to be confirmed by the Commission).
Risk Mitigation Techniques
Both financial counterparties and non-financial counterparties that are subject to the clearing obligation will be required to have procedures in place to measure, monitor and mitigate risk in respect of non-cleared OTC derivatives. The final technical standards contain provisions relating to: (a) the timing of confirmations, (b) reconciliation procedures, (c) portfolio compression, and (d) marking to market/to model. The ESAs are required to produce technical standards on certain other risk mitigation techniques (including the levels and type of collateral and segregation arrangements required and the level of additional capital). A fresh deadline for the submission of these standards is yet to be set by the Commission.
Reconciliation of non-cleared OTC derivative contracts
Financial and non-financial counterparties to an OTC derivative contract are required to agree in writing or in other equivalent electronic means with each of their counterparties the terms on which portfolios shall be reconciled before entering into the OTC derivative contract. In order to identify at an early stage any discrepancy in a material term of the OTC derivative contract, the portfolio reconciliation should be performed on a regular basis as outlined in the Technical Standards.
In the final technical standards, ESMA clarifies that portfolio compression is not mandatory but financial and non-financial counterparties with 500 or more OTC derivative contracts outstanding with a counterparty which are not centrally cleared must have procedures to regularly, and at least twice a year, analyse the possibility of conducting a portfolio compression exercise in order to reduce counterparty credit risk. They must ensure they can provide a reasonable and valid explanation to their regulator for concluding that a portfolio compression exercise is not appropriate should they not carry out one.
Marking to market and marking to model
ESMA states that market conditions that prevent marking to market include: (a) when the market is inactive (e.g. when quoted prices are not readily and regularly available) or (b) when the range of reasonable fair values estimates is significant and the probabilities of the various estimates cannot be reasonably assessed. In such circumstances financial counterparties and non-financial counterparties exceeding the clearing threshold must use marking to model with the model complying with stated criteria. The board of the counterparty is responsible for approval of the model even where the model is developed externally.
Financial and non-financial counterparties are required to ensure that the details of any derivative contracts (and not just OTC derivatives) they have concluded (and any modification or termination of such contracts) are reported to a registered trade repository. ESMA confirms that it is not possible to align the data that is required to be reported under EMIR with what is required to be reported under MiFID since EMIR's reporting obligations are more extensive. However, ESMA will continue working towards the objective of a common reporting mechanism and will discuss any differences with the trade repositories and national regulators.
ESMA has made certain modifications to the form and content requirements for these reports as well as the reporting start dates (based upon asset class).
EMIR requires that the beneficiary of rights and obligations arising from an OTC derivative transaction should be identified in a report where this differs from the counterparties to a trade. ESMA clarifies that where the transaction is executed by a structure (e.g. fund and trust) that has a number of beneficiaries, it is sufficient to identify the structure and not all of the individual beneficiaries.
ESMA states that a global Legal Entity Identifier (LEI) should be used where available, however, where an LEI is not available, then the Business Identifier Code that is currently in place should be used. In respect to product codes, ESMA considers that in the absence of a globally agreed product identifier, counterparties can use the International Securities Identification Numbers, the Alternative Instrument Identifier or the Classification of Financial Instruments Code. Equally, where trades are reported separately by each counterparty, a Unique Trade Identifier should be reported with each counterparty to allow for the matching of each side.
Despite negative feedback from market participants on the reporting of exposures, ESMA remains convinced that this information will greatly improve the monitoring of systemic risk and so this requirement has been retained.
Firms and market participants will have to digest the content of the final technical standards and start making arrangements to ensure that they meet their obligations under EMIR, including establishing relationships with clearing members, meeting margin requirements, and making arrangements to meet the reporting requirements. Market participants should also note that this is not the end of the story since further changes to the derivatives market are expected as part of the review of MiFID.