european market infrastructure regulation (emir) · european market infrastructure regulation...
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Zurich, July 2012
European Market Infrastructure Regulation (EMIR)
New challenges for financial institutions
Your partner for
navigating the challenges in
finance and risk management.
InCube Advisory
Birkenstrasse 12
CH-6003 Lucerne
Switzerland
www.incubeadvisory.com
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Globally, the Over-the-Counter (OTC) derivatives market volume amounts to USD 648 trillion (source: BIS, December 2011);
nearly 85% of the world’s outstanding derivatives market volume is accounted for by OTC derivatives (source: DB Research).
OTC derivatives markets are generally characterized by flexible and tailor-made products, satisfying the demand for bespoke
contracts customized to the specific risks that a user wants to hedge.
The financial crisis has brought to light many weaknesses in OTC derivatives markets, such as their intransparency or inherent
counterparty risks.
Over-the-Counter (OTC) derivatives market: introduction
In reaction to the financial crisis, there has been an inter-
national effort to increase stability in financial markets,
including OTC derivatives markets: In 2009, G-20 leaders
agreed that:
a) all standardized OTC derivative contracts should be cleared
through central counterparties (CCPs);
b) non-centrally cleared contracts should be subject to higher
capital requirements; and
c) all OTC derivative contracts should be reported to trade
repositories.
These changes are set to improve the efficiency and trans-
parency of OTC derivatives markets with a view to reducing
counterparty and operational risk involved in these markets as
well as overall systemic risk. Source: Semiannual OTC derivatives statistics at end-December 2011, Bank for International Settlements (BIS)
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OTC derivatives regulation in Europe is implemented through four different legislative initiatives:
European Market Infrastructure Regulation (EMIR) which constitutes the main part of the EU/EEA’s OTC derivatives market reform
Markets in Financial Instruments Directive (MiFID) Review
Short selling and credit default swap (CDS) regulatory initiative
Capital Requirements Directive IV (CRD IV - Basel III requirements)
The European Securities and Markets Authority (ESMA) will be responsible for the implementation of the new rules and the supervision
of OTC derivatives markets. Specifically, it will be responsible for interpreting the new legislation and determining which financial
instruments and market participants will be covered.
EMIR timeline (based on current expectations):
OTC derivatives regulation in Europe: overview
2010 2011 2012 2013 2009
G-20 leaders agreed on OTC derivatives “regulation” to be introduced by the end of 2012
September: EU Commission publishes first EMIR proposal
July: EU Parliament approves draft text
October: Council approves draft text
January: Debate in Council
March: EU agreed on EMIR in plenary sitting
February: ESMA publishes discussion paper on draft technical standards.
Spring/Summer: Council to consider and vote on EMIR
End September: ESMA to submit technical standards to the Commission
June: Member States to notify the Commission of penalties established under the Regulation
January: EMIR to come into effect in line with G-20 deadline
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Consistent with the G-20 commitment, the proposal of EMIR, published by the European Commission, stipulates rules for central
clearing and risk mitigation and aims to increase stability within OTC derivatives markets.
More precisely, the regulation introduces:
OTC derivatives regulation in Europe: overview
Clearing obligations for eligible OTC derivatives 1
Measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives 2
Reporting obligations for OTC derivatives 3
Requirements for trade repositories 4
Introduction of new requirements for central counterparties (CCPs) 5
Rules on the establishment of interoperability between CCPs 6
Relevant for the financial institution
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Clearing obligation: Scope
Firms will need to clear all OTC derivative transactions for the products where
ESMA has determined a clearing obligation will apply. In general terms the scope
of the clearing obligation will apply across the five main derivative asset classes -
interest rate, equity, credit, commodity and foreign exchange.
The scope of the clearing requirement will apply to all financial counterparties
transacting in OTC derivatives. In practice this presumably will cut across banks,
insurers, reinsurers and asset managers.
Some important exemptions have been secured, for example:
Corporate clients who use derivatives for hedging purposes
Corporate clients who have a small degree of non-hedging business. The
threshold for non-hedging business will be defined by the end of September
2012 (threshold will be calculated on a rolling basis and so firms could drop
in and out of scope)
Pension funds will have a three-year transitional period
EMIR: new requirements and challenges (1/3)
Potential challenges
for your institution:
Understanding the detailed technical
guidance and the interactions with
other regulatory requirements (Dodd-
Frank, Basel II/III, SST, Solvency II,
MiFID, etc.)
Identification of OTC products and
counterparties affected by the clearing
obligation
Analysis of the economic impact from
central clearing (e.g. capital and
liquidity requirements, counterparty
risks, transfer costs)
Selection of exchanges/central
counterparties for future derivatives
transactions
Implementation: organization,
governance, processes, methodologies,
data, systems, documentation, training
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Approach for non-cleared trades
Since not the complete universe of products will be suitable for clearing, the
regulation introduces extensive requirements that will strengthen the risk
management of non-cleared trades.
The most significant change will be the requirement for participants to exchange
collateral on their non-cleared trades (the forms this will take will be determined
by the end of September 2012).
It is most likely that it will follow an “initial margin” and “variation margin” type
approach - this will present firms with significant challenges as they will have to
source highly liquid collateral to cover the position across the duration of the
contract.
Furthermore firms will need to make changes to ensure
a) they are operationally strong and have the capability to mark their positions
to market on a daily basis;
b) to confirm their trades electronically; and
c) to perform a variety of risk management functions including trade
compression and portfolio reconciliation activities.
EMIR: new requirements and challenges (2/3)
Potential challenges
for your institution:
Identification of OTC products which
will not be centrally cleared in the
future
Identification/selection of adequate
counterparties for future OTC
derivatives transactions
Introduction of daily MTM valuation
(where not already available)
Review of trade confirmation
procedures and introduction of
electronic process where required
Analysis of the impacts of the collateral
requirements (e.g. capital and liquidity
requirements, counterparty risks)
Review/introduction of required
reconciliation procedures
Implementation
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Insight 1: Set-up options
Client clearing via Clearing Broker:
In order to select a clearing broker a Request for Information & Proposal (RFI & RFP) process needs to be setup in order to address main questions, such as:
Account set-up / collateral management process
Portability / default management
Risk Management
Trade flows
Pricing
Jurisdiction
Clearing Broker
(Clearing Member)
“Use” of a Clearing Broker:
Counterparty A
=
Clearing Member
“Acting” as a Clearing Member:
Central
Counterparty (CCP)
“Direct” client clearing:
In order to be able to perform “direct” clearing with a
CCP, the institution needs to be member of a central
clearer
Based on the CCP various “participation” models are
possible (e.g. GCM or DCM for EUREX)
General provisions usually are provided by the individual
CCPs
Counterparty A
“Classical” non-cleared OTC transaction:
Counterparty B
Bilateral non-cleared transactions:
“Traditional” OTC trade volume will decrease due to EMIR
Ensure which product still allowed to trade without
central clearing
Mandatory collateral requirements
Higher capital requirements under Basel III
Counterparty B
(Clearing Member)
Central
Counterparty (CCP)
Counterparty B
(Clearing Member)
Counterparty A
(Client of a clearing
broker)
Counterparty A
(Client of a clearing
broker)
ISDA Master Agreement / Schedule / CSA / Confirmation
Customer Agreement
“Clearing House Rules”
“Clearing House Rules”
A
B1
B2
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Insight 2: Collateral management
Collateral
Management
Functions
Set up “Road Map” • Documentation • Contracts (e.g. CSA) • Best practice approach • Reporting
Margin call & recall management
• Mark-to-Market
valuations • Exposure calculation
Portfolio reconciliation • Automated portfolio
reconciliation
Dispute resolution process
• Investigate and resolve
disputed margin calls
Collateral calculation • Eligibility validation • Collateral validation • Balance reconciliation
Collateral management
• Collateral settlement • Substitutions • Interest calculation
Rehypothecation • Re-use of collateral
assets (cash and securities)
Collateral “safekeeping”
• Safekeeping • Cash reinvestment • Asset servicing
Impact on collateral management
The widely anticipated regulatory
changes will likely impact the use of
collateral in OTC derivatives trading
Counterparties wishing to trade and
clear CCP-eligible instruments will
in general hire a clearing broker to
gain access to clearing houses
CCPs will likely accept cash and
highly liquid securities for initial
margin (IM) but will require cash
collateral for variation margin (VM)
Entities can therefore, expect
significant changes to the amount
and type of collateral required
Transparent and solid collateral management processes including documentation are required both for the “remaining” bilateral OTC
transactions as well as for the new centrally cleared transactions. If not yet in place, such processes have to be set up.
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Reporting to trade repositories
A number of trade repositories (essentially a central database) where information
on positions is collected will have to be established.
EMIR will require all derivative transactions (OTC and exchange traded) entered
into by EU / EAA counterparties to be reported within one day of the execution of
the contract to an EU registered or a third country recognized trade repository.
In addition all contracts that were executed prior to the entry into force of the
regulation and remain outstanding will need to be reported.
If no trade repository exists, firms will need to report the details of their trades to
ESMA - the now designated supervisor of trade repositories located in the EU /
EEA.
The ESMA Discussion Paper on draft technical standards (February 2012) builds
on this and highlights at least 30 data fields that may need to be reported.
EMIR: new requirements and challenges (3/3)
Potential challenges
for your institution:
Clarification of the transactions to be
reported
Clarification of the reporting
requirements (which transaction
register?)
Clarification of the data requirements
and reporting formats
Identification of required changes to
the existing data models and IT
infrastructure (data warehouses,
interfaces, reporting software, etc.)
Set-up of the required reporting
framework
Implementation of required processes,
governance systems and
documentation
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EMIR versus Dodd-Frank Title VII
Although both EMIR/MiFID II and Dodd-Frank Act Title VII anticipate the need for international coordination of OTC derivatives reforms and
regulation, within some of the key terms they differ:
Issue EMIR Dodd-Frank Title VII
General Scope
OTC derivatives: credit, interest rate, foreign exchange,
equity and commodities
All OTC swaps, forwards and options for credit, interest rate,
foreign exchange, equity and commodities. There is a
proposed exemption for foreign exchange derivatives and
forwards
Jurisdiction
ESMA (to determine binding technical standards across
significant areas of EMIR and for authorization and
supervision of trade repositories)
National regulators have authority for authorization and
supervision of CCPs
SEC and CFTC have authority over instruments and over trade
repositories
CFTC has authority over supervision of CCPs
Participant exemptions for clearing
Non-financial firms whose non-hedging business falls
below an ESMA-defined threshold
Intra-group transactions
Pension funds carve out for three years
Non-financial firms hedging commercial risk
Historical contracts (clearing) Trades outstanding at the time of a notification to clear
(and subsequently subject to a clearing obligation) will
have to be cleared
Trades executed before the clearing obligation is determined
will not have to be cleared. The obligation is prospective only
(as long as the trade is reported to a trade repository)
Historical contracts (reporting to trade repository)
Reporting obligation shall apply to all contracts concluded
before the entry into force of the Regulation and
outstanding at the time the Regulation takes effect
Rules still to be finalized
Further differences appearing between the two measures will include areas such as:
the shape and form of “margins” for non-cleared trades
the data reported to trade repositories
the account segregation requirements
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OTC derivatives regulation worldwide: an overview I
Introduction of OTC derivatives regulation similar to EMIR/Dodd-Frank is among others also planned in the following countries:
Although all the various countries are introducing similar regulation, there is still a great deal of co-ordination required on the part of
global regulators to ensure successful implementation.
Country Status Implementation deadline
Switzerland Working group under the lead of the Swiss Federal Department of Finance FDF in place No publications to be expected before end of September 2012 Working group is observing international developments, in particular further technical
guidance under EMIR and Dodd-Frank Act
Not yet defined
Japan Amendment to the Financial Instruments and Exchange Act passed in May 2010; gives the Japanese financial regulator (JFSA) the authority to regulate OTC derivatives
Implementing measures to be finalized by November 2012 – starting with transactions inside Japan
Hong Kong Joint consultation paper issued by the Hong Kong Monetary Authority (HKMA) and the Hong Kong Securities and Futures Commission (SFC) on the OTC derivatives market in Hong Kong in October 2011
Proposed start: 1 January 2013
Singapore The Monetary Authority of Singapore (MAS) released a consultation paper on the “Proposed regulation of OTC derivatives” on 13 February 2012
Proposed start: 1 January 2013
Australia A first discussion paper has been issued by the Council of Financial Regulators in June 2011 Proposed start: 1 January 2013
Canada End of 2010, the Canadian OTC Derivatives Working Group (OTCDWG) published a discussion paper entitled “Reform of Over-the-Counter Derivatives in Canada”
Proposed start: 1 January 2013 – not
guaranteed
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OTC derivatives regulation worldwide: an overview II
Source: FSA – OTC Derivatives Market Reforms 06/12
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OTC derivatives regulation: our services and experience
Leading international reinsurance company
Restructuring of a Derivatives Platform, including the complete trade lifecycle process (e.g. trade capture and confirmation, lifecycle and event management, trade valuation, cash and collateral management, risk reporting and reconciliation, settlement and payment, accounting)
Documentation, audit process
Program management
International insurance company
Setting up of a customized integrated risk data and reporting platform, particularly for OTC derivatives
Specification of data requirements for the analysis and reporting of credit risk and derivatives data as well as for the implementation of credit limits
Design, documentation and implementation of processes, deadlines and responsibilities for the maintenance and production of the system
Large international bank
Design and implementation of a productive risk aggregation and reporting framework
Setting up of a database containing risk measures, audit records and recon-ciliation capabilities
Open and fully auditable system (no “black box”) allowing for in-depth analysis of intermediate and final results
«Our objective: providing high quality advisory and
implementation services for the benefit of our clients.»
Our services include:
Impact Analysis:
Definition of scope, analysis of current situation and of regulatory requirements
Identification and presentation of impact on financial situation and risk exposures (capital, liquidity, counterparty risk, transfer costs, etc.)
Identification and presentation of impact on organization, governance, processes, data, systems, documentation
Gap Analysis:
Assessment of status of implementation
Identification of regulatory “gaps”
Present need for action and recommendation for practical implementation
Implementation:
Development of business and data requirements, specifications and documentation
Implementation of databases, data repositories, interfaces and reporting frameworks
Support in the testing procedures
Implementation of required processes
Training/coaching
Project Management / PMO
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Andreas Felber
Dr. phil. II
E-mail: [email protected]
Erich Felder
CFA, lic. oec. HSG
E-mail: [email protected]
InCube Advisory
Birkenstrasse 12
CH-6003 Lucerne
www.incubeadvisory.com
Contact
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This publication has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of the contents of this publication. InCube Advisory GmbH would be pleased to advise readers on how to apply the principles set out in this publication to their specific circumstances. InCube Advisory GmbH accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication. © July 2012 InCube Advisory GmbH. All rights reserved.