Thu, Apr 12, 2012

EMIR Central Clearing: The Day of Reckoning is Upon Us

The European Securities and Markets Authority (ESMA) released its discussion paper ‘Draft Technical Standards for the Regulation on OTC Derivatives, CCPs and Trade Repositories’ on 16 February 2012. Following the release of this discussion paper, ESMA will continue preparing draft technical standards to be included in the consultation paper which will most likely be published in summer 2012. This work forms part of the new proposals being introduced under EMIR which is anticipated to apply from the beginning of 2013.

EMIR’s insurgence into the EU regulatory environment is as a result of the financial crisis which led to the call for an internationally driven effort to increase stability in the financial markets. The commitment was made by G-20 leaders in September 2009, when they stated their desired aim to “improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse”. On 29 March 2012, the European Parliament overwhelmingly voted in favor of adopting EMIR during its plenary sitting and so shows no signs of coming to a halt.

The draft technical standards set out a number of key issues for firms to be aware of due to the wide-ranging changes it introduces in the world of derivative contracts. The information below is a brief overview of some of the key issues for consideration.

Clearing obligations for standardized derivative contracts

Part of the obligations being imposed by EMIR would be the compulsory clearing of certain ‘standardized’ OTC derivative contracts through central counterparties (CCPs). As yet, it has not been determined which OTC derivative contracts will be required to be cleared through a CCP however it is clear that the intention is to make this as wide-reaching as possible. The purpose of this is to reduce counterparty risk, primarily through the imposition of requiring firms to provide higher levels of collateral through clearing transactions via a CCP.

What firms should be aware of is that these mandatory clearing obligations are being extended to all ‘financial counterparties’. This means it is no longer just the traditional brokerage-type firms that should be paying attention as the scope will cover a lot more financial institutions – including investment firms, banks, alternative investment fund managers and insurers. Non-financial firms will not be subject to these clearing obligations until a pre-determined threshold has been reached, which is still to be defined by ESMA as part of the work it is carrying out.

It is worth noting that the changes are designed to also capture those firms based outside of the EU that would otherwise have been subject to the clearing obligations had they been based in the EU – however, this will only occur if they are undertaking these types of transactions with EU entities who are subject to the obligations, or alternatively if these transactions will have a direct, substantial and foreseeable effect within the EU.

CCPs will need to be officially recognized as such by their respective national authorities, with ESMA being granted the role of mediator when the authorization of a potential CCP is being challenged. For those CCPs based outside of the EU, they will only be recognized if their respective legal regimes provide for an effective equivalent system for recognition of CCPs.

Measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives

For those contracts which are not expected to be centrally cleared, EMIR will expect firms to impose risk mitigating techniques and to potentially ensure they have additional capital available should things not go as planned. ESMA’s draft technical standards make references to various risk mitigation techniques, including timely confirmation of terms of contracts, portfolio reconciliation and compression terms, marking-to-market and marking-to-model considerations and to have in place detailed procedures relating to derivative contracts’ dispute resolution.

Reporting obligation for OTC derivatives

Regardless of which contracts are required to be cleared via CCPs, EMIR requires that all derivative contracts (and any modifications subsequently) are reported to ‘trade repositories’ (essentially, central data centers) no later than a working day following the action taken on such a contract. This will create a data bank of aggregate positions held within the derivatives market and will help create transparency in the OTC derivatives market. Specifically, it will assist with assessing counterparty risk and aid regulators with early warning signals of accumulating risk levels – through the monitoring of the aggregate positions published by trade repositories for each separate class of derivative.

What firms should note is that the draft technical standards, in their current format, would result in a duplication of reporting requirements under both EMIR as well as the current transaction reporting regime. This is one of the issues which has already been highlighted to ESMA by those in the industry during the consultation period and it is not yet clear how ESMA will take this into account when finalizing its draft technical standards. Firms will need to be aware of any potential costs involved with duplicate reporting as a result.


The implications of EMIR are not to be taken lightly and firms need to make sure that they are prepared for the changes to come. Firms will need to consider:

  • The likely increase in transaction costs of contracts given that CCPs and trade repositories may pass on costs for using their services;
  • Likely increase in collateral and / or capital requirements for non-centrally cleared contracts;
  • Indirect costs associated with EMIR – such as the investing in the training of staff and ensuring adequate staff levels to deal with the additional reporting requirements;
  • Direct costs – such as putting in place the appropriate processes, systems and controls to deal with the above as well as any advisory fees necessary in preparing for the changes (for example, amending ISDA agreements);
  • Collateral obligations (i.e. covering the posting of initial and variation margins) and how this may affect a firm in making the best use of its assets; and
  • Firms need to ensure they have their desired level of access to CCPs in place.