The EMIR compliance game
04 November 2014
The dice have been rolled and it's your turn. time for Emily Cates of Rule Financial t oexplain the rules of the game
Image: Shutterstock
In the wake of the financial crisis, regulators around the world set out to reduce risk, improve transparency and to standardise products and processes in the often risky OTC derivatives market. In Europe, the culmination of these efforts is the European Market Infrastructure Regulation (EMIR). The practical implementation of EMIR can be likened to a game of Snakes and Ladders, with many slow advances and some dramatic pitfalls.
There are quite possibly 100 steps along the road to compliance and with each new looming deadline there are new ladders to climb to get ahead of the pack. However, there are also hidden snakes waiting to strike underprepared participants. While falling foul of a snake or two will not be uncommon, all firms will need to avoid those with venom that could dramatically affect their reputation and bottom line.
On 12 February 2014, the EMIR trade reporting mandate came into effect. Most large sell-side firms invested much time and many resources in ensuring that they had a robust reporting mechanism in place ahead of the deadline. However, the level of preparation and investment has been somewhat mixed on the buy side. Some firms have lacked clarity on the exact impacts of the legislation on their businesses, or have focused their attention on implementing temporary tactical solutions and simply waited to see how the service providers develop their offerings. For many buy-side firms the hope is that the number of delegated reporting venues will increase and the legislation will become clearer as the European Íø±¬³Ô¹Ï and Markets Authority (ESMA) releases more detail on the technical standards.
While the larger sell-side firms have tended to tackle the trade reporting challenge head on, they too have faced a number of issues. Having surmounted the initial challenge of working out which products are classed as derivatives under EMIR and knowing the unique product identifier (UPI), there are now two contentious issues outstanding:
The creation of the legal entity identifier (LEI), which every legal entity that needs to report under EMIR should have set up; and
The generation and exchange of unique trade identifier, which is made up from a combination of the LEI and other references.
Once the LEI has been obtained and the unique trade identifier generated by either party to a transaction, the information then has to be delivered to and consumed by the receiving party before finally being added to its own trade report. In order for trade reports to be deemed fully compliant, both parties must report the transaction and the details of each report must then be matched at the trade repository. Achieving this has not been as straight forward as it was expected to be.
Although trade reporting under EMIR is currently the primary cause for concern among most market participants, it’s important to note that this is just the first roll of the dice in the EMIR compliance game. Over the next 12 to 18 months firms will need to negotiate many more deadlines, obstacles and challenges on their long road to compliance. With most firms having successfully completed their first turn in the EMIR game, fthey now need to objectively review their market position and plan for the next phases of EMIR implementation.
The next big ladders to climb
The three main challenges facing firms in the coming months are collateral reporting, clearing, and product standardisation. These are formidable ladders to climb and they continue to create problems for all market participants, including trade repositories, service providers and central counterparties (CCPs).
Collateral reporting
The requirement to add collateral valuations to trade reports came into effect in August 2014. This poses many challenges for institutions as the valuation and collateral systems are often separate from the trading systems that the derivatives have been executed on. This means that compiling a compliant trade report will involve gathering and collating information from a number of separate systems; the trading systems and a suite of collateral valuation systems.
Trade and collateral linkage will be the biggest hurdle to compliance as most collateral is pledged on a portfolio basis rather than an individual trade or basket level, which means that the counterparty to a contract could be applying a different collateral mix or haircut to the portfolio.
Luckily, collateral valuation will not be a required matching field. However, there is much discussion around whether firms should use the pricing and haircut valuations provided by third party reporting providers, collateral custodians or their own internal valuation processes for reporting purposes.
If a contract or portfolio is only collateralised with cash then it will be relatively straight forward to use a third party’s valuation. If, however, there are non-cash collateral pledges then it becomes much harder for third parties to know how firms’ internal risk departments would value that collateral based on internal haircuts, concentration limits and thresholds. If a contract is centrally cleared then there is no choice to make, as the valuation used is always that supplied by the CCPs, which have very sophisticated margin models and collateral valuation models that are publicly available.
Ultimately, regardless of who is doing the collateral reporting, a process of linking the collateral to the portfolio will need to take place.
Clearing obligations
Calculating, monitoring and managing whether or not your trading volumes in a particular derivative product will push you over the mandatory clearing obligation threshold will come to the fore. However, all these mandatory thresholds will only come into effect for over-the-counter (OTC) derivatives once clearinghouses have been approved for those products to clear through them.
Currently, this is forecast to take place in Q1 2015 at the earliest, or at the latest Q2 2016. For the first three years following the enactment of EMIR, pension funds will remain exempt from clearing obligations, while non-financial institutions will enjoy immunity for the foreseeable future. Meanwhile, firms could undertake the following:
Re-paper existing contracts, placing the CCP as the counterparty to the transaction from both sides and agree new economic terms with the CCP that maintain the economic viability of the original contract; and
Terminate existing contracts early and then re-execute the trade on the exchange for that newly cleared product.
Clearing thresholds will take into account whether the OTC derivatives are concluded for hedging purposes. Those that are deemed to be reducing risks will be excluded from the clearing threshold. Clearing thresholds will be reviewed periodically.
The clearing obligation has not yet come into effect, however, the ESMA RTS for Central Clearing Mandate is due in September 2014 and firms can commence the clearing calculation game. These changes could eventually force firms to make some large and fundamental decisions around their execution behaviour.
Product standardisation
All new trade reporting mandates require that the trade is reported with a UPI. There is a general desire to see the Financial products Markup Language (FpML) format used across the board for derivative products. Currently, FpML supports many centrally cleared contract types and there are many more that will be developed over the next two years as CCPs start to release new products for clearing.
When a new OTC derivative product is to be centrally cleared, the CCP must submit a notice to ESMA, which will then perform the necessary checks to register the CCP as a clearer of that OTC derivative product. A CCP will have to go through a lengthy process in order to get ESMA to approve a product. Understandably then, products will be released more slowly than anticipated.
The launching of a new OTC derivative contract for a CCP will involve extensive liaison with the trading venue. Typically, historical price models will be provided by the trading venue and the CCP will provide the standard portfolio analysis of risk (SPAN) or value at risk (VAR) parameters back to the venue for the calculation of liability aggregation.
Firms should be ready for an influx of new product static data, either to standardise their current derivatives product codes or when new products are released for central clearing.
The end game
Will this legislation become a slippery snake or the ladder to success for the OTC marketplace?
After the financial crisis of 2008, the volumes traded in derivatives reduced significantly and they have never really recovered. With the transparency, standardisation and ease of access that these reforms will bring to trading, regulators and market participants, OTC derivatives as we now know them will cease to exist and will adopt the practices of the exchange-traded derivatives (ETD) market. There will always be innovation for new OTC trading structures, but rather than them being seen as the snake of the investment banking industry, perhaps in the future they will come to be the ladder to success in enabling firms to hedge their risk and optimise their collateral without the spectre of a pricing apocalypse hanging over their heads.
There are quite possibly 100 steps along the road to compliance and with each new looming deadline there are new ladders to climb to get ahead of the pack. However, there are also hidden snakes waiting to strike underprepared participants. While falling foul of a snake or two will not be uncommon, all firms will need to avoid those with venom that could dramatically affect their reputation and bottom line.
On 12 February 2014, the EMIR trade reporting mandate came into effect. Most large sell-side firms invested much time and many resources in ensuring that they had a robust reporting mechanism in place ahead of the deadline. However, the level of preparation and investment has been somewhat mixed on the buy side. Some firms have lacked clarity on the exact impacts of the legislation on their businesses, or have focused their attention on implementing temporary tactical solutions and simply waited to see how the service providers develop their offerings. For many buy-side firms the hope is that the number of delegated reporting venues will increase and the legislation will become clearer as the European Íø±¬³Ô¹Ï and Markets Authority (ESMA) releases more detail on the technical standards.
While the larger sell-side firms have tended to tackle the trade reporting challenge head on, they too have faced a number of issues. Having surmounted the initial challenge of working out which products are classed as derivatives under EMIR and knowing the unique product identifier (UPI), there are now two contentious issues outstanding:
The creation of the legal entity identifier (LEI), which every legal entity that needs to report under EMIR should have set up; and
The generation and exchange of unique trade identifier, which is made up from a combination of the LEI and other references.
Once the LEI has been obtained and the unique trade identifier generated by either party to a transaction, the information then has to be delivered to and consumed by the receiving party before finally being added to its own trade report. In order for trade reports to be deemed fully compliant, both parties must report the transaction and the details of each report must then be matched at the trade repository. Achieving this has not been as straight forward as it was expected to be.
Although trade reporting under EMIR is currently the primary cause for concern among most market participants, it’s important to note that this is just the first roll of the dice in the EMIR compliance game. Over the next 12 to 18 months firms will need to negotiate many more deadlines, obstacles and challenges on their long road to compliance. With most firms having successfully completed their first turn in the EMIR game, fthey now need to objectively review their market position and plan for the next phases of EMIR implementation.
The next big ladders to climb
The three main challenges facing firms in the coming months are collateral reporting, clearing, and product standardisation. These are formidable ladders to climb and they continue to create problems for all market participants, including trade repositories, service providers and central counterparties (CCPs).
Collateral reporting
The requirement to add collateral valuations to trade reports came into effect in August 2014. This poses many challenges for institutions as the valuation and collateral systems are often separate from the trading systems that the derivatives have been executed on. This means that compiling a compliant trade report will involve gathering and collating information from a number of separate systems; the trading systems and a suite of collateral valuation systems.
Trade and collateral linkage will be the biggest hurdle to compliance as most collateral is pledged on a portfolio basis rather than an individual trade or basket level, which means that the counterparty to a contract could be applying a different collateral mix or haircut to the portfolio.
Luckily, collateral valuation will not be a required matching field. However, there is much discussion around whether firms should use the pricing and haircut valuations provided by third party reporting providers, collateral custodians or their own internal valuation processes for reporting purposes.
If a contract or portfolio is only collateralised with cash then it will be relatively straight forward to use a third party’s valuation. If, however, there are non-cash collateral pledges then it becomes much harder for third parties to know how firms’ internal risk departments would value that collateral based on internal haircuts, concentration limits and thresholds. If a contract is centrally cleared then there is no choice to make, as the valuation used is always that supplied by the CCPs, which have very sophisticated margin models and collateral valuation models that are publicly available.
Ultimately, regardless of who is doing the collateral reporting, a process of linking the collateral to the portfolio will need to take place.
Clearing obligations
Calculating, monitoring and managing whether or not your trading volumes in a particular derivative product will push you over the mandatory clearing obligation threshold will come to the fore. However, all these mandatory thresholds will only come into effect for over-the-counter (OTC) derivatives once clearinghouses have been approved for those products to clear through them.
Currently, this is forecast to take place in Q1 2015 at the earliest, or at the latest Q2 2016. For the first three years following the enactment of EMIR, pension funds will remain exempt from clearing obligations, while non-financial institutions will enjoy immunity for the foreseeable future. Meanwhile, firms could undertake the following:
Re-paper existing contracts, placing the CCP as the counterparty to the transaction from both sides and agree new economic terms with the CCP that maintain the economic viability of the original contract; and
Terminate existing contracts early and then re-execute the trade on the exchange for that newly cleared product.
Clearing thresholds will take into account whether the OTC derivatives are concluded for hedging purposes. Those that are deemed to be reducing risks will be excluded from the clearing threshold. Clearing thresholds will be reviewed periodically.
The clearing obligation has not yet come into effect, however, the ESMA RTS for Central Clearing Mandate is due in September 2014 and firms can commence the clearing calculation game. These changes could eventually force firms to make some large and fundamental decisions around their execution behaviour.
Product standardisation
All new trade reporting mandates require that the trade is reported with a UPI. There is a general desire to see the Financial products Markup Language (FpML) format used across the board for derivative products. Currently, FpML supports many centrally cleared contract types and there are many more that will be developed over the next two years as CCPs start to release new products for clearing.
When a new OTC derivative product is to be centrally cleared, the CCP must submit a notice to ESMA, which will then perform the necessary checks to register the CCP as a clearer of that OTC derivative product. A CCP will have to go through a lengthy process in order to get ESMA to approve a product. Understandably then, products will be released more slowly than anticipated.
The launching of a new OTC derivative contract for a CCP will involve extensive liaison with the trading venue. Typically, historical price models will be provided by the trading venue and the CCP will provide the standard portfolio analysis of risk (SPAN) or value at risk (VAR) parameters back to the venue for the calculation of liability aggregation.
Firms should be ready for an influx of new product static data, either to standardise their current derivatives product codes or when new products are released for central clearing.
The end game
Will this legislation become a slippery snake or the ladder to success for the OTC marketplace?
After the financial crisis of 2008, the volumes traded in derivatives reduced significantly and they have never really recovered. With the transparency, standardisation and ease of access that these reforms will bring to trading, regulators and market participants, OTC derivatives as we now know them will cease to exist and will adopt the practices of the exchange-traded derivatives (ETD) market. There will always be innovation for new OTC trading structures, but rather than them being seen as the snake of the investment banking industry, perhaps in the future they will come to be the ladder to success in enabling firms to hedge their risk and optimise their collateral without the spectre of a pricing apocalypse hanging over their heads.
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