EMIR – is it doing its job in regulating the OTC derivatives market?
By James Conaghan, Director, PwC
Published: 30 June 2014
The European Market Infrastructure Regulation (EMIR) has been live since February 2014. By all accounts it has had a rocky start with many companies not ready to comply, some repositories unable to cope with the demand and confusion in relation to what is in scope.
A bit of background…
Why was EMIR implemented? Like so many other recent regulations the main catalyst was the global financial crisis. It exposed fundamental weaknesses in the regulation of the global US$650 trillion over the counter (OTC) derivatives market resulting in the G20 agreeing on a set of OTC market reforms designed to reduce systematic risks and to improve market transparency: by the end of 2012 the goal was that derivatives contracts would be traded on exchanges or electronic platforms, cleared through central counterparties (CCPs), reported to trade repositories (TRs) and subject to capital or other requirements to reflect the riskiness of transactions. The EU implemented most of these requirements through the European Market Infrastructure Regulation (EMIR) which came into force on 16 August 2012. EMIR introduces clearing, transaction reporting and significant risk management procedures for firms, as well as a pan-European regulatory regime for CCPs and TRs.
Who is subject to EMIR?
- Financial firms and non-financial firms established in the EU that are counterparties to derivatives contracts;
- ‘Financial counterparties’ include banks, insurers, MiFID authorised investment firms, fund managers, UCITS funds, Alternative Investment Funds (AIFs)[1], spread betting firms and pension schemes; and
- ‘Non-financial counterparties’ include any counterparty established in the EU that is not defined under EMIR as a financial counterparty, including non-financial firms, CCPs, TRs and trading venues.
What does EMIR require firms to do?
Clearing requirements
Firms must arrange for all derivative contracts deemed ‘clearing eligible’ by the European Securities and Markets Authority to be centrally cleared by a CCP. Central clearing imposes a CCP between each side of a trade, thus reducing credit risk between market participants. EMIR also sets out margin and collateral standards for trades cleared through European CCPs. Non-financial counterparties will be subject to clearing requirements only if their derivatives positions exceed a clearing threshold set out under EMIR.
Reporting requirements
Firms must report exchange traded and OTC traded derivative contracts to TRs. The reporting requirements will allow regulators to monitor the build-up of systemic risk through excessive risk concentrations.
As part of the new reporting requirements, EMIR requires all derivative end users to adopt new entity, product and transaction universal identifier regimes. The Legal Entity Identifier (LEI) is a newly created universal entity level identification scheme. The transaction also requires a Unique Trade Identifier (UTI). The UTI acts as a tag to ensure every trade entering one of the six European repositories can be accurately identified, and it ensures that if two sides of the same trade are reported separately to two different repositories, they can be paired.
Risk management requirements for uncleared contracts
Firms must comply with capital and margin requirements for derivative contracts which remain outside the clearing obligation. Firms must also comply with certain risk management requirements for uncleared contracts (including timely trade confirmation, daily mark-to-market or mark-to-model valuation, reconciliation, compression and dispute resolution).
Where are we now?
Status
The European Securities and Markets Authority (ESMA) registered the first trade repositories (TRs) on 7 November 2013, an event which triggered a 12 February 2014 start date for reporting derivative transactions under EMIR. This meant from the 12 February 2014 onwards both counterparties to a derivative transaction must file a transaction report with an EMIR authorised TR. There are six EMIR authorised TR’s to date:
- CME Trade Repository Ltd. (CME TR)
- DTCC Derivatives Repository Ltd. (DDRL)
- ICE Trade Vault Europe Ltd. (ICE TVEL)
- Krajowy Depozyt Papierów Wartosciowych S.A. (KDPW)
- Regis-TR S.A.
- UnaVista Limited
Outstanding issues
Unmatched trades
Europe's trade reporting mandate requires both counterparties to a listed or over-the-counter derivatives trade to report their side of the transaction to a trade repository, which involves the submission of a counterparty’s Legal Entity Identifier (LEI) and the transaction's Unique Trade Identifier (UTI). The trade repository must then match up both sides of the trades. A high number of market participants still haven't registered for an LEI – the code that identifies each reporting counterparty and which is needed to generate a UTI. There has also been confusion in relation how to generate a UTI. Without a common UTI there's really no way for the repository to know it's the same trade. Additionally, TR’s are having data quality issues with counterparties not reporting in the same way resulting in further mismatching of trades.
Matching such a high volume of trades was always going to be a challenge as systems are reliant on the quality of data supplied. If counterparties are not supplying key matching fields such as UTIs and LEI codes or equivalent entity identifiers it is not surprising that EMIR reporting has encountered this issue in relation to unmatched trades. It is going to take a number of months for the regulation and the technical standards around the regulation to evolve and standardise.
No clear definition of ‘derivative’
Another outstanding issue hindering EMIR reporting is the lack of clarity with respect to the application of EMIR in relation to FX forwards and physically settled commodity forwards. This stems from the fact that the definition of ‘derivative’ or ‘derivative contract’ under EMIR refers to the list of financial instruments contained within MiFID. Due to the different transpositions of MiFID across each EU Member State, there are inconsistent approaches in relation to the definition of ‘financial instruments’ with regard to certain derivatives resulting in negative effects on the consistent application of EMIR. The European Commission has agreed with ESMA that further work is needed and has undertaken that further assessment will be done urgently. It has also asked ESMA to provide it with further information, such as how each EU Member State has transposed MiFID in relation to the distinction between an FX spot and an FX forward. On 10 April 2014, the European Commission published a consultation document on FX financial instruments. The consultation document potentially marks a significant step in the resolution of this issues arising in this area.
Non-compliant firms
Numerous entities have experienced difficulties complying with the reporting start date due to various factors, including the delay in onboarding with certain trade repositories as they struggled to cope with the demand and difficulties in understanding how to generate a unique trade identifier. These difficulties in meeting the reporting start date have been communicated to key national competent authorities, specifically the Financial Conduct Authority (FCA) in the UK, the Central Bank of Ireland (CBI) and the Commission de Surveillance du Secteur Financier (CSSF) in Luxembourg. In its ‘Supervisory priorities arising from EMIR’, these regulators have indicated that they will take a more pragmatic approach toward those entities who fail to comply, provided firms can demonstrate that they have used reasonable best efforts to implement EMIR requirements and have a proactive and efficient plan in place for promptly complying with the new EMIR requirements.
What next?
It is clear that EMIR requires a bedding in period as many entities are still unprepared and even those who made the February deadline still encountered issues due to unclear guidance and overloaded repositories. It will take time for the the regulation to evolve and standardise. Further guidance is needed from the EU Commission and understanding from local Regulators as entities try to implement the EMIR requirements correctly so that the EU has a working regime that regulates the OTC derivatives market in line with the G20 2015 aim.
This includes all funds (EU and non EU) managed by an authorised or registered AIFM.