Focus - OTC Derivatives

Transcription

1 Capital Markets and Financial Institutions - 23 July 2013 Focus - OTC Derivatives The trade with OTC derivatives will shortly change significantly when the effects of the new EMIR Regulation appear. Soon, the market structure that the Regulation seeks to establish will be in place and in the future, OTC derivatives trading will take place on more transparent and more systematic terms than previously. In this newsletter, we focus on the EMIR Regulation while we try to provide an overview of the actors, obligations and sanctions introduced by the Regulation and the derived legislative acts. 1

2 The EMIR Regulation Following the downturn on the financial markets in 2008 and the following years, numerous rules on market organization and behavior have been adopted. The EMIR Regulation (click on link) is just one of the many regulatory initiatives that followed in the wake of the financial crisis which some observers describe as the EU regulatory tsunami. One thing is certain: the many legislative initiatives are just now beginning to materialize, and their entry into force will redefine the rules of the European capital markets and the market participants thereon. The Regulation covers OTC derivatives trading and introduces new rules for so-called central counterparties and trade repositories. EMIR is a targeted action from the EU intended to ensure the supervision and regulation of the previously unregulated OTC trades so as to increase transparency of the infrastructure and derivatives markets in order to ensure a better hedging and pricing mechanism. The macroeconomic objective is that the new initiatives will support a more efficient derivatives market than the current one. The Regulation constitutes the general framework, while technical details are to be determined through Level 2 regulation. Level 2 regulation is adopted by the Commission on the basis of drafts from the European Securities and Markets Authority (ESMA). At present, a great deal of technical standards has already been adopted. The technical standards are adopted as regulations that are binding in their entirety and directly applicable in all member states. More specifically, this means that the technical standards for the EMIR Regulation at the time of its entry into force will become part of the national law of the member states. An overview of the technical standards which have already been adopted is provided in Figure 1. Figure 1. Overview of adopted technical standards Regulatory Minimum information to trade repositories Indirect clearing, public register and risk mitigation techniques Information on application for trade repository The publication of data from the trade repositories Capital requirements for CCP s Other requirements for CCP s Implementing Format and frequency of trading reports Format for application as trade repositories Format for records to be kept by the CCP 2

3 While this newsletter deals with EMIR, it is important to note that it is only an analysis one pieces of the puzzle. EMIR has interfaces and overlapping refractive surfaces against a number of other key EU initiatives, including in particular (i) CRD IV which leads to increased financial incentives for banks and investment firms to use CCP clearing; (ii) MiFID II which moves a part of the trading in derivatives to regulated markets and regulates a number of the trading aspects; (iii) MAD II which is extended to the new types of derivatives; and (iv) REMIT the scope of which will be limited by EMIR to the extent that the clearing obligation of EMIR will cover energy derivatives. New Elements The EMIR Regulation introduces a number of new obligations as well as a number of new participants. Overall, the new obligations fall into three categories as illustrated in Figure 2 Figure 2. Obligations in the EMIR Regulation The new participants include both the so-called central counterparties (CCP s) and trade repositories. Central Counterparties One of the main innovations are the CCP s which are to be included as buyer to every seller and seller to every buyer. The CCP is destined to serve as an electronic platform (a trade system) for the trading of OTC derivatives. The trading via CCP means that the OTC traders counterparty credit risk is limited to a single counterparty as the CCP works as an intermediary in all trades. Any settlement risk for participants is minimized by "netting" by which opposite claims are set off. This means that the CCP carries out bilateral netting with each participant after which the overall effect is mulitilateral netting. The tasks of the CCP additionally include the handling of payments, exchange of collateral and other similar acts in the transaction. Provided that the CCP's solidity is sufficient, this will result in an increased stability in the financial system. Figure 3 illustrates the principle of trading with OTC derivatives before and after the adoption of the EMIR Regulation (next page). 3

4 Figure 3. Trading with OTC derivatives with and without CCP OTC trade CCP trade B C F A B A D CCP F E E D C Trade Repositories The trade repositories must centrally collect and maintain the records of derivatives since the market participants are subject to an obligation to report the details of any derivative contract they have entered into to a trade repository. The trade repositories thus play a significant role in the attempt to increase transparency. Trade repositories also need to regularly publish aggregate positions by class of derivatives on the basis of the reported agreements. The Traders In addition, the Regulation introduces a new division of the traders. A distinction is made between financial counterparties and non-financial counterparties (NFC s), and depending on which category a company belongs to and with whom the company is trading, the company will be subject to various obligations. The distinction between financial and non-financial counterparties is illustrated in Figure 4. Figure 4. Financial and non-financial counterparties Financial counterparties Investment firms Credit institutions Insurance undertakings Assurance undertakings Reinsurance undertakings UCITS and, where relevant, its management company Institution for occupational retirement Alternative investment funds managed by As it AIFMs appears, the non-financial counterparties are Non-financial counterparties All companies other than the CCP s and the financial counterparties. Are the clearing thresholds exceeded? Yes NFC+ No NFC- 4

5 As it appears, the non-financial counterparties are divided into two groups, depending on whether the thresholds in Figure 5 are exceeded or not. Any non-financial counterparty trading to an extent that exceeds just one of the thresholds is referred to as NFC+. Both financial counterparties and NFC+ s are subject to the clearing obligation of the regulation. Figure 5. Overview of thresholds a. b. c. d. e. EUR 1 billion EUR 1 billion EUR 3 billion EUR 3 billion EUR 3 billion notional value for credit derivative contracts notional value for equity derivative contracts notional value for interest rate derivative contracts notional value for foreign exchange derivative contracts notional value for commodity derivative contracts and other OTC derivative contracts not defined under points a.-d. The Clearing Obligation The clearing obligation means that some derivative contracts must be cleared. It is not yet determined which of the derivatives that are covered by the EMIR Regulation and thereby the clearing obligation. As mentioned, the distinction is made between financial and non-financial counterparties and between non-financial counterparties exceeding the clearing threshold values (NFC+) and non-financial counterparties that do not (NFC-). The clearing obligation is partly dependent on whether the derivative is subject to the obligation, but also on whether it is entered into between two parties covered by the obligation. Only agreements between financial counterparties, agreements between a financial counterparty and a non-financial counterparty exceeding a threshold value (NFC+), and agreements between two nonfinancial counterparties, both exceeding a threshold value must be cleared. This is illustrated in Figure 6. Figure 6. The clearing obligation Clearing No clearing Financial counterparty Financial counterparty NFC- NFC- Financial counterparty NFC+ NFC- NFC+ NFC+ NFC+ NFC- Financial counterparty 5

6 The practical handling of the clearing obligation can be solved in three ways: member clearing, customer clearing and indirect clearing. Which type of clearing each company is going to implement, will largely depend on the company's resources compared to the contractual conditions imposed by CCP respectively the customer. Member clearing is characterized by the counterparty becoming a member of a relevant CCP. This is illustrated in Figure 7. The possibility of direct membership is restricted to an exclusive crowd which includes international finance houses that meet the membership criteria. Figure 7. Member clearing Customer clearing is characterized by the counterparty entering into an agreement with a member of a CCP, which allows for clearing through the relevant CCP. This can be seen in Figur 8. Figur 8. Customer clearing Indirect clearing is characterized by the counterparty establishing a contractual relationship with a customer of a direct member. This is illustrated in Figure 9. Figure 9. Indirect clearing The Reporting Obligation EMIR requires all counterparties and CCP s to report details of any derivative contract they have entered into and any modification or termination of the contract to a trade repository. The reporting obligation applies to contracts entered into before EMIR enters into force, if they are still outstanding, and the contracts entered into after EMIR has entered into force. 6

7 The reporting obligation applies to both financial and non-financial counterparties, whether the nonfinancial counterparties exceed the thresholds or not. Derivative contracts should be reported no later than the first working day following the conclusion of the contract, amendment or termination, and reports must as a minimum contain the disclosure of: a. the parties of the contract and, if these are not the same, the beneficiaries of the rights and obligations arising out of the contract derivatives; b. the main characteristics and the contract, including derivative type, the underlying maturity, nominal value, price, and settlement date. In the annex of the adopted technical standard (click the link), the information to be reported is explained. If the CCP has a reporting system, the parties may report through this. The Risk Mitigation Obligation Both the clearing obligation and the reporting obligation relates to the OTC-derivatives that are to be cleared. Contrary to this, the risk mitigation obligation relates to the OTC derivatives that are not subject to the clearing obligation. The risk mitigation obligation applies to financial counterparties and non-financial counterparties, whether the latter exceeds the threshold or not. Counterparties must exercise due diligence to ensure that appropriate procedures to measure, reduce and monitor the operational risk and the counterparty credit risk in the transactions are met. In relation to the reporting obligation, it is noted that any agreement that was not cleared in the first place, and cleared subsequently, must be reported. In this area too there is a technical standard (click the link) that lays down more specific rules for compliance with the obligation. The intention is that the counterparties are obliged, if possible by electronic means, to confirm the agreed OTC derivative contract terms. The requirement as to when this confirmation must be done will vary depending on the parties involved and type of the derivative. The distinction is made between transactions in which both parties are either financial counterparties or NFC+ s and transactions where one party is a NFC. An overview of the deadline for confirmation, in relation to the type of agreement that has been concluded and when the agreement is concluded is illustrated in Figure 10 and Figure 11 (next page). 7

8 Figure 10. The risk mitigation obligation on transactions not involving an NFC- Figure 11. The risk mitigation obligation on transactions involving an NFC- 8

9 The risk mitigation obligation also implies that counterparties need to make so-called portfolio reconciliation. According to the EMIR Regulation, it is required that parties to an OTC derivative contract which is not cleared must have "Formalized procedures that are robust, resilient and auditable in order to reconcile portfolios" and "manage the associated risk, and at an early stage identify and resolute disputes between the parties and monitor the value of outstanding contracts." ESMA has set a requirement that counterparties (both financial and non-financial) must agree on, in writing, the details of how key trading conditions and market values must be reconciled before the derivatives are traded. Portfolio reconciliation is to be carried out by the counterparties to OTC derivative contracts themselves or on behalf of either party by a qualified third party that has been authorized to do so and must be made before the OTC derivatives are traded. The frequency of portfolio reconciliation is determined on the basis of the involved counterparties and the number of outstanding trades. Penalties The sanctions for violating the EMIR Regulation are twofold. First, there are rules in the regulation governing the non-compliance of the regulation by trade repositories and secondly member states must lay down penalties for violations of the other provisions of the regulation. Penalties at EU-level ESMA may make decisions on the imposition of fines if a trade repository negligently and intentionally violates certain enumerated obligations, which in general include organizational requirements for the trade repository and conflict of interests. The level of fines is defined to be between EUR 5,000 and EUR 20,000. This amount may be adjusted with aggravating or mitigating coefficients, but regardless, the fine cannot exceed 20% of the annual turnover of the trade repository in the previous financial year. The fine must be at least equal to the profit which trade repository has obtained from the violation. ESMA is also granted power to issue enforcement fines in order to force a trade repository to bring the violation to an end. The extent of the fine for trade repositories has been fixed at 3% of the daily turnover. Penalties for the breach of the Regulation by trade repositories are shown in Figure 12. 9

10 Figure 12. EU penalty provisions Article Obligation Subject of the obligation Annex I.I Organizational requirements or conflicts of interest Trade repositories Annex I.II Operational requirements Trade repositories Annex I.III Transparency Trade repositories Annex I.IV Barriers to supervisory activities Trade repositories Article 66 Bring violation to an end Trade repositories National Penalties In compliance with Denmark's obligations under the Regulation, the Danish Ministry of Business and Growth issued Executive Order No. 299 of 20 March 2013 (click on link, in Danish) on penalties for infringements of the EMIR Regulation. The order came into force on 1 April The Order provides that violation of EMIR is fined unless a higher penalty is prescribed under other legislation. Nor the Regulation or the Executive Order have established a framework for the level of fines, but it is expected that guidelines will be prepared. The penalty provisions of the Order are illustrated in Figure 13. Figure 13. Penalty provisions under the Statutory Order 299/2013 Article Obligation Subject of the obligation 4(1) The clearing obligation 7(1) 8(1) Equal access to CCP s on nondiscriminatory terms To provide trade feeds for approved CCP s on a non-discriminatory and transparent basis 9(1) Reporting obligation 10(1) 11(1)-(4) Obligation to report to ESMA and start clearing Risk mitigation techniques for non-cleared OTC derivative contracts. Financial institutions and nonfinancial counterparties (+) CCP s Markets Financial institutions, nonfinancial counterparties (+) and CCP s Non-financial counterparties (+) Financial institutions and financial counterparties Timetable and Perspectives At present, the Regulation itself and many of the technical standards are in force as mentioned before. In addition to these two major events, a number of other milestones are worth noting. The full effect of the regulation is seen only when the entire regulatory framework is in place, and the market structure 10

11 which the Regulation seeks to create is established. Some of the obligations introduced by the Regulation entered into force at the time of the entry into force of the Regulation, while others entered and enter into force as the technical standards are adopted. A third group of obligations are dependent on some external, physical conditions, such as the establishment of a trade repository. Within the next six months, it is expected that the reporting obligation will enter into force and that a presentation of draft technical standards will occur in order to determine when the clearing obligation will enter into force. The specific dates are indicated in Figure 14. Figure 14. Expected effective dates Known date Minimum Maximum Publication of technical standards in the Official Journal 23. February 2013 Entry into force of the technical standards 15 March 2013 CCP s apply for authorization 15 March September 2013 The national competent authorities must approve CCP 15 September Marts 2014 Deadline for ESMA s draft technical standards for the clearing obligation 15 Marts September 2014 The reporting requirement is effective for credit and interest rate derivatives October July 2015 The reporting requirement is effective for other derivatives 1 January July 2015 With the entry into force of EMIR, the market participants trading OTC derivatives must investigate and decide whether they can and must be direct members of a CCP or whether it suffices to clear through another member. Market participants must be aware of and financially prepared for the significant de- 11

12 mands for collateral when participating in a CCP, but they must also keep in mind that considerable capital requirements for OTC traded derivatives will be introduced along with EMIR s entry into force. Whether EMIR will have the intended effect: to prevent and eliminate systemic 'damage' to the derivatives markets, only time will tell. Although EMIR aims to create transparency on the markets, and that this gives the European Supervisory Authorities insight herein and thus the opportunity to intervene if necessary, the price will be paid by the market participants who are incurring significant additional costs. The above does not constitute legal counseling and Moalem Weitemeyer Bendtsen does not warrant the accuracy of the information. With the above text, Moalem Weitemeyer Bendtsen has not assumed responsibility of any kind as a consequence of a reader s use of the above as a basis of decisions or considerations. 12

13 Contact David Moalem, Partner Tel Mob Marcia Bossen Møller, Junior Associate Tel Mob Maria Thomsen, Junior Associate Tel Mob Peter Smed, Trainee Tel Mob