challenges for non-financial counterparties in the european union

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1 CALCULATING THE CLEARING THRESHOLD: challenges for non-financial counterparties in the european union While EMIR mandates clearing and reporting requirements on over-the-counter (OTC) derivatives for Financial Counterparties (FCs), it exempts Non-Financial Counterparties (NFCs) from parts of reporting and clearing requirements only until their positions in proprietary trades remain within a pre-defined clearing threshold (defined for each asset class by ESMA). In order to avoid the infrastructure and process costs for the increased EMIR reporting and risk management responsibilities, every NFC has to closely monitor its vulnerability to breach the mandated clearing threshold. For many, however, this is no small task. In this article, Mahima Gupta and Shashin Mishra review the challenges involved for all participants and the next steps for the industry as well as regulators needed to maintain the integrity of the clearing threshold rule. CALCULATING THE CLEARING THRESHOLD: CHALLENGES FOR THE EU NFCs & REGULATORS In the aftermath of the 2008 global crisis, the G20 summit acknowledged the need for better management and oversight of financial market players across geographies. The European Market Infrastructure Regulation (EMIR) was introduced to monitor and reduce systemic risk in the European Union s (EU) financial ecosystem. While it mandates clearing and reporting requirements on over-the-counter (OTC) derivatives for Financial Counterparties (FCs), it exempts Non-Financial Counterparties (NFCs) from parts of reporting and clearing requirements because they trade in derivatives mainly for hedging purposes in order to mitigate the risks from their core businesses. However, this exemption applies only until the gross nominal notional for their uncleared positions in proprietary trades remains within a pre-defined threshold, or clearing threshold, as defined for each asset class by the European Securities and Markets Authority (ESMA). Once this clearing threshold is breached for any asset class, the NFC is then classified as NFC+. Under this designation, the firm faces increased reporting (transaction, valuation and collateral) and clearing mandates along with risk management procedures (e.g., internal marking-to-market of OTC trades), until it falls back within the threshold for all asset classes. 12

2 ASSET CLASS Credit derivative contracts Equity derivative contracts Interest rate derivative contracts Foreign exchange derivative contracts Commodity derivative contracts and others VALUE OF THE CLEARING THRESHOLDS EUR 1 billion EUR 1 billion EUR 3 billion EUR 3 billion EUR 3 billion Figure 1. Value of the clearing thresholds, in gross notional value, for different asset classes As a result, every NFC has to closely monitor its vulnerability to breach the mandated clearing threshold, in order to avoid the infrastructure and process costs associated with increased EMIR reporting and risk management responsibilities. While the clearing threshold for each asset class appears to be an easy target to benchmark against, the mere calculation of one s own OTC positions can be challenging due to the lack of industry consensus or standards and lack of appropriate guidance from regulators. Key challenges involved in calculating the gross nominal notional are analyzed below. IDENTIFICATION OF A HEDGE TRADE VERSUS A PROPRIETARY TRADE According to ESMA s rules, the clearing threshold must be monitored against the gross notional value of proprietary trades, excluding the hedge transactions from calculations. The idea is to collate and monitor the risk amassed by speculative trading, in addition to that incurred by business as usual (BAU). A hedge trade can be classified as offsetting risk from a particular business trade or a portfolio. Trades by a single legal entity can also be considered eligible hedge trades to mitigate the risk at a group level for all associated entities, termed as a macro hedge. For example, an energy producer may enter hedge trades on a macro or portfolio basis to mitigate the risks associated with fuel requirements, CO2 emission allowances, etc., on behalf of its group s upstream oil and gas business. The hedging may also be done to optimize market conditions, keep the firm active in the derivatives markets, avoid becoming vulnerable to biased pricing and/or contribute to the liquidity of relatively illiquid markets. Thus, when looked at individually, it is difficult to establish the intent of a derivative transaction as risk reducing or a hedge. The criteria to qualify as a hedge transaction, being subjective in most cases, cannot be standardized and configured in trade booking or processing systems so as to mark a trade hedge or proprietary. Sorting through deals manually in order to assess their categorization is cost and effort intensive without the guarantee of accuracy. NFCs can use a value at risk (VaR) method to confirm that the aggregated effect of their derivative portfolio is risk reducing. But, this can amount to placing any loss-making speculative position under the hedge category, given that the notional value of the propriety portfolio has to be calculated as gross. The benefits of remaining an NFC clearly outweigh the costs of upgrading to NFC+ or more, adding to the lure of justifying non-candidate trades to the hedge category. Keeping the regulatory aspect aside, being able to segregate speculative trades from the BAU and hedge trades will help any firm assess and manage their trading risk and operations much more efficiently. Even if implemented at the behest of ESMA, both FCs and NFCs should strive to achieve this as and when the challenges are resolved by the industry and/or by employing one or more of these interim approaches: CROSSINGS: The Sapient Journal of Trading & Risk Management 13

3 Maintaining the hedged positions at a portfolio or macro level. This is much easier than explaining it at a transaction level, and it is more efficient to manage the risk within the hedge positions at a portfolio level. However, this can provide a qualified mask for proprietary trading as the intent is not recorded. Regulators will have a tough time verifying and segregating real hedge trades from the grouped and masked ones. Conversely, it will be difficult for market participants to justify the hedge trades and portfolios, if challenged. Identifying the hedging trades. This should be relatively easy for the firms whose treasury performs the hedging function (in addition to financing activities) for their commercial activity risk. Here, the positions taken by the treasury can comfortably be termed hedging activity and any proprietary position is easily segregated, since it mainly requires a separate mandate or string of sign-offs. Assigning the task of risk management to a single entity within the group. This will help gain hedging efficiency as well as make the identification easier than if hedging was to be done by each individual entity for itself. However, if the hedging and business entities fall out of sync, there could be a situation where the hedged position remains while the initiating proprietary/business position may have already matured, leading to reverse market risk. Segregating hedge trading desks from the proprietary trading desks. This helps to keep a resolute yet independent tab on the two activities. The risk here is similar to the above approach. CALCULATION OF THE NOTIONAL VALUE OF TRANSACTIONS volumes for multi-legged trades such as swaption straddle. Some swap execution facilities (SEFs) are said to be counting both the receiver and payer legs of a swaption straddle and report double the volumes as compared to SEFs who are counting only a single leg in a transaction. It is left to the potential SEF user to determine whether the SEF is double counting or not. Similar issues will be faced by the market participants while calculating the notional values of such trades in their books. Currently, regulators are not offering guidelines on how they will monitor this calculation methodology but, until that is achieved, the implementation can be done to benefit the business or reporting interests of the implementing entity. Similarly, for a strip of options, should firms consider all legs for the notional value calculation or the active and eligible leg at that point in time? In other words, should the notional be calculated as per {notional per fixing} or {notional x number of fixings}? Should the notional be calculated on a commodity physical leg using the market rate for the underlying commodity or the strike rate? These are some questions that risk management professionals have been deliberating without agreeing upon an industry-wide approach. Without a standard approach, market participants will develop custom implementations to suit their profile and needs, which the regulators will find difficult to corroborate or benchmark amongst the reporting entities. Until the time a firm guideline is released by regulators or an industry body such as ISDA, participants have only two alternatives to continue to practice their present notional calculation methodology or to revisit all such contracts and alter their notional calculations to optimize their regulatory profile. There are many structured products already under debate across the industry for their notional value calculation methodology, with no resolution as of yet. A key example is the market split on reporting 14

4 Firms that are revisiting their contracts should consider the following: Revisiting would require extensive analysis to first gauge the benefits that such an alteration exercise may gain. If this does not designate them as an NFC, in the foreseeable future, they may be better off not embarking on this journey. Review of the notional calculations methodology should be viewed in conjunction with the impact on other parameters, such as net PnL or risk calculations on such structures. It would impact both commercial risk and hedge portfolios because the notional value calculation methodology must be the same for each of them. Hence, firms should take a long-term view of the kind of structures to be booked under each category. Firms that continue with their existing practice should consider the following: Participants can assert that they continued with their BAU practice and did not alter their methodology or were not influenced by regulatory needs and earn credibility with regulators. It would also save the company any operational and infrastructure costs that would have been used for an alternative implementation. However, following the approach of continuing as-is may not result in the most optimal regulatory profile. APPLYING THE NETTING RULES While netting is allowed at the counterparty level for Clearing Threshold calculations under EMIR, certain non- EU jurisdictions, such as Qatar, do not acknowledge Credit Support Annex (CSA) and, thus, do not allow netting. In such scenarios, BASEL reporting of credit risk positions against those counterparties will be out of sync with the notional value of positions reporting for EMIR. The application of netting rules can also cause risk management conflicts within the financial entity. If senior management cannot gauge the correct representation to work with, they may need to enhance their risk systems in order to mine and report the same position data but reflect for different regulators to monitor and manage. COUNTING THE INTER-AFFILIATE TRADES The Clearing Threshold calculation requirements include inter-affiliate trades. However, since the threshold is determined on a group level instead of being calculated separately for each legal entity within the group, there are calls from industry standard groups, such as ISDA and SIFMA, to change the requirements. Intra group transactions are not a good indicator of the overall systemic risk and hence should not be used for the group level gross notional calculation. CROSSINGS: The Sapient Journal of Trading & Risk Management 15

5 CLEARED FUTURE CONTRACTS ON NON-EU EXCHANGES ARE CATEGORIZED AS OTC BY ESMA According to ESMA guidelines, any exchange-traded derivatives contract executed on a non-eu exchange that is not recognized as equivalent to a European regulated market is defined as an OTC derivative. This means that such trades would add to the notional value for Clearing Threshold calculations. Since the Clearing Threshold limit for each asset class is already deemed conservative by industry participants, it further increases the potential for breaching the threshold limit. As a consequence, firms trading on non-eu exchanges are at greater risk of crossing the Clearing Threshold and becoming NFC+. They will have to then report these trades as OTC for EMIR along with the valuation and collateral information. Plus, they will have to adhere to the central clearing mandate under EMIR. The resulting influence on the geographic distribution of exchange-traded derivatives (ETD) trading is already making an impact. Firms are moving away from energy ETDs on US exchanges as demonstrated by the reported significant drop (up to 22% in monthly volumes) in CME s energy futures volumes, immediately after ESMA s clarification in August The volumes dropped even further and continued to do so until June In comparison, volumes traded at ICE Futures Europe, where the futures executed do not count towards the NFC+ calculation, have risen over the same period and to almost the same extent as the drop in CME s business. 1 The whole cross-border situation presents a challenge to reporting firms as well as exchanges, not to mention the liquidity impact it would have on certain geographies. Ideally, and as per the G20 commitment, regulators are meant to work together to increase efficiencies, reduce duplication in reporting and improve risk management. While it has not been called out anywhere, the tacit expectation from the participants was to have reporting obligations along with some adjustments to their business mix and mandates. Still, very few would have anticipated a resulting geographic shift in businesses and a consequence of cannibalization of each other s markets. CONCLUSION ESMA guidance on the Clearing Threshold calculation for moving from NFC to NFC+ status is still too complicated and ambiguous. Not only is there a lack of guidance from regulators, industry consensus is also missing. Until there is clear guidance, affected industry participants should come together as a working group to agree upon some guidelines which will help them avoid future implementation costs. Market participants too would need to be agile in adapting to the changing business mandates and market scenarios while striving to maintain an optimal and sustainable long-term regulatory risk profile. And even without EMIR requirements, any financial firm would benefit from being able to differentiate between a proprietary and hedge trade. The issues that are covered in this article not only indicate an impending implementation challenge for the reporting market participants, they also highlight the roadblocks facing regulators as they try to enforce a standardized reporting approach. Unfortunately, existing gaps and ambiguity in implementation specifics can be manipulated by the reporting entities to stay below the reporting and risk management radar which defeats the very purpose of correctly identifying and monitoring systemic risk in the financial markets. 16

6 Resources EFET. (n.d.). EFET feedback on the macro-portfolio approach Retrieved from Cms_Data/Contents/EFET/Folders/Documents/ MembersSection/OtherGrps/TFMarketSup/ PubPosPapers/~contents/BUL2RHPXHKFX358E/ EFET_Macro-Portfolio-Hedging_ pdf EMIR ATE. (n.d.). Clearing Threshold Calculations. Retrieved from items/clearing-threshold-calculations.html ESMA. (n.d.). Non-Financial Counterparties. Retrieved from ESMA Official Site: eu/page/non-financial-counterparties-0 FCA. (n.d.). Non-financial counterparties subject to EMIR. Retrieved from static/documents/factsheets/non-financialcounterparties-factsheet.pdf ISDA & SIFMA. (n.d.). ISDA & SIFMA comments to multiple agencies in response to draft rts on risk mitigation. Retrieved from comment-letters/2014/sifma-isda-submitscomments-to-multiple-agencies-in-response-todraft-rts-on-risk-mitigation-techniques-for-otcderivative-contracts-not-cleared-by-a-ccp Netherlands Authority For the Financial Markets. (n.d.). The main consequences and obligations for financial institutions. Retrieved from nl/en/professionals/regelgeving/european/emir/ gevolgen-financiele-instellingen.aspx THE AUTHORS Mahima Gupta is a Senior Manager with the Solutions team at Sapient Global Markets. She is involved in the product management of multiple solutions, including the Compliance Management & Reporting System (CMRS). She has over 11 years of experience in traded risk management, regulatory reporting and business consulting in the global capital markets. She is currently based in Gurgaon and is focused on various regulatory change initiatives unraveling in the US, Europe and APAC. mgupta4@sapient.com Shashin Mishra is a London-based Senior Manager with the Solutions team at Sapient Global Markets. Currently, he is the Product Manager for the Portfolio Reconciliation product and leads client services for the CMRS solutions in the UK and EU. Previously, Shashin has led CMRS solution implementations for supporting Dodd-Frank and EMIR requirements and has over 8 years of product management experience across industries. smishra2@sapient.com Risk.net. (n.d.). Tradition and Tullett Prebon draw fire in sef volumes flap. Retrieved from net/risk-magazine/news/ /tradition-andtullett-prebon-draw-fire-in-sef-volumes-flap References 1. Risk.net. (n.d.). ESMA derivatives definition hits cme futures volumes. Retrieved from risk-magazine/news/ /esma-derivativesdefinition-hits-cme-futures-volumes CROSSINGS: The Sapient Journal of Trading & Risk Management 17