EMIR: full steam ahead
07 January 2014
Rule Financial’s Emily Cates takes a look at the progress of European Market Infrastructure Regulation compliance programmes and implementation
Image: Shutterstock
The European Markets Infrastructure Regulation (EMIR) rules governing trade reporting came in to force on 23 February 2013. Eleven months on, what are the current delivery timeframes for compliance initiatives and how are firms and institutions responding to the implementation of the legislation?
Trade reporting
Trade reporting obligations were originally expected to be enforceable from 1 July for credit and rates and 1 January for foreign exchange (FX) and equities. However, due to delays in the approval of trade repositories by the European Securities and Markets Association (ESMA), the mandatory reporting requirement for all trades is now set for February. There has also been much confusion with regards to the products that are classified as a derivative trade under EMIR and therefore fall within its scope. For example, FX spot transactions have been confirmed as out of scope by the UK Financial Conduct Authority (FCA) (in line with the Markets in Financial Instruments Directive, or MiFID), although any type of FX forward remains within scope.
To further complicate matters, ESMA’s recommendation to delay exchange-traded derivatives (ETD) reporting due to a lack of clarity in the marketplace was rejected by the EU Commission. It was initially anticipated that ETD transactions would not need to be reported until 2015. This revelation has proved troublesome for those firms that have deferred the implementation of an ETD trade reporting solution.
A number of aspects of the trade reporting mandate are currently proving difficult to implement. Foremost among these is the creation of a unique transaction identifier (UTI), which both counterparties will need to use in order to identify the trade with a trade repository. Deciding which counterparty will need to generate the UTI, and then determining how best to exchange, consume, track and maintain it over the life of a derivative transaction, are just some of the IT headaches currently being experienced.
Allied to this issue is the task of back-loading. ESMA has stipulated that all trades that were live between 12 August 2012 and the go-live date need to be back-loaded to the chosen trade repository. This is not a trivial task and as the need for an agreed UTI is thrown into the mix, it is causing many an operational headache.
Reconciliation and dispute resolution
EMIR business conduct rules were enforceable from 15 September 2013, and dictate that all institutions (financial and non-financial) have in place processes and procedures for confirmation matching and escalation, portfolio reconciliation and escalation, portfolio compression, mark-to-market models, and inter-group transactions. Many of the processes for meeting these requirements are still extremely manually intensive and, although there are a plethora of third-party vendors offering services in this space, many are still in their infancy. For this reason, a number of firms have not made decisions on whether to implement third-party solutions.
The initial challenge faced by firms striving to comply with the business conduct rules is the need to amend existing legal documentation so that it incorporates the operating procedures for the new requirements. This can either be achieved through contract re-negotiation or by implementing the International Swaps and Derivatives Association (ISDA) 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure protocol. The protocol requires that active resolution of disputes is achieved within five business days, and some derivative operations departments have stated that they will need to increase their department’s dispute resolution resources significantly in order to accommodate this new regime.
Many institutions are behind the curve in this area, having devoted a large proportion of their compliance efforts to meeting the trade reporting mandate. Although it is anticipated that authorities will initially be reasonably lenient with firms that are not fully compliant, it’s only a matter of time before regulators will have to start enforcing the rules in order to hit home the point.
All on board?
Central counterparties (CCPs) all over the world are applying to ESMA for recognition under EMIR. This is because in order to continue offering services to EU members and their subsidiaries without inflicting a 2 percent risk weighting on their transactions, CCPs will need to be EMIR compliant. Although 29 non-EU CCPs have already applied, the prevailing view is that this is not enough, as many non-EU CPPs are not fully aware of the implications of not being a qualifying central counterparty (QCCP). From 15 September 2013 (which was the CCP application deadline),
ESMA has six months to approve CCPs for QCCP status. The earliest a CCP could be approved was 15 September 2013 and the latest is 15 March. ESMA will then take a further six months to publish the technical standards for the clearing obligation.
At some point between April and September, QCCPs will start to launch central clearing for OTC products that have not been cleared before. It remains to be seen whether there will be a front loading rush of CCPs wanting to be first to market. However, it is important to keep in mind that ESMA also needs to deliver a public register for the CCPs—this will then inform wider industry activity, which will then trigger on-boarding, etc.
For CCPs, the process of launching a new product is highly complex as they will have to develop standardised pricing models, back testing, and ‘what if’ scenarios, and fully test the product in Beta test environments before launch. The participants that are then obliged to clear the product through a CCP will need to decide which CCP to use (if there are more than one), agree the pricing models, standardise the confirmations, and accept the margining terms. It’s a resource-hungry process for all involved (the exchange, CCP and participant) and the concern is that volume capacity will be reduced by the added impetus of imposing a clearing obligation deadline on the participants.
There is also the possibility that while some participants will meet the clearing obligation threshold and will be forced to trade OTC, others will not and will therefore be able to continue to bilaterally trade the same product that those meeting the threshold will have to clear. This could lead to pricing arbitrage opportunities where a clearer may use a different pricing model compared to two bilateral counterparties.
Parking your collateral
Once the initial trade reporting deadline in February 2014 has been met, firms have six months to report the collateral associated with those initial transactions, and will need to report any collateral changes thereafter on an ongoing basis; this can be done either at a portfolio level or an individual trade level.
Because most participants are focusing on the 86 fields of information required for day one reporting, few are considering the longer-term collateral reporting requirements. In many institutions, the collateral management systems are independent from the OTC and ETD trading/back-office systems and the collateral associated with each is not directly linked. In the same way that UTI generation, exchange, mapping, and tracking are causing problems in the world of trade reporting, the linking and tracking of collateral baskets to UTIs or portfolios will create challenges for collateral management and the trading/back-office systems.
The inclusion of collateral as part of the broader trade reporting mandate is intended to ensure transparency around client portability and risk mitigation in the event of a default. Most custodians and general clearing members are still formulating their client segregation models and are currently looking to offer three to four different options depending on the client’s requirements. Despite wanting to keep their primary assets with their preferred custodians, many firms will be prohibited from doing so by an ESMA directive that stipulates that CCPs must keep collateral with custodians that have a recognised securities settlement system.
Understandably, custodians are now considering the huge business impact of not becoming a recognised securities settlement system, with many exploring the option of partnering with recognised securities settlement systems in order to satisfy the criteria. Others are considering white label arrangements with securities settlement systems. All of the above considerations need to be made in a developing landscape of quad party arrangements and TARGET2-Securities, which are gradually harmonising the securities settlement systems landscape.
En route
With the impending regulatory deadlines and the need to show compliance with EMIR, most firms are speeding along the road to compliance. However, it’s clear that CCPs, custodians and other major infrastructure service providers, which have arguably faced the most formidable of regulatory challenges, have some catching up to do if they are to get their compliance initiatives across the finish line before the deadlines hit. They will be the ones that have the most to gain or lose in the race to comply and, although they may have gotten off to a slow and uncertain start, they are beginning to gather pace. Some uncertainty remains, but most firms are at least en route to regulatory compliance
Trade reporting
Trade reporting obligations were originally expected to be enforceable from 1 July for credit and rates and 1 January for foreign exchange (FX) and equities. However, due to delays in the approval of trade repositories by the European Securities and Markets Association (ESMA), the mandatory reporting requirement for all trades is now set for February. There has also been much confusion with regards to the products that are classified as a derivative trade under EMIR and therefore fall within its scope. For example, FX spot transactions have been confirmed as out of scope by the UK Financial Conduct Authority (FCA) (in line with the Markets in Financial Instruments Directive, or MiFID), although any type of FX forward remains within scope.
To further complicate matters, ESMA’s recommendation to delay exchange-traded derivatives (ETD) reporting due to a lack of clarity in the marketplace was rejected by the EU Commission. It was initially anticipated that ETD transactions would not need to be reported until 2015. This revelation has proved troublesome for those firms that have deferred the implementation of an ETD trade reporting solution.
A number of aspects of the trade reporting mandate are currently proving difficult to implement. Foremost among these is the creation of a unique transaction identifier (UTI), which both counterparties will need to use in order to identify the trade with a trade repository. Deciding which counterparty will need to generate the UTI, and then determining how best to exchange, consume, track and maintain it over the life of a derivative transaction, are just some of the IT headaches currently being experienced.
Allied to this issue is the task of back-loading. ESMA has stipulated that all trades that were live between 12 August 2012 and the go-live date need to be back-loaded to the chosen trade repository. This is not a trivial task and as the need for an agreed UTI is thrown into the mix, it is causing many an operational headache.
Reconciliation and dispute resolution
EMIR business conduct rules were enforceable from 15 September 2013, and dictate that all institutions (financial and non-financial) have in place processes and procedures for confirmation matching and escalation, portfolio reconciliation and escalation, portfolio compression, mark-to-market models, and inter-group transactions. Many of the processes for meeting these requirements are still extremely manually intensive and, although there are a plethora of third-party vendors offering services in this space, many are still in their infancy. For this reason, a number of firms have not made decisions on whether to implement third-party solutions.
The initial challenge faced by firms striving to comply with the business conduct rules is the need to amend existing legal documentation so that it incorporates the operating procedures for the new requirements. This can either be achieved through contract re-negotiation or by implementing the International Swaps and Derivatives Association (ISDA) 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure protocol. The protocol requires that active resolution of disputes is achieved within five business days, and some derivative operations departments have stated that they will need to increase their department’s dispute resolution resources significantly in order to accommodate this new regime.
Many institutions are behind the curve in this area, having devoted a large proportion of their compliance efforts to meeting the trade reporting mandate. Although it is anticipated that authorities will initially be reasonably lenient with firms that are not fully compliant, it’s only a matter of time before regulators will have to start enforcing the rules in order to hit home the point.
All on board?
Central counterparties (CCPs) all over the world are applying to ESMA for recognition under EMIR. This is because in order to continue offering services to EU members and their subsidiaries without inflicting a 2 percent risk weighting on their transactions, CCPs will need to be EMIR compliant. Although 29 non-EU CCPs have already applied, the prevailing view is that this is not enough, as many non-EU CPPs are not fully aware of the implications of not being a qualifying central counterparty (QCCP). From 15 September 2013 (which was the CCP application deadline),
ESMA has six months to approve CCPs for QCCP status. The earliest a CCP could be approved was 15 September 2013 and the latest is 15 March. ESMA will then take a further six months to publish the technical standards for the clearing obligation.
At some point between April and September, QCCPs will start to launch central clearing for OTC products that have not been cleared before. It remains to be seen whether there will be a front loading rush of CCPs wanting to be first to market. However, it is important to keep in mind that ESMA also needs to deliver a public register for the CCPs—this will then inform wider industry activity, which will then trigger on-boarding, etc.
For CCPs, the process of launching a new product is highly complex as they will have to develop standardised pricing models, back testing, and ‘what if’ scenarios, and fully test the product in Beta test environments before launch. The participants that are then obliged to clear the product through a CCP will need to decide which CCP to use (if there are more than one), agree the pricing models, standardise the confirmations, and accept the margining terms. It’s a resource-hungry process for all involved (the exchange, CCP and participant) and the concern is that volume capacity will be reduced by the added impetus of imposing a clearing obligation deadline on the participants.
There is also the possibility that while some participants will meet the clearing obligation threshold and will be forced to trade OTC, others will not and will therefore be able to continue to bilaterally trade the same product that those meeting the threshold will have to clear. This could lead to pricing arbitrage opportunities where a clearer may use a different pricing model compared to two bilateral counterparties.
Parking your collateral
Once the initial trade reporting deadline in February 2014 has been met, firms have six months to report the collateral associated with those initial transactions, and will need to report any collateral changes thereafter on an ongoing basis; this can be done either at a portfolio level or an individual trade level.
Because most participants are focusing on the 86 fields of information required for day one reporting, few are considering the longer-term collateral reporting requirements. In many institutions, the collateral management systems are independent from the OTC and ETD trading/back-office systems and the collateral associated with each is not directly linked. In the same way that UTI generation, exchange, mapping, and tracking are causing problems in the world of trade reporting, the linking and tracking of collateral baskets to UTIs or portfolios will create challenges for collateral management and the trading/back-office systems.
The inclusion of collateral as part of the broader trade reporting mandate is intended to ensure transparency around client portability and risk mitigation in the event of a default. Most custodians and general clearing members are still formulating their client segregation models and are currently looking to offer three to four different options depending on the client’s requirements. Despite wanting to keep their primary assets with their preferred custodians, many firms will be prohibited from doing so by an ESMA directive that stipulates that CCPs must keep collateral with custodians that have a recognised securities settlement system.
Understandably, custodians are now considering the huge business impact of not becoming a recognised securities settlement system, with many exploring the option of partnering with recognised securities settlement systems in order to satisfy the criteria. Others are considering white label arrangements with securities settlement systems. All of the above considerations need to be made in a developing landscape of quad party arrangements and TARGET2-Securities, which are gradually harmonising the securities settlement systems landscape.
En route
With the impending regulatory deadlines and the need to show compliance with EMIR, most firms are speeding along the road to compliance. However, it’s clear that CCPs, custodians and other major infrastructure service providers, which have arguably faced the most formidable of regulatory challenges, have some catching up to do if they are to get their compliance initiatives across the finish line before the deadlines hit. They will be the ones that have the most to gain or lose in the race to comply and, although they may have gotten off to a slow and uncertain start, they are beginning to gather pace. Some uncertainty remains, but most firms are at least en route to regulatory compliance
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