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European Market Infrastructure Regulation (EMIR) – Making sweeping changes in post-trade settlement

Published on December 20, 2017 by Ramesh Tunga

Overview

European Market Infrastructure Regulation (EMIR), a regulation that came into force on August 16, 2012, is designed to increase stability of over-the-counter (OTC) derivatives markets in EU states by increasing transparency and reducing counterparty risk.

In November 2011, G20 leaders met in Cannes and agreed that international standards on margining for non-centrally cleared OTC derivatives should be developed. The EMIR is the mechanism through which the EU is implementing this commitment, in phases. Some parts have already been implemented, while others will not be fully implemented until 2020.

Derivatives play an important role in an economy but are associated with risks. The EMIR establishes common organizational, conduct-of-business and prudential standards for central counterparties (CCPs) and trade repositories (TRs). While the EMIR’s provisions relate to OTC derivatives, CCPs and TRs, the regulation also imposes requirements on all types and sizes of entities that enter into derivative contracts, including entities not involved in financial services. It applies indirectly to non-EU firms trading with EU firms. In summary, the regulation requires that entities that enter any form of derivative contract, including interest rate, foreign exchange, equity, credit and commodity derivative contracts

1. Report every derivative contract that they enter to a TR

2. Implement new risk management standards, including operational processes and margining for OTC derivatives

3. Clear transactions through a CCP for those OTC derivatives that are subject to mandatory clearing obligations

Areas affected

OTC market: Dealers act as market makers by quoting prices at which they will buy or sell a security or currency. A trade can be executed between two parties in an OTC market, without others being aware of the price at which the transaction was effected. OTC markets can therefore be less transparent than exchanges and are subject to fewer regulations.

A CCP is a financial institution that acts as an intermediary between securities-market participants. This reduces the amount of counterparty risk that market participants are exposed to. An obvious benefit of operating in such an environment is that if a market participant has filled up its credit lines with a trading firm using a CCP, it no longer has a large number of transactions with that firm. Instead, it has a large number of transactions with the CCP and a clear credit line with the trading firm, allowing the participant to write more business without a likelihood of default.

TRs are central data centers that collect and maintain records of derivatives. They play a key role in enhancing the transparency of derivatives markets and in reducing risks to financial stability.

Goals

Enhancing transparency: The EMIR requires that detailed information on each derivative contract be reported to TRs and be made available to supervisory authorities. TRs, in turn, are required to subsequently publish aggregate positions by class of derivatives, for both OTC and listed derivatives. The European Securities and Markets Authority (ESMA) is responsible for surveillance of TRs and for granting and withdrawing accreditation.

Mitigating credit risk: The EMIR aims to reduce counterparty credit risk of derivative contracts. In particular, all standardized OTC derivative contracts must be centrally cleared through CCPs. If a contract is not cleared by a CCP, risk-mitigation techniques must be applied. CCPs must comply with stringent prudential, organizational and conduct-of-business requirements.

Reducing operational risk: The regulation also requires that market participants monitor and mitigate operational risks associated with derivatives trade, such as fraud and human error, for example, by using electronic means to promptly confirm terms of OTC derivative contracts.

Obligations for companies

Reporting obligation: The EMIR requires that all counterparties with outstanding derivative contracts report details of such contracts and any new contracts they enter to an authorized TR.

Clearing obligation: Contracts that financial counterparties do not clear through a CCP will also be subject to bilateral collateral requirements. Non-financial counterparties will be subject to clearing and bilateral collateral requirements only if their OTC derivatives positions are above a certain threshold and do not directly reduce commercial risks or are not related to treasury financing activity. Counterparties may fulfil this obligation by becoming a direct clearing member of a CCP or a client of a clearing member, or indirectly through a clearing member.

Risk management obligation: The ESMA can require counterparties to clear OTC derivative contracts of a particular type once a CCP has been authorized under the EMIR to handle that type of contract. For contracts that are not cleared, all counterparties are required to comply with operational risk management requirements (including timely confirmation, valuation, reconciliation, compression and dispute resolution). These primary requirements apply to the operational aspects of derivatives – those events that occur after a transaction is entered into. They do not apply to pre-trade activities, marketing, advice or sales.

EMIR review and expected changes

After reviewing the EMIR, the European Commission proposed a set of amendments in mid-2017, including the following:

Reducing costs for and burdens on market participants: Introducing simpler and proportionate rules on OTC derivatives that will reduce costs for and burdens on market participants, without compromising financial stability of the market or economy.

CCP: Introducing measures for more integrated supervision and enhanced responsibilities for central banks relating to financial market infrastructure and market participants at the EU level, to support development of deeper and better-integrated capital markets across the EU.

How Acuity Knowledge Partners can help

Acuity Knowledge Partners has strong capability in terms of domain and technology expertise to help clients build strong processes to adhere to the new regulation. Our solid competencies in risk management, compliance, data management, portfolio operations, securities settlement and reporting will assist clients to be fully compliant with the regulation and reduce costs associated with its implementation.

Recommended reading:

https://ec.europa.eu/info/business-economy-euro/banking-and-finance/financial-markets/post-trade-services/derivatives-emir_en

Bibliography:

https://ec.europa.eu
https://www.cisi.org
http://gdprcoalition.ie/
https://ico.org.uk/


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About the Author

Assistant Director, Quantitative Services

Ramesh heads Data Management services at Acuity Knowledge Partners, responsible for driving projects on data collection, cleansing, maintenance, analytics and visualization to help asset managers and banks form informed business insights. He has rich experience across different asset classes and multiple service lines, including operations, market research, data analytics, and financial services.

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