OTC Derivative Market Regulation: Challenges for Corporates

by Sven Walterscheidt, Senior Manager, Corporate Treasury Solutions, PwC (Germany) and Erwin Bastianen, Senior Consultant, Corporate Treasury Solutions, PwC (the Netherlands)

When the credit crisis was evaluated during the G20-summit in Pittsburgh in September 2009, the over-the-counter (OTC) derivative market was flagged as one of the main causes. For this reason, the Dodd-Frank Act (DFA) in the United States and the European Market Infrastructure Regulation (EMIR) in the European Union were developed. Although the regulations were mainly focused on the systemic risks caused by financial parties, non-financial parties are also impacted. The new OTC derivatives regulation will change the handling of derivatives fundamentally and will pose new challenges for treasury departments. With the publication of an important part of the technical standards on February 23 2013, EMIR started to have its first implications on treasury operations on March 15 2013.

Scope and objectives

EMIR is already in force
The regulation EMIR came into force on August 16 2012, while an important part of the technical standards has come into force on March 15 2013. The reduction of counterparty risk, the reduction of operational risk and the increase of transparency in the OTC derivative market are the three main objectives pursued by EMIR.

EMIR poses challenges on every organisational level.

EMIR makes a clear distinction between financial and non-financial counterparties. Financial counterparties do not only include banks and insurance companies, but also for example investment firms authorised in accordance with the Markets in Financial Instruments Directive (MiFID). EMIR is applicable to all OTC derivative transactions in which at least one of the counterparties is established in the European Union. In the case that an OTC derivative is concluded between an entity in Luxembourg and an entity in New York, the derivative is subject to both the European regulation (EMIR) and the American regulation (DFA). For such derivatives, the recognition of third-country institutions could be a solution.

Reduction of counterparty risk
To reduce the counterparty risk, EMIR establishes Central Counterparties (CCPs). These CCPs will effectively be the new counterparty in an OTC derivative contract to both original counterparties. A CCP will also organise the valuation of the derivative contract and the resulting clearing (the exchange of collateral, often cash, also known as margin requirements). If there is no CCP authorised to clear a certain class of derivatives, then the original parties in the contract have to impose bilateral margin requirements. The exact requirements for this bilateral margining are not known yet, but will be in line with the global standards as drafted by BCBS-IOSCO.

Clearing will be mandatory for all financial counterparties. A non-financial counterparty only needs to clear its derivative position when its total gross derivative position per class of derivative exceeds the preset thresholds. The position is calculated on a group wide basis, so internal derivatives have to be included in the calculation. The derivative position is calculated as rolling average over 30 working days. The thresholds are set on these levels:

• Equity derivatives € 1bn
• Credit derivatives € 1bn
• Interest rate derivatives € 3bn
• Foreign exchange derivatives € 3bn
• Commodity and other derivatives € 3bn

When the threshold on one type of derivatives is breached, all other derivative classes need to be cleared as well.

Derivatives, which are held by non-financial counterparties and are used for hedging purposes, are excluded when the derivative positions are evaluated against the clearing thresholds. EMIR describes these hedging purposes as “OTC derivative contracts… which are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity”. The OTC derivative is objectively reducing risks if one of the following criteria is met:

• It covers the risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the ordinary course of business;
• It covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to above, resulting from fluctuation of interest rates, inflation rates or foreign exchange rates;
• It qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS).

Intragroup derivatives are derivatives which are subject to the same consolidation and a centralised risk management. Regarding these derivatives, an exemption of the clearing obligation can be claimed. This notification should be filed in writing to the competent authorities, meaning the competent authorities in the countries of both relevant entities. These competent authorities have a period of 30 days to object to this request and otherwise the exemption is in force.

The aforementioned requirements imply that NFCs that are likely to exceed the clearing threshold and want to remain active in the OTC derivative market need to either become a clearing member or direct or indirect client of a clearing member. This means respectively direct or indirect access to a CCP. A clearing member is a direct client of a CCP and therefore also plays a role in the continuance of a CCP. For most NFCs the advantages of becoming a clearing member will not outweigh the costs and therefore they should become client of such clearing member to have access to a CCP.[[[PAGE]]]

Reduction of operational risk
Operational risk refers mainly to transaction risks and risk management processes. By imposing minimum requirements in these areas, ESMA expects to increase efficiency and security in the OTC derivative market. EMIR states that risk management procedures of counterparties need to be robust, resilient and auditable.

An OTC derivative needs to be timely confirmed, where available via electronic means, to the counterparty if the derivative is not subject to central clearing. The deadlines for these confirmations differ between financial and non-financial counterparties and between types of derivatives. Above that, the deadlines will become stricter over the coming years. In the first period, the confirmation deadline will be between five and seven days, depending on the type of derivative. For NFCs exempted from the clearing obligation, these deadlines will be reduced to two days over the coming years. For derivatives traded after 16.00 local time or with a counterparty in another time zone, the deadlines are extended by one day.

Another important requirement for the reduction of operational risk is the periodic portfolio reconciliation for derivatives which are not centrally cleared. On such moments the counterparties need to reconcile all critical terms of the derivative contracts including their valuations. The frequency of this reconciliation depends on the number of transactions with each individual counterparty.

Other required risk-mitigation techniques relate to portfolio compression, dispute resolution and the monitoring of the value of outstanding contracts. The latter, however, is only applicable to financial counterparties and non-financial counterparties above the threshold.

Increase in transparency
An inherent limitation of OTC derivatives is the lack of transparency, as an OTC derivative is not traded on an exchange but agreed upon bilaterally between counterparties. The OTC derivative market grew exponentially over the last decades and supervisors did not have any idea on the positions of certain market participants. By increasing transparency the regulator can identify systemic risks earlier.

To increase the transparency of the OTC derivatives market, all counterparties are obliged to report their derivative portfolios to a so-called Trade Repository (TR). The reporting obligation is applicable to all counterparties and therefore no distinction is made between financial and non-financial counterparties. It is important to note that the reporting obligation is applicable to all derivative contracts, so also the derivative contracts traded on an exchange.

Above that, it is remarkable that intragroup derivatives are not exempted from this reporting obligation. Therefore all financial and non-financial counterparties are obliged to also report their intragroup derivatives.

Current impact

On March 15 2013 the technical standards came into force, which implies that EMIR has its first impact on treasury operations. Although no CCPs or TRs are registered yet, some obligations are already applicable to both financial and non-financial counterparties. Since March 15, a non-financial counterparty is obliged to:

• Notify the national competent authority and the ESMA in case the clearing threshold is exceeded (Art. 10(1)(a));
• Apply the appropriate confirmation deadlines per derivative class. These deadlines depend on the fact whether you exceed the clearing threshold or not.

Challenges

Although EMIR is focusing on the financial players in the OTC derivative market, the non-financial users of OTC derivatives will feel the impact as well. The treasury organisation will be impacted on all possible levels. In the remainder we would like to outline the challenges that treasury will face as a result of the EMIR implementation.[[[PAGE]]]

Strategic

• The treasury policy should be made EMIR compliant, with referral to the regulation or clearly stating the applicable confirmation deadlines, periodic reconciliations and reporting requirements. Above that, the treasury policy should define your hedging policy with applicable hedge ratios and/ or tables in order to be able to correctly claim the hedging exemption.
• It could be that (some) banks desire Credit Support Annexes (CSAs) to do derivative transactions because otherwise they will face collateral asymmetry as a result of EMIR. Companies should decide on their willingness to accept bilateral agreements with their counterparties regarding the exchange of collateral. Important here is the ability to strictly monitor and forecast the liquidity risk that is born as a result.

Tactical

• The approved counterparties for derivative transactions should be revised based on the offering of your banks. For example, are you able to outsource your reporting obligation to them and what is the impact on their derivative pricing if you do not sign a CSA with them?
• The role of your internal and external auditor should be assessed. By doing a periodic review on your EMIR compliancy, a certain comfort level could be provided to the competent authorities and ESMA. In some countries the involvement of the external auditor in the verification of EMIR compliance will even be mandatory.
• The risk and control framework should be adapted to ensure EMIR compliance, for example regarding the confirmation deadlines towards counterparties. Next to that, it should be ensured that the reporting obligation and the periodic portfolio reconciliations will be fulfilled.

Operational

The meeting minutes of treasury and/ or finance committees should carefully document the rationale behind derivative transactions, especially when these are not in line with the treasury policy. The reason is, if applicable, to have a sound basis to claim the hedging exemption for the relevant derivative contracts.

l Systems need to be adapted, especially regarding the reporting requirements towards TRs. If you would choose to outsource the reporting obligation, corporate treasury could still undertake the reporting of intragroup derivatives. Next to that, some additional monitoring/ reporting requirements could result from EMIR regarding liquidity risk or periodic valuations. In the end, corporate treasury can be held responsible for fulfilling the reporting obligation for both intragroup and external derivatives.

Consequences

The best starting point to make your organisation compliant to EMIR is to start with an impact analysis which would result in a detailed work plan what should be rolled out over the coming months.

A non-financial counterparty should at least ask itself the following questions:

• What does the new trading and clearing mechanism demand from my systems?
• How can we manage the liquidity risks caused by EMIR?
• Do we have enough capacity and knowledge in the back-office to fulfill the reporting and confirmation requirements under EMIR? And if not, would it be advantageous to outsource the reporting obligation?

Next to that, the following items should at least be covered in the subsequent work plan:

• Compose good documentation on purpose of derivatives, especially those not in a hedge accounting relationship;
• Redesign processes, procedures and controls around derivative trading and administration;
• Prepare for file request for clearing exemption for intragroup derivatives;
• Identify to whom to report in every applicable jurisdiction (’competent authority’);
• Decide on which banks to deal with in the future;
• Prepare reports on outstanding derivatives for future TR;
• Assess the interaction between different pieces of regulation e.g., Dodd-Frank Act, REMIT, MiFID II and Basel III/ CRD IV.