Internal policies must “define a priori“ the types of OTC derivative contracts included in the hedging portfolios.
Is it possible, then, to change the portfolios allocation after the trade was reported under EMIR and MiFID II?
Positive answer to this question may add some value to OTC derivatives trading strategies.
Suppose, the OTC derivatives hedging transaction has been concluded and reported to the trade repository according to the respective EMIR requirements.
Considering it was economically-equivalent OTC (EEOTC) trade, also the position report under MiFD II has to be submitted to the trading venue, accompanied by the hedging flag (note that the obligation to report positions under Article 58 of MIFID rests also with investment firms when executing EEOTC transactions on behalf of their clients).
The point is, however, after effecting the above EMIR and MiFID reports market situation has changed and extraordinary arbitrage opportunities appeared.
They emerged along with the dilemma: is it lawful to reclassify the above transactions - despite the fact that they have already been reported - from hedging to the speculative portfolios?
Or, given these transaction have been already included in the reports under EMIR and MiFID II, is any change and transition between the hedging/speculation flags impossible?
The second of the above alternatives - although more comprehensive and integral - obviously comes at cost.
The unequivocal determination of the said options influences on the perception of the overall structure of speculative and hedging portfolios: are they rigid and permanent or, quite opposite, flexible and interchangeable?
There is also further issue involved: whether the trader must - irrevocably - determine the allocation of the trade to the applicable portfolio at the inception of the transaction, or there is “a grace period” (but how long?) to change the decision.
It is to be noted that there are restrictive regulatory requirements as regards risk management systems.
They apply across MiFID II and EMIR frameworks (although ESMA’s clarifications in the EMIR Q&As (answer to the OTC Question 10) preceded the subsequent inclusion of analogous legal text in the MiFID II regulatory technical standards regarding ancillary activity exemption).
According to the requirements risk management systems should fulfil the following criteria:
1. the risk management systems should prevent non-hedging transactions to be qualified as hedging solely on the grounds that they form part of a risk-reducing portfolio on an overall basis;
2. quantitative risk management systems should be complemented by qualitative statements as part of internal policies, defining a priori the types of OTC derivative contracts included in the hedging portfolios and the eligibility criteria, and stating that the transactions in contracts included in the hedging portfolios are limited to covering risks directly related to commercial or treasury financing activities;
3. the risk management systems should provide for a sufficiently disaggregate view of the hedging portfolios in terms of e.g. asset class, product, time horizon, in order to establish the direct link between the portfolio of hedging transactions and the risks that this portfolio is hedging;
4. non-financial counterparties should establish a sufficiently clear link between the type of contracts entered into and the commercial or treasury financing activity of the group (in such a case, it is not acceptable to class the whole portfolio, including the speculative components, as hedging even if it can be shown that the aggregate effect of the whole portfolio is risk reducing).
The requirement that needs to be underlined in the above passage is that internal policies must “define a priori“ the types of OTC derivative contracts included in the hedging portfolios.
It may suggest that such qualifications are not subject to flexibility and should be consistent and permanent across trading cycles.
For those, however, intending to retain the right to change their mind as regards the portfolios’ character after the report was submitted there is a good news - ESMA revisited the issue and in the answer to the Question 18 (Questions and Answers, on MiFID II and MiFIR commodity derivatives topics, ESMA70-872942901-28, Position reporting, updated on 15 December 2017) assessed as follows:
“The obligation to report positions under Article 58 of MIFID rests with members or participants of regulated markets, MTFs and clients of OTFs or with investment firms when executing EEOTC transactions on behalf of their clients.
It is the client’s responsibility to ensure that their position is accurately described in their position report, in particular regarding whether their positions are for hedging or speculative purposes. It is a matter for the individual client as to how they satisfy this obligation and they may provide an initial instruction that unless informed otherwise, the investment firm should report certain defined positions to be for hedging (or speculative) purposes providing that this is an accurate description at the time.
There may, however, be circumstances where a client is able more accurately to assign new transactions to hedging or speculative positions only after the initial trade. In this case the client should ensure that their position report is adjusted accordingly to the hedging or non-hedging nature of their position.”
In this regulatory circular ESMA expressly admitted that there may be circumstances where a client is able more accurately to assign new transactions to hedging or speculative positions only later - after the “initial trade” and after submitting the positions report.
In this clarification ESMA treats the above situation as normal and only requires that the position report “is adjusted accordingly”.
I think it is not, however, the final determination of the problem, but the start of the discussion.
Good starting point may be the question what is meant under the term used: “initial trade”.
Second questionable issue is the scope of application, given that the ESMA’s interpretation has been adopted in the context of the MiFID II positions reporting regime only.
Is it also applicable for the EMIR reporting? I suppose there are no reasonable grounds for the restrictive application - consequently, if the MiFID II positions report can be amended under the above circumstances, the EMIR report should be subject to a change too.
And, last but not least, what is the maximal deadline for such reclassifications, if any.
Nevertheless, the above ESMA‘s clarification can be assessed as a valuable regulatory support for derivatives traders on the OTC market.