Commodity firms strongly opposed that exceeding the clearing threshold for one class of OTC derivative should trigger application of the clearing obligation or of the risk mitigation techniques for all classes of OTC derivative contracts.
“Draft technical standards under the Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, CCPs and Trade Repositories” of 27 September 2012 ESMA/2012/600 (Final Report) brings a multitude of decisions of paramount practical importance for EMIR implementation by market participants. This is not the end of the game as final report was scheduled to be submitted to the European Commission by 30 September 2012 and the Commission has three months to decide whether to endorse ESMA’s draft technical standards. It can be presumed, however, that the ESMA’s stance on EMIR’s implementation architecture (adopted after conducting thorough public consultations) may be influential.
ESMA’s decisions are of a particular importance to the non-financial counterparties (NFCs, non-financials). EMIR recognises that non-financials use OTC derivatives to protect themselves against commercial risks directly linked to their commercial activities or treasury financing activities. As a result, these OTC derivative contracts that protect the NFCs against risks directly related to their commercial activities and treasury financing activities as well as those that, for different purposes, do not exceed the clearing thresholds are not subject to the clearing obligation.
And the key fact for NFCs is that when the clearing thresholds would be exceeded, the clearing obligation would apply to all future OTC derivatives concluded by the NFC after it has exceeded the clearing thresholds, no matter which purpose they have.
ESMA considers that such an interpretation “is well established.” Given significant administrative burden involved, market participants should be cognizant of this rule, since it may heavily influence on their market strategies.
OTC derivative contracts reducing risks are excluded from the calculation of the clearing threshold.
The consequences of exceeding the clearing threshold are not only related to the clearing obligation but extend to risk mitigation techniques, in particular non-financials that do not exceed the clearing threshold are not required to mark-to-market their OTC derivative contracts.
The weight of this interpretation is emphasised by another one clarifying that the counterparty is considered as exceeding the clearing thresholds and therefore is subject to the relevant EMIR requirement for all classes of OTC derivative contracts and not only for those pertaining to the class of OTC derivatives where the clearing threshold is exceeded. In other words the excess of one of the values set for a class of OTC derivatives triggers the excess of the clearing threshold for all classes.
In the aftermath of the said rules, it may be said a some sort of “contamination” is spreading across asset classes due to clearing threshold breaching and its effects may be costly (CCP fees). It is therefore vital for non-financials to implement internal procedures ensuring the engagement in trading in each asset class at a predefined level.
Let’s recall that for the purpose of the EMIR’s clearing thresholds, 5 asset classes are considered i.e. credit derivatives, equity derivatives, interest rate, foreign exchange and, finally, commodity and others. ESMA also indicated that it would set a threshold of EUR 1 billion in gross notional value of OTC derivative contracts for each of the credit and equity derivative contracts and of EUR 3 billion in gross notional value of OTC derivative contracts for each of the interest rate, foreign exchange, and commodity or others derivative contracts.
Gross notional value of OTC derivative contracts concluded by NFCs decisive for the purpose of setting the clearing thresholds
Another significant, however, debatable issue decided by ESMA in its above-mentioned Final Report is the reference to the gross notional value of OTC derivative contracts concluded by NFCs for the purpose of setting the clearing thresholds. The argument for such an approach that occurred the most convincing to ESMA was the simplicity of the EMIR architecture.
EMIR provides that the values of the clearing thresholds are to be determined taking into account the systemic relevance of the sum of net positions and exposures per counterparty and per class of OTC derivatives. ESMA underlines the fact that this is different from the net exposure across counterparties and across asset class.
Analysing the problem ESMA has taken into account the relation between full netting, counterparty netting and gross figures. It is rather clear that the result of the sum of net positions and exposures per counterparty and per class of OTC derivatives would be higher than the fully netted amount.
The other arguments that led ESMA to conclude that the use of the gross value as a proxy of the systemic relevance of the risk is reasonable and practical (although ESMA agrees that generally market values are a better measure of the risk than the notional values), among others, were:
1. EMIR only requires FCs and NFCs exceeding the clearing threshold to mark-to-market their OTC derivative contracts on a daily basis. NFCs below the clearing threshold are not subject to the daily mark-to-market requirement. It would be paradoxical and to some extend circular to use the market value to set the clearing threshold when this measure is used for requiring daily mark-to-market;
2. Using marking-to-market would expose NFCs to external factors in the application of the clearing threshold. An increase in market price could lead a company to exceed the clearing threshold although it would not have concluded additional contracts;
3. The use of the notional value of the OTC derivative contracts allows some stability in the figures considered to monitor the clearing threshold which is particularly relevant for small and medium companies and would avoid the burden and costs to implement a complex system and process for monitoring purpose.
Counterparty required to make notification in case of intra-group OTC derivative contracts fulfilling the conditions set in EMIR
ESMA clarifies that the notification is performed per counterparty to the relevant competent authority and may cover all the intra-group OTC derivative contracts fulfilling the conditions set in EMIR provided the relevant information is clearly provided per counterparty.
Although the counterparty is responsible for the notification to the competent authority, it may delegate the performance of the notification to another entity such as its head office.
ESMA decided that it is not possible to allow one notification across a group, mainly due to the fact that the group may be made up of different legal entities which may be located in different jurisdictions and may be subject to a different framework. As ESMA concludes, the process of one notification across a group would not allow for its assessment by the competent authority.
Timely confirmation as a risk mitigation for OTC derivative contracts not cleared by a CCP
In order to specify what would be a timely confirmation ESMA intends to set several interim objectives for periods ranging from the entry into force of the technical standards, to August 2013, February 2014 and August 2014, which will allow interim enhancement of the timeframe before reaching the end-goal timing. The end goal timing is the business day following execution for financial counterparties and NFCs above the clearing threshold and the second business day following execution for NFCs below the clearing threshold.
Voluntarily cleared contracts
Final Report mentions also further potential points of concern for market participants, however, the nature of these problems does not allow to resolve them in the ESMA’s technical standards.
The instance of such an issue may be the question why voluntarily cleared OTC derivative contracts are not excluded from the scope of the calculation of the clearing threshold. Logically, the systemic risk (being the foundation of the EMIR’s legislation) is not impaired by such voluntarily cleared contracts.
In this respect, ESMA underlines that these issues are related to provisions in the Level 1 text and the mandate granted by EMIR does not extend to these aspects.
The same answer is relevant for another frequently stressed request that the calculation of the clearing threshold should not consider OTC derivative contracts entered into at the group level but only at the level of the legal entity.
So, it is for the European Commission to decide whether to endorse ESMA’s draft technical standards. However, preliminary work at non-financials to design their IT infrastructure and appropriate procedures to be able to cope with demanding EMIR’s technical standards requirements in my opinion should start right now.