Overall, non-financial counterparties (NFCs), represent a large share of total number of counterparties in OTC derivative markets (72%), but a very small proportion of the volumes (7% of the outstanding volumes as measured by trade count and 2% of the outstanding volumes as measured by notional amount (ESMA EMIR Review Report no. 1 of 13 August 2015 - Review on the use of OTC derivatives by non-financial counterparties (2015/1251), p. 14).
However, the commodity OTC derivatives are the specific category for NFCs, since a majority of the volume (65%) includes at least one NFC.
Hence, the OTC commodity derivatives market - as less driven by financial counterparties (FCs) - appears to be the one in that NFCs tend to play a larger role, not to exclude a market-making.
EMIR provides that where appropriate, rules applicable to financial counterparties should also apply to NFCs.
The legislator recognises that NFCs use OTC derivative contracts, inter alia, to cover themselves against risks directly linked to their commercial or treasury financing activities.
Therefore, EMIR was drafted with requirements applicable to NFCs that differ depending on the level of non-hedging activity of the NFC in OTC derivatives.
When this activity exceeds clearing threshold, the NFC becomes subject to similar requirements to those applicable to financial counterparties, and is referred to as an NFC above the threshold or an "NFC+" ("NFC-" for non-financial counterparties below a clearing threshold respectively).
EMIR for NFCs in brief
The EMIR requirements for most NFCs are generally in three broad categories:
– measuring level of non-hedging OTC derivatives transactions – "the clearing threshold",
– reporting derivatives to trade repositories,
– risk mitigation for uncleared OTC derivatives.
The second general observation is at a minimum, NFCs must report and confirm all derivative trades, while NFCs with large speculative OTC derivatives positions are required to centrally clear or collateralise OTC derivative contracts.
In principle, the three main groups of requirements imposed by EMIR are:
1) to report derivative contracts to a trade repository,
2) to clear OTC derivative contracts that are subject to the clearing obligation if the clearing threshold is crossed,
3) to apply risk mitigation techniques to OTC derivative contracts if the clearing threshold is not exceeded (or - if the threshold is exceeded - to those OTC derivative contracts that are not subject to the clearing obligation).
In particular, NFC+ are subject to the clearing obligation (Article 4 of EMIR) and to bilateral margining (Article 11(3) of EMIR) while NFC- are exempted from those two requirements.
Hence, it may be concluded that if the clearing threshold is not exceeded, the non-financials should pay attention:
1) to the obligation for reporting derivative contracts to the trade repository (with the exception of collateral and valuations reporting), as well as
2) to certain risk mitigation techniques with respect to OTC derivatives (not all, however, as same of them apply only when the clearing threshold is exceeded).
As regards EMIR derivatives reporting it is noteworthy that European Commission's Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 of May 2017 envisions the modification that transactions between a financial counterparty and a small non-financial counterparty would be reported by the financial counterparty on behalf of both counterparties.
Recital 14 of the said European Commission's draft Regulation reads:
"To reduce the burden of reporting for small non-financial counterparties, the financial counterparty should be responsible, and legally liable, for reporting on behalf of both itself and the non-financial counterparty that is not subject to the clearing obligation with regard to OTC derivative contracts entered into by that non-financial counterparty as well as for ensuring the accuracy of the details reported."
When assessing its positions versus clearing thresholds, an NFC must:
− include all contracts entered into by all non financial entities within the consolidated group,
− monitor the threshold against the consolidated group's rolling 30 day average of gross notional by class,
− notify the national regulatory authority and ESMA if a threshold is exceeded on any one day,
'Hedging' derivatives are excluded from the calculation, but not from the additional requirements if a threshold is breached.
If a threshold is breached all future OTC derivatives are subject to additional requirements.
From 15 March 2013, NFCs have been required to notify the national regulatory authority and ESMA if their gross notional position exceeds the clearing threshold.
NFCs should also notify the national regulatory authority and ESMA if their rolling 30 day average position no longer exceeds the clearing threshold.
In turn, when it comes to EMIR risk-mitigation techniques, ESMA in the Q&A document dated 5 August 2013 has confirmed that non-financial counterparties below the clearing threshold are subject to the following ones:
- timely confirmation: the confirmation timeframes applicable to NFC- are specified in Article 12(2) of the RTS on OTC derivatives,
- portfolio reconciliation: the reconciliation frequency applicable to NFC- is specified in Article 13(3)(b) of the RTS on OTC derivatives,
- portfolio compression, under the conditions defined in Article 14 of the RTS on OTC derivatives,
- dispute resolution, as further specified in Article 15(1) of the RTS on OTC derivatives.
Pursuant to EMIR the risk mitigation techniques belonging to the second group (i.e. that non-financials apply only when the clearing threshold is exceeded), are:
- the requirement to mark-to-market on a daily basis the value of outstanding contracts (where market conditions prevent marking-to-market, reliable and prudent marking-to-model are used),
- requirement for the timely, accurate and appropriately segregated exchange of collateral.
When reporting to trade repositories (TR), counterparties must indicate whether they are a financial or a non-financial counterparty in the TR field "Financial or non-financial nature of the counterparty".
NFC+/NFC- differentiation
ESMA EMIR Review Report no. 1 - Review on the use of OTC derivatives by non-financial counterparties (2015/1251) underlines, EMIR establishes a two-step mechanism for non-financial counterparties to determine whether they are NFC+ or NFC-.
First, counterparties need to assess, on a trade by trade basis, whether their transactions are concluded for hedging purposes. This assessment is reflected in the TR field "directly linked to commercial activity or treasury financing".
Second, counterparties need to sum the gross notional amounts of their outstanding OTC derivative contracts not concluded for hedging purposes, across all the non-financial counterparties of their group.
This aggregation should be done per asset-class and the resulting figures should be compared to the so-called clearing threshold defined in Article 11 of the RTS on OTC derivatives: EUR 1 billion for the credit and equity asset classes, EUR 3 billion for the commodity, interest rate and foreign exchange asset classes.
When the aggregate of non-hedging positions of a group exceeds any of those thresholds, all the non-financial counterparties of that group should be classified as NFC+ and as a result:
a) Notify its competent authority and ESMA that it exceeds the clearing threshold; and
b) Report to TR the value "Y" in the dedicated TR field "Clearing Threshold".
When it comes to some quantitative data, the above ESMA report of 13 August 2015 evidences the number of groups of NFC+ is fairly limited, with 43 groups representing 424 counterparties. Those groups held on average 5,000 trades each, with average notional above EUR 36,000mn at group level. As an order of magnitude, the typical portfolio size of a group of NFC+ is about five times bigger than the average portfolio of FCs in terms of trade count and 1.5 times bigger in terms of notional amount.
NFC+ and large NFC-, although being also smaller than for FCs in general, the level of exposure to their counterparties is significant and much closer to those of FCs than to those of small NFC-. With regard to the level of exposure, NFC+ and large NFC- have around 500 to 600 trades on average versus 872 for FCs and 20 for small NFC-; and the average notional value of trades for NFC+ and large NFC- is around 4 to 5 billion EUR on average versus 21 for FCs and 0.1 for NFCs.
It is noteworthy, ESMA is considering to move from the current two-step process (hedging/non hedging and clearing threshold) to a one-step process, where counterparties would qualify as NFC+ when their outstanding positions exceeds certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging (see the afore-mentioned ESMA Report of 13 August 2015, p. 12).
The timely confirmation of the terms of the relevant OTC derivative contract
Article 12 of the RTS contains a patchwork of specific regulations differentiating the timelines for contract confirmations depending on the type of entity (financial or non-financial) and the derivative’s class.
Considering, however, that from the entire scope of derivatives non-financials are particularly interested in derivatives on commodities, it is noteworthy, such derivatives being concluded up to and including 31 August 2013 are required to be confirmed by the end of the seventh business day following the date of execution of the derivative contract (the relevant deadline for derivatives concluded after 31 August 2013 up to and including 31 August 2014 is the end of the fourth business day following the date of execution of the derivative contract and for derivatives concluded after 31 August 2014 the end of the second business day following the date of execution).
The key easement on EMIR reporting field for non-financial counterparties below the clearing threshold is they are not required to report collateral, mark to market, or mark to model valuations (RTS Article 3(4)).
So, the conclusion is, the non-financials should now take due care to have procedures in place requiring the relevant contracts be confirmed within the above timelines. For timelines regarding other classes of derivatives (for instance credit default swaps and interest rate swaps) see Article 12 of the RTS.
EMIR requires the non-financials below the clearing threshold to have “formalised processes which are robust, resilient and auditable in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them, and to monitor the value of outstanding contracts.”
RTS in that regard elaborates specific points on portfolio reconciliation, portfolio compression and dispute resolution arrangements.
See here for more details on timely confirmation requirements under EMIR...
Portfolio reconciliation
The main purpose of the portfolio reconciliation is to identify at an early stage any discrepancy in a material term of the OTC derivative contract, including its valuation.
The portfolio reconciliation must cover key trade terms that identify each particular OTC derivative contract and must include at least the valuation attributed to each contract arising from the requirement to mark-to-market (or to-model where applicable).
For a non-financial counterparty below the clearing threshold portfolio reconciliation is required to be performed once per quarter when the counterparties have more than 100 OTC derivative contracts outstanding with each other at any time during the quarter and once per year when the relevant number is 100 or less.
Furthermore, there is an obligation imposed to agree in writing or other equivalent electronic means with each of counterparties on the arrangements under which portfolios will be reconciled. Such agreement must be reached before entering into the OTC derivative contract.
An easement has been also envisioned since the portfolio reconciliation may be performed by the counterparties to the OTC derivative contracts itself or by a qualified third party duly mandated to this effect.
To conclude this part of an issue, if the non-financials have 100 or less OTC derivative contracts outstanding with each other, the required frequency of the portfolio reconciliation is only once per year, which does not appear overly burdensome and particularly disrupting business processes carried out so far. The requirement to agree before entering into the OTC derivative contract on the arrangements under which portfolios will be reconciled practically also would not pose any real difficulty. If the counterparties mandate the said service to the third party, the new EMIR’s requirement to reconcile portfolios would not involve too much additional work on the part of non-financial market participants.
It is necessary to add that for a financial counterparties and for a non-financial counterparty that excess the clearing threshold the required frequency of the portfolio reconciliation is greater and it must be performed:
(i) each business day when the counterparties have 500 or more OTC derivative contracts outstanding with each other;
(ii) once per week when the counterparties have between 51 and 499 OTC derivative contracts outstanding with each other at any time during the week;
(iii) once per quarter when the counterparties have 50 or less OTC derivative contracts outstanding with each other at any time during the quarter.
See here for more details on the portfolio reconciliation requirements under EMIR...
Portfolio compression
Pursuant to EMIR RTS financial counterparties and non-financial counterparties with 500 or more OTC derivative contracts outstanding with a counterparty which are not centrally cleared must have in place procedures to regularly, and at least twice a year, analyse the possibility to conduct a portfolio compression exercise in order to reduce their counterparty credit risk and engage in such a portfolio compression exercise.
Moreover, financial counterparties and non-financial counterparties must ensure that they are able to provide a reasonable and valid explanation to the relevant competent authority for concluding that a portfolio compression exercise is not appropriate.
It is striking from the above regulatory language that the requirement for portfolio compression has not been formulated in the overly prescriptive manner. In fact, the obligation to “have in place procedures to regularly, and at least twice a year, analyse the possibility” of the portfolio compression and to be “able to provide a reasonable and valid explanation” for not conducting this task requires in my opinion only minor supplement to the existing documentation.
See here for more details on portfolio compression requirements under EMIR...
Dispute resolution
Pursuant to the EMIR RTS, when concluding OTC derivative contracts with each other, financial counterparties and non-financial counterparties must have agreed detailed procedures and processes in relation to:
(i) the identification, recording, and monitoring of disputes relating to the recognition or valuation of the contract and to the exchange of collateral between counterparties. Those procedures should at least record the length of time for which the dispute remains outstanding, the counterparty and the amount which is disputed;
(ii) the resolution of disputes in a timely manner with a specific process for those disputes that are not resolved within five business days.
The particular term appears in the above provision, namely five business days as a deadline above which the process should be “specific”. This is a new issue to include in the drafting for the contracts.
See here for more details on dispute resolution requirements under EMIR...
Industry standards - Counterparty status election
Parties wishing to implement EMIR portfolio requirements into their contractual documentation have at their disposal at least two master agreements:
- the ISDA 2013 Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol published by the International Swaps and Derivatives Association, Inc. (the "ISDA Protocol"), and
- EFET's form of EMIR Risk Mitigation Techniques Agreement (the ERMTA).
ERMTA allows the Parties to designate their status for these purposes in the corresponding section of the Election Sheet (terms capitalised defined in ERMTA).
In the applicable section in the Election Sheet, the Parties can either jointly make 'no' designation as to their status, or may designate their status by marking each statement in the Election Sheet that will apply.
The status, which has been designated in the Election Sheet is deemed to be correct as of the Effective Date and each time the Parties enter into an EMIR Relevant Transaction; and the status designations as selected on the Election Sheet are deemed to be repeated on each day that an EMIR Relevant Transaction is outstanding.
Where a Party has made an election as to its counterparty status, and thereafter the counterparty status changes, that Party must promptly inform the other Party of such a change, by written notice.
Further, where the change affects the obligations of one or both Parties under EMIR and the Regulatory Technical Standards, the affected Party must promptly ensure compliance with all such obligations.
Where a Party has made an election as to its counterparty status and such designation is incorrect or misleading, or where a Party fails to send a Change of Status Notice, the Parties must use commercially reasonable efforts in order to amend the terms of any EMIR Relevant Transaction or Covered Agreement in order for each Party to fulfil its respective obligations under EMIR and the Supporting Regulation.
But such failure is not intended under ERMTA to give rise to termination rights in respect of any transactions.
EMIR reform propositions on non-financial counterparties - May 2017
Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 published by the European Commission in May 2017 put forward some important modifications with respect to NFCs' legal regime (see box).
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Recital 7 of the said Proposal of May 2017 reads:
"Non-financial counterparties are less interconnected than financial counterparties. They are also often active in only one class of OTC derivative. Their activity therefore poses less of a systemic risk to the financial system than the activity of financial counterparties. The scope of the clearing obligation for non-financial counterparties should therefore be narrowed, so that those non-financial counterparties are subject to the clearing obligation only with regard to the asset class or asset classes that exceed the clearing threshold, while retaining their requirement to exchange collateral when any of the clearing thresholds is exceeded."
Article 1(8) of the draft amends paragraphs 1 and 2 of EMIR Article 10.
The amended paragraph 1 changes the way the clearing thresholds are calculated.
According to the said draft, a non-financial counterparty becomes subject to the clearing obligation if its aggregate month-end average position for the months March, April and May exceeds the clearing thresholds, instead of if the rolling average position over 30 working days exceeds the thresholds which is the case under the current EMIR rules.
The reference to paragraph 3 means that the current hedging exemption is retained so only those OTC derivative contracts which are not objectively measurable as reducing risks directly relation to the commercial activity or treasury financing activity are calculated to the thresholds.
The point (b) of the second subparagraph of paragraph 1 specifies that the clearing obligation applies only for the asset class or asset classes for which the clearing threshold has been exceeded and for which a clearing obligation exists.
Challenges
In effect of EMIR requirements non-financial counterparties above the clearing threshold (NFC+) need to decide whether to set up client clearing arrangements.
NFCs+ will also need to be able to post daily collateral (variation margin) in cash, which may prove demanding.
See also the ESMA’s templates for notification of exceeding the clearing threshold and notification of no longer exceeding the clearing threshold.
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Intra-group exemption under EMIR