Global perspective and the clearing/risk mitigation techniques dichotomy
EMIR legislative developments with respect to risk mitigation techniques reflect broader global tendencies (see for example IOSCO Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives FR01/2015 of 28 January 2015.
Under EMIR rules standardized derivative contracts should be cleared through central counterparties while contracts not cleared by a CCP require exchange of collateral and counterparties must hold adequate capital and have mitigation techniques in place.
The important observation has been made (Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives, March 2015, p. 7), only standardised derivatives are suitable for central clearing. However, a substantial fraction of derivatives is not standardised and cannot be centrally cleared.
Risk-mitigation techniques for OTC derivative contracts not cleared by a CCP
(Article 11(1)-(4) of EMIR (Regulation (EU) No 648/2012))
1. Financial counterparties and non-financial counterparties that enter into an OTC derivative contract not cleared by a CCP, shall ensure, exercising due diligence, that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least:
(a) the timely confirmation, where available, by electronic means, of the terms of the relevant OTC derivative contract;
(b) 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.
2. Financial counterparties and non-financial counterparties referred to in Article 10 shall 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 shall be used.
3. Financial counterparties shall have risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts that are entered into on or after 16 August 2012. Non-financial counterparties referred to in Article 10 shall have risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts that are entered into on or after the clearing threshold is exceeded.
4. Financial. counterparties shall hold an appropriate and proportionate amount of capital to manage the risk not covered by appropriate exchange of collateral.
The aforementioned document refers to the Global Financial Stability Report, April 2010, Chapter 3, which assumes that one quarter of interest rate swaps, one third of credit default swaps, and two thirds of other OTC derivatives will not be sufficiently standardised and liquid to be centrally cleared.
Consequently, the preliminary EMIR exercise for firms is to differentiate between derivative contracts subject to clearing and those to which risk mitigation techniques apply and, moreover, precisely identify derivatives subject to each of the above relevant requirements.
EMIR's catalogue of risk mitigation techniques
Risk mitigation techniques under EMIR include:
- Mark-to-market valuation,
Dates of application
The dates on which the relevant requirements for OTC derivatives not cleared by a CCP apply are:
- for portfolio reconciliation, portfolio compression and dispute resolution - 15 September 2013;
- for timely confirmations and daily valuations - 15 March 2013.
In ESMA's Q&As the following point has been raised:
"Do the procedures prescribed in Article 11 of EMIR have to be implemented between a financial or non-financial counterparty subject to EMIR, and a counterparty that is exempted as defined in Article 1 of EMIR?"
The ESMA's position in that regard is:
"No. However, both the exempted and the non-exempted counterparties may on a voluntary basis choose to establish any contractual arrangements with the objective of replicating the obligations of Article 11 of EMIR."
Similarly, the EU-based counterparty is not required to apply risk mitigation techniques under Art. 11 EMIR when it executes OTC-derivative contracts cleared by a third-country CCP not recognized under Art. 25 EMIR.
ESMA's reasoning in that regard was that Article 11 of EMIR only applies to OTC derivative contracts not cleared by a CCP, irrespective of its status under EMIR.
The conditions under which financial and non-financial counterparties can be serviced by third-country CCPs are generally addressed in Articles 25 and 89 of EMIR.
This covers the transitional period during which financial and non-financial counterparties can be serviced by third-country CCPs that have applied for recognition before 15 September 2013, as well as after the transitional period when financial and non-financial counterparties can still access non recognised third-country CCPs as clients (via a third-country clearing member only) if they wish to clear products other than derivatives subject to a clearing obligation under EMIR.
With regards to the clearing obligation, Article 4(3) clarifies that clearing with a third country CCP is only allowed when that CCP is recognised under Article 25, irrespective of the capacity in which EU-based counterparties access the CCP (as clearing members, clients or through indirect clearing arrangements).
The practical ambiguity arose whether entities subjected to EMIR are allowed to delegate the risk-management procedures and arrangements to an asset manager, who is providing portfolio management service to the counterparty on an agency basis.
Such a delegation is in principle possible to the extent it is permitted under the relevant applicable national or EU legislation regulating the activities of asset managers or of investment funds.
Special treatment for C6 energy derivatives contracts
Pursuant to MiFID II Directive EMIR risk mitigation techniques will not apply during the 42-month transitional period (counted from the entry into application of the said Directive) to C6 energy derivatives (i.e. physically settled coal and oil traded on an OTF) entered into:
- by non-financial counterparties below EMIR clearing threshold, or
- by non-financial counterparties that will be authorised for the first time as investment firms as from the date of entry into application of the MiFID II.