Risk Mitigation Techniques under EMIR

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.

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:

- Timely confirmation,

- Portfolio compression,

- Portfolio reconciliation,

- Mark-to-market valuation,

- Dispute resolution,

- Collateral requirement,

- Adequate capital to cover the exposures arising from OTC derivatives not cleared by a CCP. 

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.

Coverage 

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).

Delegation issue

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.

For other impacts of C6 energy derivatives' regulation on EMIR arrangements see here.

IOSCO Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives FR01/2015 of 28 January 2015

Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions, Margin requirements for non-centrally cleared derivatives, March 2015, p. 7