Wednesday, December 26, 2012

Developing debt markets – Lessons to be learned from a India

I have recently come across some interesting transcripts from presentations by Harun R. Khan about the Indian debt markets. They not only describe very well the state of Indian debt markets today but also provide some useful insights into how debt markets work and why this is important. If you don’t have much time, you can read my summary below. Otherwise, you will find the transcripts at the end of this post.

What is the current shape of Indian debt markets?

Today, India’s financial markets are dominated by equities. The debt market is underdeveloped.

In addition, as regards corporate debt issues, 93 % of them are private placements, due to extensive disclosure requirements, higher cost, plain vanilla character, and lower speed in case of a public debt issue. Publicly traded debt is, therefore, still dominated by government bonds.

What is a developed debt market?

Four main criteria measure the efficiency of debt markets:

  • Diversity of financial instruments
  • Diversity of participants and the heterogeneity of their responses to new information (“Breadth”)
  • Capacity of the market to dissipate price fluctuations (“Resilience”)
  • Capacity of the market to handle large transactions without causing sharp price changes (“Depth”)

Why is it imperative to develop functioning debt markets?

Developing debt markets fosters economic growth and development:

  • Debt markets transfer capital from savers to borrowers. Thus, they attribute funds efficiently.
  • Debt markets help transferring, pooling, and sharing of risks.
  • Government debt markets shape a yield curve that is essential for pricing other financial assets.

In addition to the above general rationales, India has specific reasons to develop its debt markets:

  • The country has substantial future funding requirements that cannot be met by bank financing alone. This is especially true for long-term financing, which banks cannot stem alone, due to increasing asset liability mismatch dilemmas over longer periods of time. For example, infrastructure funding requirements currently amount to 10 % of India’s annual GDP.
  • Functioning debt markets promote financial inclusion for small and medium-sized enterprises and retail investors.
  • Healthy domestic debt markets will reduce the dependency of Indian firms on external commercial borrowings in foreign currency. This will ultimately lead to stronger corporate balance sheets as currency exchange risk and volatility decrease. As the Rupee exchange rate volatility has grown significantly in recent years, RBI considers this raison d’être for domestic debt markets as substantial.
  • Functioning debt markets are safeguards for financial stability in India. The argument is that external commercial funding can be, in case of severe external shocks, very quickly drawn off from the Indian financial system. This actually happened in 2008, when India’s capital account dropped substantially due to liquidity requirements in the lending countries.

Major initiatives for developing Indias debt markets

Major initiatives by RBI and the Indian government concern the following:

  • Promote transparency by developing an imperative bond reporting platform
  • Allow REPO transactions in corporate bonds to make investing in corporate bonds more attractive to institutional investors
  • Alleviate exposure norms for primary dealers, market makers, and central counterparties to enable them to play a larger role in the corporate bond market
  • Introduce credit default swaps and interest rate swaps to facilitate hedging credit risk and market risk associated with holding bonds
  • Reform India’s legal system (bankruptcy framework, enforcement of creditors’ rights, etc.)
  • Introduce suitable credit enhancement mechanisms to allow SMEs to issue high quality bonds
  • Open up investment regulation for pension funds and insurance companies to allow them more extensive investments in corporate bonds
  • Open local debt markets gradually to foreign investors and reduce withholding taxes on coupon payments
  • Stimulate wider participation of retail investors in the market through bond exchanges and mutual funds


  • Address by Harun R. Khan „Corporate Debt Market: Developments, Issues & Challenges“ dated October 12, 2012
  • Presentation by Harun R. Khan “Role of State in Developing Markets” dated September 18, 2012.

Tuesday, December 18, 2012

Accounting for Financial Derivatives under IFRS

IFRS rules differentiate 3 types of derivatives, e.g. hedge derivatives, non-hedge derivatives, and embedded derivatives.

Hedge derivatives

Hedge accounting rules apply under 4 cumulative conditions:

  • Upon inception, the entity assigns and documents the hedging relationship and its risk management objective.
  • It expects the hedge to be highly efficient (= capacity to offset changes in fair value or cash flows attributable to the hedged risk during the period for which the hedge is designed + actual results of the hedge within the range of 80-125 % + assessment of the effectiveness at least at the time an entity prepares its annual or interim financial statements).
  • The company can measure the hedge's effectiveness reliably.
  • The firm assesses the hedge on an ongoing basis.

In addition, the hedge of an overall net position, rather than of a specific item, does not qualify for hedge accounting.

Once the hedging nature of a financial instrument established, the accountant differentiates 3 hedging relationships:

  • A fair value hedge counters an exposure to changes in fair value of a recognized asset or liability or an unrecognized firm commitment. The fair value hedge might also target a portion of such asset, liability or commitment if the company runs a particular risk that could affect its profit or loss.
  • A cash flow hedge matches the exposure to variability in cash flows that is linked to a particular risk of a recognized asset, liability, or highly probable forecast transaction.
  • Hedge of a net investment in a foreign operation

Accounting for a fair value hedge

The gain or loss from remeasuring the hedging instrument at fair value is recognized in profit or loss, thereby adjusting the carrying amount of the hedged item.

Accounting for a cash flow hedge

The portion of the gain or loss on the hedging instrument that constitutes an effective hedge shall be recognized on the company's balance sheet as other comprehensive income. The ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss.

Accounting for the hedge of a net investment in a foreign operation

Again, the portion of the gain or loss on the hedging instrument that constitutes an effective hedge shall be recognized in other comprehensive income. The ineffective portion of the gain or loss on the hedging instrument shall be recognized in profit or loss.

Non-hedge Derivatives

Non-hedge derivatives are always recognized at fair value.

Embedded Derivatives

An embedded derivative is a component of a hybrid contract that combines a derivative with a non-derivative host. In this context, “embedded” means that the derivative part is not independently transferable by way of contract.

Accounting for embedded derivatives is subject to the following rules:

The above mentioned derivative accounting rules shall apply to the hybrid contract as a whole if the underlying is an IFRS financial asset (See my December 15, 2012 post).

By contrast, if the host is not an IFRS financial asset, the embedded derivative is separated from the host. It is then recognized as a derivative if

  • the embedded derivative's economic and risk characteristics are not closely related to those of the host; or
  • the company has chosen to account the entire hybrid contract at fair value through profit or loss.


  • IFRS 9 – Financial Instruments
  • IFRS 32 – Financial Instruments: Presentation
  • IAS 39 – Financial Instruments: Recognition and Measurement

Saturday, December 15, 2012

Accounting for Financial Instruments under IFRS – When numbers meet words

My today’s assignment is to explain 152 pages of IFRS language in a few lucid paragraphs. If you have ever tried to read IFRS 9 and 32 and IAS 39, you will recognize that this is not an easy task.

You might think that this post is an oversimplification of the above rules, and I will probably agree with you to some extend. However, I prefer some oversimplification to the obscurity inherent in IFRS’ language.

Recognition of financial instruments

To pinpoint financial instruments, you need a contract. Conversely, in absence of a contract, there is no financial instrument.

At this stage, legal and accounting definitions require each-other. Let’s, therefore, stick to the very basic civil law rules, e.g. the Roman corpus iuris civilis. In the Second Book, Title XIV, No. 1, § 2, you can read “Et est pactio, duorum pluriumve in idem placitum consensus.” (= A contract is the consent of two or more persons on the same subject.).

Classification of financial instruments

IFRS accounting rules differentiate assets, liabilities, and equity. Derivatives represent a specific category of financial instruments and will be subject of a later post.

Every discipline defines the above categories in another way. From an IFRS perspective,

  • A financial asset is cash; a contractual right to receive a financial asset; a contractual right to exchange financial assets, liabilities, or equity; or equity of a third party.
  • A financial liability is a contractual obligation to deliver or exchange a financial asset.
  • Equity is a residual interest in the assets of the entity, after deducting liabilities.

Classifying financial instruments means considering the substance of the contract. In other words, a contract will not become a financial asset just because you label it as such.

In case of a compound financial instrument, asset and liability components are separated first and the residual is recognized as equity.

A reclassification of financial assets is possible if the entity changes its business model for managing financial assets; financial liabilities and equity shall not be reclassified.

Measurement of financial instruments

Financial assets

Financial assets shall be recorded at amortized costs, if the company holds them to collect its cash flows (= payments of principal and interest). Amortized costs refer to the value of the asset’s future cash flows, discounted at the effective interest rate and net of any adjustment for impairment and uncollectibility. Additional gains or losses can only be recognized upon derecognition of the asset.

If the company does not intend to hold the financial asset until maturity (= held for trading), it is measured at fair value. Fair value means transaction costs. If, however, the transaction costs differ from the market price, the asset is accounted at the amount of the transaction costs plus or minus the difference with the market price, the latter being recognized as a profit or loss, either immediately or differed. Subsequently, fair value is the asset's market price at measurement date.
The movements of the market price are normally recognized as a profit or loss. However, the firm can opt for presenting a gain or loss on equity, not held for trading, outside the company’s income statement, as other comprehensive income.

Financial liabilities

In principle, financial liabilities are measured at amortized cost.

Per contra, the following liabilities are measured at fair value:

  • financial liabilities held for trading;
  • residual liabilities after imperfect derecognition of financial liabilities;
  • guarantees;
  • loan commitments at below market interest rates;
  • Financial liabilities subject to fair value accounting upon option of the company (Such option is only available in specific cases such as embedded derivatives and accounting mismatch.)

Amortized cost and fair value definitions are the essentially the same as for financial assets. Similar to the above, the firm can present subsequent gains or losses on liabilities, measured at fair value, outside its regular earnings, as other comprehensive income.


The initial value of equity consists of par value plus additional paid-in capital minus transaction costs.

Changes in the fair value of equity are not recognized in the financial statements.

Derecognition of financial instruments

Financial assets and liabilities can be derecognized upon

  • discharge, cancellation, or expiry of contractual rights to the cash flows; or
  • transfer of the financial instrument, either directly, or indirectly by committing oneself to forward the cash flows received.

A partial derecognition for specifically identified cash flows is possible.

Upon derecognition, the difference between the carrying amount at the date of derecognition and the consideration received (if any) shall be recognized in profit or loss.


  • IFRS 9 – Financial Instruments
  • IFRS 32 – Financial Instruments: Presentation
  • IAS 39 – Financial Instruments: Recognition and Measurement

Monday, December 10, 2012

Project Bonds – Definition, purpose, concerns, and remedies

1. What are project bonds?

Project bonds are private debt issued by a project company to finance a specific off-balance-sheet project. Because the project company’s only purpose is the project, project bonds are an asset-based form of financing. Project bonds can be placed publicly or, most oftentimes, privately.

Today’s project bond market is concentrated in the US and Canada; issues in Europe and emerging markets are still seldom.

2. Who needs project bonds?

Project bonds are necessary from both the borrower’s and the investor’s point of view:

First, bank lending capacity has and will become ever more limited, due to increasing capital requirements and liquidity constraints for commercial banks as well as tight public budgets. This is especially true for long-term financing, which is, nevertheless, fundamental for an economy’s competitiveness, productivity, and long-term growth.

Second, from an institutional investor's (pension fund, insurance company, etc.) perspective, there is a strong demand for long-term investment opportunities. However, bond markets for very long maturities are oftentimes underdeveloped.

Project Desertec

3. Project bond concerns

Riskiness of project bonds

Project finance is characterized by the following factors:

  • off-balance-sheet financing (e.g. usually non-recourse vis-à-vis the sponsor);
  • longer maturity, compared to corporate loans;
  • higher leverage, compared to traditional corporate finance.

All of the above make the investment more risky for an institutional investor because they typically invest exclusively in high-quality assets.

Debt origination

A general remark is that bank loans are faster and cheaper to deliver than bonds. Indeed, bonds require a rating and the respect of a specific issuing procedure (namely marketing documentation), which increases time and transaction costs. The result is that project bond financing is often inefficient for small transactions.

Another challenge related to bond debt origination is the fact that deliverability and pricing of project bonds are unknown until actual issuance of the bond, As a matter of fact, this might counter the typical public bidding process (“Certain Funds Period”). In addition, public authorities can lack necessary project bond know-how which will enhance this issue even further.

Finally, bonds are settled upon issuance. This can contradict the financing needs of the project company that will usually need funding spread over the whole construction phase and, as a consequence, will cause cost of carry of early provided funds.

Loan vs. bond administration

Compared to traditional bank financing, bonds carry a certain number of disadvantages:

  • The confidentiality of bank loans is higher: For one, possible restructuring negotiations are lead out only among a limited number of banks. In addition, bond markets need, even in the normal course of business, higher disclosure requirements to bridge the information asymmetry between investors and issuer and to compensate for the close monitoring that is common place in case of bank financing and lacks in case of bond financing.
  • Bond financing terms are usually less flexible than bank loan terms and conditions. Moreover, the administration (prepayments, waiver proceedings, etc.) of bonds is normally less flexible than the administration of bank loans. For example, in case of bank financing, an agent will coordinate voting processes within the banking pool. This function is usually missing in case of bond issues.

Liquidity of project bond markets

Oftentimes, project bond markets lack infrastructure and liquidity. This can lead not only to bond pricing dilemmas but also to a more difficult refinancing of bonds.

Dhukwan Project

4. Solution proposals

Riskiness of project bonds

The riskiness of project bonds can be moderated by two basic means, e.g. by modifying the structure of the debt itself or by providing credit enhancement.

The first method refers to debt tranching, thus cutting the overall debt burden of the project company into different pieces and conceiving a priority order of repayment. This solution, however, will necessarily make the financing structure more complex and, as a consequence, potentially shy away investors.

The idea of providing credit enhancement tries to alleviate the off-balance-sheet character of project bond financing. De facto, credit enhancement gives investors indirectly access to the balance sheet of third parties such as project sponsors, commercial banks, state-owned or supranational development banks, and debt service reserve funds. In legal terms, third-party support can be arranged particularly as a letter of credit, guarantee, stand-alone facility, or sub-participation. The EU/EIB 2020 project bond initiative might serve as an example here. The downside of this second solution is that is operates in the shadow banking area: Because credit enhancement usually constitutes, from a bank's perspective, an off-balance-sheet item, it runs against current attempts to reform the stability of financial system.

Debt origination

The administrative origination process can only be shortened through standardization. As far as possible, such standardization should apply to any stakeholder in the origination process. Examples include rating methodologies for project bonds and a legal framework for SPV issuers.

To promote project bonds, it will be necessary to amend public tender regulation. By way of explanation, it is essential that the bidding process specifically closes out the uncertainty linked to size and pricing of bond issues. What's more, firm underwriting by investment banks can also ensure a certain funds period for the project.

Excess funding at the outset of the project can potentially be avoided by deploying MTN programs. Obviously, the high costs for preparing a MTN program imply that this solution can only apply to large-size projects.

Loan vs. bond administration

If not already provided for in mandatory bond regulation, a legal structure for efficient bond administration should be put in place by way of contract. Standard forms for loan agreements should serve as a template here.

Creating conclusive incentives for investors may also help to enhance the administration of bonds. As a matter of fact, if investors can benefit from straightforward bond execution, they will also enhance their efforts to ensure efficient administration. Incentives could include

  • Link credit enhancement and the assigned rating to bond administration processes (Example: Reduction of credit enhancement in case a waiver is not treated during a specific time period.)
  • Link coupon rates to the efficiency of the bond administration
  • Extend simple majority decisions as much as possible

Liquidity of project bond markets

Liquidity of project bond markets can be built up by taking the following initiatives:

  • Create a capital market infrastructure for project bonds, allowing a more efficient placement, listing, trading, and settlement
  • Encourage private investment in project bonds by providing a supportive investor regulation
  • Attract foreign investors to domestic project bonds by setting tax incentives such as lower interest rates on interest income and by canceling withholding tax requirements on interest payments
  • Favor market making activities for project bond markets


  • Scannella – Project Finance in the Energy Industry: New Debt-based Financing Models, International Business Research 2012, pages 83 et seq.
  • S&P Rating Direct – How Europe’s New Credit Enhancements for Project Finance Bonds could affect Ratings, November 13, 2012
  • Sawant – Emerging Market Infrastructure Project Bonds: Their Risks and Returns, Journal of Structured Finance 2010, pages 75 et seq.
  • European PPP Expertise Centre – Financing PPPs with Project Bonds, October 2012
  • Lam, Chiang, Chan – Critical Success Factors for Bond Financing of Construction Projects in Asia, Journal of Management in Engineering 2011, pages 190 et seq.
  • European Commission – A Pilot for the Europe 2020 Project Bond Initiative, October 19, 2011
  • European Commission – Regulation Proposal Europe 2020 Project Bond Initiative, October 19, 2011

Friday, November 23, 2012

The Internal Audit Function in Banks – How to become a BIS compliant auditor

I am searching today for an internal auditor.... not any internal auditor, but a BIS compliant auditor:

Leading European Universal Bank seeks high caliber internal auditor with sufficient authority, stature, and independence

The Position

Matters of regulatory interest don't petrify you? Independence and objectivity are the anchors of your professional life? You are free from conditions that threaten your ability to carry out your internal audit responsibilities in an unbiased manner? You believe in your work product and make no quality compromises? Then we have the right position for you.

As an internal auditor in our firm, your main task is to help reducing the risk of loss and reputational damage to our bank. Your team will guarantee the quality and effectiveness of our bank's internal control, risk management and governance systems processes.

The position is with our permanent internal audit function and is part of our sound corporate governance scheme. You will report to the head of our audit committee, in charge of overseeing our bank's internal audit function.

Your Responsibilities

Your day-to-day activities will consist of

  • ensuring compliance of our business lines with laws and regulations, our sound internal auditing standards, and our code of ethics;
  • guaranteeing the effectiveness and efficiency of the internal control, risk management, and governance systems and processes, created by our business units and support functions;
  • regularly communicating with supervisors of our internal audit function to identify risk areas, understand risk mitigation measures, and understand and respond to weaknesses;
  • evaluating the reliability, effectiveness, and integrity of our management information systems and processes;
  • safeguarding our assets;
  • supporting our head of internal audit at parent company level in defining the group and holding company’s internal audit strategy, determining the organization of the internal audit function both at parent and subsidiary bank levels, and formulating internal audit principles.

For this purpose, you will be granted access to all bank records and data and will be asked to form an independent and informed view of the risks faced by our bank.

By all means, you will only advise on internal control measures. Designing, selecting, implementing, or operating these measures will be carried out by our senior management.

We know that performing similar tasks and routine jobs may negatively affect your capacity for critical judgment and, ultimately, lead to you loosing objectivity. This is why you will periodically rotate within your function. To preserve your independence, “cooling-off” periods are to be respected if you change function in our group.

Your Qualifications

To join us, you must be a person of integrity, independent of our audited activities, and develop sufficient standing and authority within our bank. We take for granted, that you observe the law and have not been party to any illegal activity. As integrity is key for this position, we will ask you to be straightforward, honest, and truthful.

Additional qualifications include

  • observant use of confidential information;
  • evaluation of both current and potential future risks;
  • willingness and capacity to defend and assume responsibility for your own judgments and assessments;
  • ability to collect and understand information, to examine and evaluate audit evidence, and to communicate with stakeholders in our bank;
  • practice of care and skills expected of a reasonably prudent and competent professional;
  • ability to discuss, your views, findings, and conclusions directly with the audit committee and the board of directors;
  • ,as our audit function covers every activity (including outsourced activities) and every entity of our bank, disposal of a high level of intellectual flexibility and ability adapt quickly;
  • honesty, diligence, and responsibility.

After a short learning curve, we expect you to be able to judge outcomes and make an impact at the highest level of our organization.

Please note that we will only consider applications from knowledgeable and experienced auditors.

What we offer

We are searching to recruit a high potential candidate and offer him a fast-track career in our company. From day one on, you will be granted access to the board of directors, that is ultimately responsible for the internal audit function.

We guarantee job security, as our internal audit function should normally be conducted by our bank’s own internal audit staff. Even if we should, for specific purposes, outsource internal audit activities in the future, your skills will still be needed in our firm, as our board of directors will always remain ultimately responsible for these activities and for maintaining an internal audit function within our bank.

Your compensation package will be excellent and, in addition, decoupled from the financial performance of your audited business lines.

Your career in our firm will be guided by annual performance reviews. In addition, you will receive feedback from our board of directors that should review the effectiveness and efficiency of the internal control system and the performance of the internal audit function at least once a year.

We have flat hierarchies and ensure an organizational structure that clearly assigns responsibility, authority, and reporting relationships and ensures that delegated responsibilities are effectively carried out.


Please don’t compliment me for this post. The language comes, in great part, from BIS’ June 2012 report on the internal audit function in banks.

Sunday, November 11, 2012

Germany's Berenberg Bank – A Report on the 422nd Financial Year

Germany's Berenberg Bank has received good press over the last months. For example, the FT wrote about Berenberg's involvement in Talanx' recent IPO:

Apart from being Germany’s oldest bank, Berenberg is also a rapidly growing force in equity capital markets, thanks in large part to the relations it has fostered over the years between its traditional client base of wealthy Germans and the world’s biggest fund managers. That success, in turn, stems from its manageable size and its partnership structure – a natural brake on risk and a natural motivator for focusing on clients.”

The bank has been founded in 1590 and is headquartered in Hamburg. Today, Berenberg's staff amounts to 1,100; the bank has 9 offices in Germany and 9 offices abroad. However, in terms of revenues, it is still very much focused on Germany: 80 % of its revenue is generated in Germany, whereas only 20 % is generated abroad.


After a glimpse at the cover of its 2011 annual report, you will immediately understand what this bank is proud of:

The “report on the 422nd financial year” describes it more specifically:

  • Today, we are simultaneously the second oldest bank in the world, and one of the most dynamic in Europe.”
  • Our bank is characterized by a high level of continuity. We are proud of our corporate culture, which has matured over centuries, and proud of our many long-standing client relationships and the average length of service of our staff.”
  • [The core capital ratio of 14.1 %] is an expression and evidence of our conservative business policy.”

The bank is privately held by the Berenberg family (> 25 %), Managing Partners (> 25 %), Christian Erbprinz zu Fürstenberg (15 %), Jan-Philipp Reemtsma (15 %), and Compagnie du Bois Sauvage S.A. (12 %). According to the bank, this ownership structure guarantees a special kind of independence of its employees who are free of corporate interests.

Financial Performance

Looking at the financial information, we can see that Berenberg has not only performed strongly during the financial crisis but also has a very solid business performance:


Business Divisions

Private Banking

Private Banking serves wealthy private investors and families in protecting and multiplying their wealth. Asset structuring is carried out on a quantitative and qualitative basis. Berenberg puts a special emphasis on art: In 2011, it has set up a subsidiary called Berenberg Art Advice, which answers questions about art as an investment class and advises clients namely on transactions and collection management.

Investment Banking

This business division is organized in three segments, e.g. equities, financial markets, and strategic advisory. The equities segment does equity research (400 European companies in 24 sectors), equity sales and execution, and advisory on equity issues and IPOs. The financial markets segment does fixed income research as well as fixed income and currency trading. Finally, strategic advisory focuses on transaction advisory and corporate broking services.

Asset Management

This business division concentrates on quantitative investment strategies. Clients are of institutional nature and include insurers, pension funds, banks, and foundations.

Corporate Banking

Corporate Banking advises small and middle sized companies on the selection and implementation of optimum funding structures, with a special focus on the shipping industry.

A general principle that applies to the whole bank, is particularly true for the corporate banking division: As a matter of fact, Berenberg does not want to offer every single service possible. To the contrary, it targets niche markets and tries to develop specialist know-how in those areas. Examples include the shipping and real estate sectors.


Compared to annual reports of universal banks, it is almost a pleasure to read Berenberg's annual report. The bank's business model and big picture are easily understandable. In my view, this straightforwardness is a good concept in today's banking world, where banks are often blamed for being over-complicated and carrying systemic importance.

However, while reading about Berenberg, you get sometimes the impression that it is not really a “bank” as most ordinary persons would understand the expression. For example, Berenberg's corporate banking division only seems to have a “support function” in order to generate business opportunities for the other divisions of the bank. Consequently, Berenberg is more an advisory firm that provides comprehensive financial consulting and corporate services than a traditional bank. From this perspective, it is right that Berenberg is at the same time a very traditional and progressive financial institution.


  • Berenberg Bank Annual Report 2011
  • “Talanx offers lesson on big bank failings” - Financial Times October 22, 2012

Wednesday, November 7, 2012

ESMA's Draft EMIR Technical Standards – As easy as baking a chocolate cake?

Let's assume you want to make a chocolate cake. You will need to accomplish three steps: First, you take basic ingredients such as eggs, flour, and sugar and mix them up. Second, you add chocolate and mix the dough again. Finally, you bake your cake for some time.

The process of understanding the current status of Europe's EMIR legislation is essentially the same:

  • First, you read the EU regulation 648/2012 dated July 4, 2012 – Please skip the first 13 pages and go directly to the actual regulation on page 14. As a matter of choice, you might also skip the regulation altogether and read my post of September 30, 2012.
  • Second, you read ESMA's draft regulatory standards issued on September 27, 2012 – Once more, just read annexes II – VII and skip the first 69 pages. If you absolutely want to avoid reading any of ESMA's proposals, just keep on reading this post.
  • Finally, you will probably have to spent some time thinking about what you will have read about EMIR. The topic is actually a bit complex and, obviously, not everything will be relevant for your specific purpose.

In its draft regulatory standards, ESMA intensifies the already applicable EMIR regulation 648/2012 in three principal areas:

  • Clearing obligation (Annex II of ESMA's final report);
  • Central counterparties (Annex III – V of ESMA's final report);
  • Trade repositories (Annex VI – VI of ESMA's final report).

Clearing Obligation

Indirect Clearing

ESMA's proposal clarifies the notion of “indirect clearing”. This notion refers to the practice of clearing services offered by a client of a CCP to a third party. As a reminder, EMIR allows for indirect clearing if counterparty risk is mastered and assets and positions of the counterparty are protected.

The draft technical standards now specify that a clearing member shall provide indirect clearing services only to credit institutions and investment firms. In addition, the contractual tripartite documentation must include client's obligation to honor the obligations of the indirect client; it must also be sufficiently accessible to any potential client. Finally, clients' and indirect clients' records and accounts held with the CCP must be separated and their assets and positions be fairly liquid.

Notification of authorized CCP

This notification will detail the type of OTC derivative contracts to be cleared by the CCP as well as phasing-in conditions. Besides, it will give some information about the transaction volume and the degree of standardization of the derivative.

Public Register of Classified OTC Derivatives

The public register that identifies derivatives to be cleared via CCP will include detailed information on

  • asset class,
  • type of derivative,
  • underlying,
  • notional and settlement currency,
  • maturity, and
  • settlement conditions.

Liquidity Fragmentation

I always wonder why regulators must constantly come up with ever more definitions and technical terms. Liquidity fragmentation is an example for this practice. The notion simply means that two parties would like to trade a derivative that is cleared by more than one CCP. In this case, either both parties have to adhere to the same CCP or they adhere to different CCPs which have put in place a clearing arrangement among them. Is it really necessary to regulate this?

Non-financial counterparties

Non-financial counterparties must only clear OTC derivatives via CCP if they exceed the following clearing thresholds:

As already provided for in the EMIR regulation, risk reducing derivatives shall not be taken into account for calculating the above clearing thresholds. As ESMA's new proposal now specifies, risk reducing means

  • either covering any direct loss in the value of an asset
  • or covering any indirect loss in the value of an asset, due to interest rate, foreign exchange rate, or credit risk fluctuation,
  • or qualifying as a hedge under IFRS.

Risk mitigation techniques for OTC derivatives not cleared via CCP

ESMA's proposal adds some details to obligations already set out by the EMIR regulation:

  • Timely confirmation means, as regards credit default swaps and interest rate swaps, two business days until February 28, 2014 and one business day thereafter. Other derivative transactions must be confirmed within three business days until August 31, 2013, within two business days until August 31, 2014, and within one business day thereafter.

  • Portfolio reconciliation, carried out either by the counterparties themselves or by a qualified third party mandated to this effect, shall be obligatory in the following situations:

  • Portfolio compression shall be operated at least twice a year if more than 500 derivative contracts are outstanding among the parties.

  • The participants must put in place a dispute resolution mechanism for collateral recognition and valuation. In addition, disputes over 15 MEUR, outstanding for at least 15 business days, shall be reported to local authorities.

  • Compared to the EMIR regulation, ESMA further explicates the marking-to-model valuation. However, the relevant criteria (consistence with economic methodologies, independent monitoring, etc.) still remain imprecise. This seems normal as it would be somewhat burdensome to elaborate the model itself in a EU regulation.

  • ESMA reveals details on the exemption of intragroup transactions from CCP clearing.

Central Counterparties and Trade Repositories

The ESMA regulations applicable for central counterparties and trade repositories are very detailed. Their presentation would not only exceed the limits of this post (and my time available for writing it) but, I guess, also your tolerance as a reader.


  • ESMA Final Report – Draft Technical Standards under EU Regulation No. 648/2012.

  • EU Regulation 648/2012 dated 4 July 2012

Saturday, November 3, 2012

Clearing Derivatives in the post EMIR Era – “Driving in Safeland will become complicated!”

Assume you are living in Safeland. Safeland is a developed country. Today, it has one major problem: Out of 100,000 inhabitants, 40 people die, on a yearly average, in car accidents (Systemic Risk). This rate compares to 2009 figures of countries like Afghanistan, Egypt, and Eritrea.

Safeland's government (G 20, European Union, ESMA, and Bank for International Settlements) decide to limit the danger inherent in driving a car (Derivative) in Safeland.

To win the battle, the government suggests drastic measures:

  • Professional drivers (Financial Counterparties) are no more allowed to drive their own car. Instead, every time they would like to drive, they must lend their car at a national agency (Central Counterparty – CCP). This agency will only borrow you a car if you deposit some guarantee for lending it (Collateral). In addition, you cannot drive as long as you want and where you want. Predefined arrangements are offered which specify the lending conditions (ESMA Classified Derivative).
  • Non-professional drivers (Non-Financial Counterparties) participate much less in Safeland's car traffic. They are, therefore, considered less dangerous (systemic) and can still buy and drive their own car. Obviously, the government intends to further specify what a non-professional driver is. The idea is to monitor closely the distance that each individual is driving over specified time periods (Clearing Threshold). However, non-professional drivers must deposit, in addition to the selling price, a guarantee (Collateral) with their car vendor (OTC Counterparty). What's more, non-professional drivers are not only obliged to prepare properly for each trip (Risk Management Techniques) but also to pass regular health checks and to adapt their initial guarantee deposit if necessary (Mark to market / Mark to model). Finally, they will have to fill out surveys on a monthly basis and report any anomaly they have encountered during a trip (Reporting Obligation to the Competent Authority).

As you can imagine, Safeland's professional drivers are not happy. They argue that the proposal is improper. After all, they are professionals and know how to drive cars. “This makes sense.” says Safeland's prime minister on national television and grants several concessions:

  • First, if a car can only speed up to 50 km/h (Structured Derivative Transaction / Not ESMA Classified Derivative), even professional drivers can still own it by themselves.
  • Second, drivers employed by Safeland's government and other public entities are not subject to limitations. Obviously, the state of Safeland is expected to have enough cash to fix a problem, if any.
  • Finally, on private roads, professional drivers can do whatever they like (Intragroup Transactions).

What about Safeland's tourists?” – asks Peter, a lobbyist for Safeland's tourist industry, who doesn't want his name to appear on this blog – “Can they still visit our beautiful country, bringing their own car?” The short answer of Safeland's government is “No, they will be treated as if they were Safeland citizens.”

Let me finish with a final notice to any Safeland citizens who already own a car today: Don't worry, you can keep it in the future. Hopefully, you have recently bought a new car....