Sunday, September 30, 2012

The European Market Infrastructure Regulation (EMIR) – The beginning of the end of OTC derivatives?

French people (probably like any other people) love their summer holidays. They take the time to relax and to enjoy (most oftentimes French) beach holidays. This year, however, the European legislator had prepared a nice present for finance professionals in Europe: Just some days before the summer break, it adopted a new regulation on OTC derivatives, central counterparties (CCP), and trade repositories. 59 pages long which, as you might expect, feel much longer when reading.

I will try to summarize the main elements today. The topic of the regulation can be broken down into 3 questions:

  • Under which conditions are companies and banks obliged to trade financial derivatives via CCP?
  • If these conditions are not met, which rules are they obliged to respect when trading on a one-on-one basis?
  • How must CCPs and trade repositories be organized?

Clearing Obligation via CCP – Cumulative Conditions

To evaluate whether you must clear derivatives via a CCP, you should follow the below steps:

1. Classified OTC Derivative

EMIR identifies 5 types of OTC Derivatives:

  • Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash
  • Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities which may be settled in cash or, under specific conditions, physically
  • Derivative instruments for the transfer of credit risk
  • Financial contracts for differences
  • Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash

To fall under the clearing obligation, a financial instrument must not only qualify as an OTC derivative but also be added by the European Securities and Markets Authority (ESMA) to a class of derivatives that must be cleared via CCP. The derivative classes will be available in a public register on ESMA's website.

When identifying classes of derivatives to be cleared via CCP, ESMA shall take into account the following criteria:

  • Degree of standardization of the contractual terms and operational processes
  • Volume and liquidity
  • Availability of fair, reliable, and generally accepted pricing information
  • Interconnectedness between counterparties using the relevant class of derivatives
  • Impact of using the relevant classes of derivates on the levels of couterparty credit risk
  • Promote equal conditions of competition within the internal market

2. Date of trade of the derivative

The directive itself is applicable since 16 August 2012. However, the clearing obligation only applies to those derivative contracts concluded

  • after the date of application specified by ESMA for the class of derivatives in question or
  • after the admission of a CCP for a class of derivatives but before the above date of application if the derivative's maturity exceeds a minimum maturity to be specified by ESMA.

The clearing obligation ceases if an authorized CCP for the class of derivatives is no longer available.

3. Counterparties

Eligible financial counterparties are

  • Investment Firms
  • Credit Institutions
  • Insurance Undertakings
  • Assurance Undertakings
  • Reinsurance Undertakings
  • UCITS including respective Management Companies
  • Institutions for Occupational Retirement Provision
  • Alternative Investment Funds

Eligible non-financial counterparties refer to any undertaking which is not a financial counterparty and whose average derivative contracts position over 30 working days exceeds a clearing threshold to be specified by ESMA in its regulatory technical standards.

For both financial and non-financial counterparties, non-EU entities are included if they would be subject to a clearing obligation were they established in the EU.

4. Exceptions

Five types of derivatives / counterparties are exempt from the obligation to clear via CCP:

  • Derivatives concluded with member states' bodies managing public debt
  • Derivatives concluded with public sector entities benefiting from explicit central government guarantees
  • Derivatives concluded with the BIS, multilateral development banks, the EFSF, and the ESM
  • Derivatives concluded until 16 August 2015 with pension scheme arrangements (institutions for occupational retirement provision, occupational retirement provision businesses – to be specified by the member states)
  • Intragroup transactions

OTC Derivatives not cleared via CCP

Except for intragroup transactions, EMIR specifies the following obligations for both financial and non-financial counterparties:

  • Appropriate procedures and arrangements to measure, monitor, and mitigate operational and counterparty risk (confirmations, reconcile portfolios and manage associated risk, dispute resolution, valuation of outstanding contracts)
  • Daily marking-to-market or, exceptionally marking-to-model
  • Risk-management procedures that require timely, accurate, and appropriately segregated exchange of collateral or, in case the risk is not covered by collateral, holding appropriate and proportionate amounts of capital

These rules will be specified by ESMA's upcoming regulatory technical standards.

CCP and Trade Repository Regulation

I will keep the explanations short here. Unless you would like to run a CCP or trade repository, these stipulations will be less interesting for you.

With respect to trade repositories, EMIR specifies the following:

  • the registration process for EU trade repositories;
  • ESMA's information, investigation, and inspection rights and supervisory measures towards EU trade repositories;
  • the recognition conditions for non-EU trade repositories;
  • operating requirements.

Now back to the question I asked at the outset: Is this the beginning of the end of OTC derivatives? I don't think so. The new regulation will certainly limit the OTC scope for standardized products but there will always be enough space for structured transactions to be carried out on an OTC basis.


  • EU Regulation 648/2002 dated July 4, 2012 (called European Market Infrastructure Regulation or simply EMIR)