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