The European Market Infrastructure Regulation (EMIR) is the cornerstone body of European legislation for the regulation of over-the-counter (OTC) derivatives.
The Regulation came in the aftermath of the financial crisis as part of the global OTC derivatives reform, with the aim to increase transparency and reduce systemic risk in derivatives markets.
Who is in scope of EMIR? Financial firms such as banks, fund management companies, insurance companies, as well as some non-financial corporates with substantial treasury activities, are all within the scope once engaged in derivatives transactions, with regulatory requirements significantly increased if transactions happen over-the-counter. In practice, due to the widespread use of certain derivative contracts such as FX forwards, great many firms may be affected by the Regulation.
Key aspects of EMIR
EMIR introduced new regulatory requirements for financial (FCs) and some non-financial counterparties (NFCs), most notably the central clearing of specified standardized OTC derivative contracts and the use of risk-mitigation techniques for those that are not centrally cleared. Trading in derivatives has been furthermore made subject to mandatory reporting for both OTC and exchange-traded (ETD) products.
What are the main impacts of EMIR on market participants? Have a look below at the three categories to find out more.
EMIR mandates that certain OTC derivatives contracts be cleared through a central counterparty (CCP).
The clearing obligation applies to financial counterparties (FCs) such as banks, insurers and asset managers as well as some non-financial counterparties (NFCs). The obligations follow an extended phase-in process that began in mid-2016 and will only be completed for all asset classes and all types of counterparties by mid-2019. Whether a firm is subject to mandatory clearing requirements depends on the nature of its business and the clearing thresholds set out in Regulatory Technical Standards (RTS).
Firm categories according to EMIR:
|Category 1||FCs which are also clearing members – major CCPs have published the list of their clearing members.|
|Category 2||FCs and alternative investment funds (AIFs) whose month-end average of outstanding gross notional amount of non-centrally cleared derivatives is above EUR 8 billion|
|Category 3||FCs and AIFs that fall below the above mentioned EUR 8 billion threshold.|
|Category 4||NFCs not included in Categories 1, 2 or 3.|
Following the categorization above, the European authorities have so far made three types of derivatives subject to mandatory clearing:
|Types of Derivatives||Category 1||Category 2||Category 3||Category 4|
|IRS in the G4 currencies (i.e. EUR, GBP, USD and JPY)||21 June 2016||21 Deceber 2016||21 June 2019 (initially 21 June 2017)||21 December 2018|
|IRS in the non- G4 currencies (i.e. SEK, PLN and NOK)||9 February 2017||8 August 2017||21 June 2019 (initially 9 February 2018)||9 August 2019|
|Index CDS||9 February 2017||9 August 2017||21 June 2019 (initially 9 February 2018)||9 May 2019|
As the RTS are reviewed on a regular basis, firms trading in derivatives are advised to keep track of the relevant developments.
A substantial portion of OTC derivatives are not standardized and therefore will not be centrally cleared. To further reduce counterparty risk inherent to such trades, EMIR introduced risk mitigation techniques applicable to all non-centrally cleared transactions in both pre- and post-trade space. Those include timely confirmation, portfolio reconciliation and compression, dispute resolution, daily valuation and the exchange of collateral.
- Timely confirmation
Requires counterparties to document the agreement of all the terms of a contract. While the requirement applies to both financial and non-financial counterparties, the timing depends on the classification of an entity under EMIR and the type of the OTC derivative traded.
- Portfolio reconciliation
Mandates counterparties to reconcile key trade terms identifying particular OTC derivative contract to identify any discrepancies, including its valuation. The required frequency of reconciliation depends on the nature of the counterparty and the number of trades outstanding with respective counterpart.
- Portfolio compression
Counterparties with more than 500 outstanding OTC derivative contracts with each other are to have in place procedures that allow them to regularly analyze whether a portfolio compression is possible.
- Dispute resolution
Requires counterparties to agree procedures and processes to identify, record and monitor disputes related to the valuation of the OTC contract and to the exchange of collateral between counterparties, as well as to resolve disputes in a timely manner. Counterparties can be required to report long lasting, high value disputes to a local regulator.
- Daily valuation
Certain counterparties are to perform daily mark-to-market valuation of the outstanding contracts. Only if market conditions do not allow for the employment of a mark-to-market valuation, for example if the market is inactive or where the range of fair estimates is significant, a reliable and prudent mark-to-model method may be used.
- Exchange of collateral
Both financial and non-financial counterparties are required to exchange two-way initial margin (IM) and variation margin (VM) with respect to OTC trades that are not centrally cleared.
IM refers to the collateral collected to cover a counterparty’s current and potential future exposure between the last margin collection and the liquidation of positions or hedging following a default of the other counterparty.
Initial margin is to be exchanged on a gross basis. Furthermore, to reflect the results of the daily mark-to-market or mark-to-model of outstanding contracts, counterparties are to exchange additional collateral referred to as a VM.
VM applies to all counterparties and does not have a materiality threshold.
Margin requirements follow an extended phase-in period as well, per amount of non-centrally cleared derivatives, with applicable dates set out in RTS:
Date of application Firm category or OTC type Variation margin 4 February 2017 Applies to entities with group notional amount above EUR 3 trillion 1 March 2017 Applies to all counterparties Initial margin 4 February 2017 Applies to counterparties with group notional amount above EUR 3 trillion 1 September 2017 Applies to counterparties with group notional amount above EUR 2.25 trillion 1 September 2018 Applies to counterparties with group notional amount above EUR 1.5 trillion 1 September 2019 Applies to counterparties with group notional amount above EUR 0.75 trillion 1 September 2020 Applies to counterparties with group notional amount above EUR 8 billion
All counterparties are required to report on OTC and exchange-traded (ETD) derivative trades to a registered trade repository (TR), using a unique Legal Entity Identifier (LEI). The reporting must take place following the execution of a trade and on an ongoing basis, should the contract be subject to any changes or a termination. While nominally both parties are required to submit a report on each trade, either party could choose to delegate reporting to a third party or enter into an arrangement whereby one party reports on behalf of both counterparties. The detailed requirements pertaining to regulatory reporting are set out in the final EMIR technical standards.
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