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All clear? EU introduces clearing and reporting regime for OTC derivatives
EMIR May 2012

EU introduces Securing your access clearing | OTC and reporting derivatives regime and central for OTC clearing derivatives

Contents

Executive summary EMIR introducing an EU regime for OTC derivative trading International mandate for reform of OTC derivatives market EMIR requirements Overlap with US Dodd-Frank Act Who is subject to EMIR? Requirements for cleared contracts Bilateral trading and cleared trading comparison Risk management requirements for uncleared contracts Reporting obligations Coordination with other legislative initiatives Third country issues Key issues for firms How we can help Contacts

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Executive summary

Whats changing in EU derivatives markets

The EU is near completing rules which will restructure post-trade operations for over the counter (OTC) derivatives in less than a year, through a regulation focusing on OTC derivative transactions, central counterparties (CCPs) and trade repositories (TRs), known as the European Market Infrastructure Regulation (EMIR). The European Union (EU), along with the other G20 countries, committed to reform the OTC derivatives market by 2012, and this commitment is driving the EUs tight timetable for implementation. The EMIR rules will require firms to report all derivative contracts to TRs, to clear eligible OTC derivative contracts through CCPs and to apply risk management standards for uncleared trades. It will also establish new authorisation and regulatory schemes for CCPs and TRs.

On 29 March 2012 the European Parliament (Parliament) approved the EMIR text, paving the way for its passage by the European Council of Finance Ministers (Council) this spring. We expect the reporting requirements to become effective by early 2013 and for clearing requirements to be phased in from spring 2013. The version passed by the Council contained few significant changes from prior versions, except that the clearing requirement was expanded to include certain OTC derivative trades conducted between counterparties located outside of the EU. The requirement is stated in extremely broad terms and the European Securities and Markets Authority (ESMA) is required to develop meaningful criteria to refine it.

While the text of EMIR is near-final at this stage, regulators still need to produce twenty-five sets of regulatory technical standards (RTS) defining some of the key requirements and their effective dates. Notably, RTS will clarify which OTC derivative contracts are subject to mandatory central clearing, define the reporting requirements and establish margin and collateral standards for CCPs.

Impacts for firms

The EMIR rules are designed to increase market stability and to reduce market interdependencies. Long-term the new regime will substantially reduce counterparty risks for firms dealing in OTC derivatives, improve trade processing efficiency, and reduce the risk of contagion for both market participants and markets themselves. It will also lead to more standardisation of OTC derivative contracts and tighter spreads on transactions. However, firms also need to anticipate some effects of EMIR which may be challenging:

EU introduces Securing your access clearing | OTC and reporting derivatives regime and central for OTC clearing derivatives

 The OTC derivatives market will evolve into a two-tier market for centrally cleared and bilaterally cleared trades. Firms will face increased costs from clearing fees and additional reporting requirements. Both clearing brokers and trading firms will need to make operational changes to ensure compliance with the new regulations. Firms are also likely to face higher capital charges and will need to post margin in cash or other designated eligible securities, in relation to contracts which are not continually cleared. The narrowing of eligible collateral requirements may result in a shortage of such assets, giving rise to a growth in collateral trading and related services.

The demand for clearing services over the next twelve months may exceed supply and operational capability of CCPs to on board clients, with the result that central clearing may not be immediately available to all those entities captured by the scope of EMIR. In the short-term, trade volumes may decrease while market participants assess the costs of hedging risks, the challenges of matching risks to standardised products and the overall costs of OTC derivative maintaining OTC derivatives positions.

How we can help

PwC have the expertise and knowledge to help you ensure that your firm is operationally ready to meet the new clearing and reporting requirements and collateral management challenges. In addition, EMIR is part of a package of EU legislative reforms affecting capital markets activities. The introduction of a European OTC derivative clearing infrastructure and its operational rules, taken together with the other EU and US capital market reform, requires a strategic response from market participants. We are working with firms to help them understand the overlaps between EMIR and other capital market reform measures. We can help you to develop strategic approaches to take advantage of the opportunities offered by market restructuring as well as adapting to these changes in an efficient and cost effective way.

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EMIR introducing an EU regime for OTC derivative trading

The EU is close to achieving the first major milestone in imposing mandatory clearing and reporting requirements for OTC derivatives contacts, in time to meet the December 2012 deadline set by the G20 in 2009. The rules are embodied in EMIR, which was adopted by the European Parliament on 29th March 2012. After the Council adopts it at an upcoming meeting, the legal framework will be largely in place. EMIR will come into force 20 days after publication in the EUs Official Journal. However, EU regulators are still working on many of the RTS which underpin EMIR, so questions remain around when the new regime will actually go live. We expect the reporting requirements to become effective by early 2013 and for clearing requirements to be phased in from spring 2013. This timetable may give the industry a few months breathing room, but it has implications from a practical perspective because important uncertainties still remain. EMIRs clearing requirements will impact all OTC derivative contracts traded in the EU, and certain contracts traded in third countries. Firms will need to fundamentally restructure their OTC derivative trading operations, by either transferring counterparty risk management to CCPs or adapting to increased capital and collateral requirements and enhanced risk management standards for bilateral trades. New reporting requirements for all derivative contracts will give regulators, and eventually the market, access to improved data relating to derivative trading across the

EU. The enhanced transparency is expected to help regulators better spot threats to financial stability that may arise from derivatives trading. The new rules also create the market infrastructure to support this regime by introducing common authorisation and operational requirements for CCPs and registration and supervision requirements for TRs by European regulations.

would be traded on-exchange or through electronic trading platforms, cleared through CCPs (or subject to appropriate credit risk management rules) and reported to TRs. G20 countries are making progress in achieving four basic OTC derivative reform objectives: mitigating credit counterparty risk reducing operational risk increasing transparency enhancing market integrity. In the United States (US), the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) introduced OTC derivative clearing requirements which, like EMIR, apply to non-financial firms as well as to regulated financial firms. For the EU, EMIR creates the clearing and basic reporting infrastructure. The EU plans to introduce exchange trading requirements and market disclosure requirements for derivatives through revisions to the Markets in Financial Instruments Directive (MiFID), which are currently being negotiated in Brussels.

International mandate for reform of OTC derivatives markets

In 2008 Bear Sterns near-collapse, Lehman Brothers failure and the AIG bail-out revealed significant weaknesses in the structure of OTC derivatives markets. Because the bulk of OTC derivatives trading currently takes place off-exchange, directly between individual market participants, regulators and other market participants have very little transparency as to the nature and volumes of trading. Further, the current structure of the OTC derivative market creates complex interdependencies between market participants, which exacerbates the spread of contagion when firms get into trouble. In the financial crisis, poor counterparty risk management led to inadequate collateralisation and catastrophic losses. Lack of contract standardisation and poor back office operations resulted in trade processes backlogs taking years to resolve. Off-exchange contract negotiations impeded price formation and left regulators and risk managers without adequate market information. In September 2009 the G20 leaders agreed that by no later than December 2012 OTC derivative contracts in all G20 markets

Key EMIR implementation dates

Council approves EMIR text May 2012 EMIR published in Official Journal, effective 20days after publication July 2012 RTS approved, effective 20 days after publication in Official Journal March 2013

ESAs deliver Level 2 RTS consultations June 2012 6

ESMA and ESAs complete RTS by 30 September 2012

EU introduces clearing and reporting regime for OTC derivatives

EMIR requirements
EMIR sets out the following requirements in relation to OTC derivative trading: clearing obligation for eligible OTC derivative trades reporting obligation for all derivative trades measures to reduce counterparty credit risk and operational risk for OTC derivative trades which are bilaterally traded rules for the authorisation and operation of CCPs rules on the interoperability between CCPS rules for the registration and operation of TRs. The new rules will improve market stability by replacing individual market participants counterparty risk management processes with standardised CCP requirements. Most importantly, EMIR will interpose the CCP between counterparties thus reducing potential credit default contagion between firms and markets. The new reporting requirements will apply to all derivative trades and aim to ensure that regulators can monitor the build-up of systemic risk through excessive risk concentrations. Risk concentration within the CCPs themselves will be addressed through strict requirements covering issues such as governance, capital requirements and default funding mechanisms. EMIR requirements apply to trading in derivative contracts, as defined within MiFID. The EMIR mandatory clearing and reporting requirements set the scene for the new exchange-trading and pre-and posttrade transparency requirements that will apply under proposed revisions to MiFID (MiFID II). The EU is also amending its market abuse regime to cover trading in OTC derivatives and to seek to bring more integrity to OTC derivative trading practices and conduct of business.

However, the Dodd-Frank Act rules on OTC derivatives go further, capturing nonfinancial firms in the scope of authorisation requirements, imposing new conduct of business rules on dealers, creating position limits and position management rights, and mandating exchange trading. Further, the controversial Volker rule under the DoddFrank Act contains a swap push out rule which requires the legal separation of swap trading operations from certain other firm activities. Thus far, the EU has not sought to require legal seperation of derivative trading activites.

However pension scheme operators will still be subject to reporting requirements and collateralisation requirements. Other similar schemes such as those generating retirement income or schemes operated by life insurance companies may also qualify for this exemption if certain conditions are met.

Who is subject to EMIR?

EMIR rules apply to CCPs and their clearing members, financial counterparties, certain non-financial counterparties and TRs. Not all market participants will have to comply with EMIR there are four exemptions from the mandatory clearing requirement: Contracts below a clearing threshold ESMA will determine thresholds below which derivative contracts entered into by non-financial firms will not be subject to the clearing requirement. Exempt trades will still have to be reported to TRs by financial institutions facilitating such transactions. Financial institutions involved in managing public debt Central banks, public bodies responsible for or intervening in the management of public debt and the Bank for International Settlements are exempt from central clearing and reporting obligations. Intra-group transactions Groups of financial firms, groups of non-financial firms, and firms combining financial and non-financial firms may be eligible for an exemption. This exemption requires full consolidation of the group and centralised risk management processes and supervisory pre-approval. Further guidance on how this exemption will work in practice will be provided in the RTS from ESMA. Pension funds EU policy makers recognise that pension scheme operators minimise their cash positions to maximise long-term returns for policy holder returns (i.e. they seek to be asset rich, cash poor). Until industry can develop a non-cash collateral alternative, EMIR will exempt pension scheme operators from clearing requirements for three years.

Who is a financial counterparty under EMIR? This term is defined widely under EMIR to include MiFID investment firms, credit institutions, non-life insurers, life assurance firms, reinsurers, undertakings for collective investments in transferable securities (UCITS) and their managers, occupational pension schemes (IORPs) and alternative investment fund managers (AIFMs).

Overlap with US DoddFrank Act

Both the Dodd-Frank Act and EMIR contain wide ranging extraterritorial requirements which capture OTC derivative trading activities conducted in third countries. Firms transformation programmes must anticipate the reach of both sets of rules. There are many similarities between the two regimes rules: both set out clearing requirements, CCP authorisation and regulatory regimes, margin and segregation rules and rules for reporting and trade repositories.

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Requirements for clearing contracts

EMIR establishes a bottom-up and topdown approach. National supervisors will authorise CCPs to clear certain types of derivatives and to inform ESMA of these authorisations. Then ESMA will consider whether mandatory clearing should apply to that class of derivative across the EU. Separately, ESMA can decide to mandate central clearing for certain classes of derivatives across the EU, and invite CCPs to tender for the right to clear those types of derivatives. However, in the short-term, we expect to see the market infrastructure grow primarily from the bottom-up, while ESMA builds up its capabilities and knowledge in this area. EMIR sets out preliminary criteria for clearing eligibility, including: trading volumes, whether contracts are already cleared by a CCP, the ability of CCPs to handle anticipated volumes and any special risks which may be created by centrally clearing such contracts. ESMA will elaborate further on these criteria in RTS, setting out the basis on which it will make such assessments going forward.

Foreign exchange swaps and forwards pose particular challenges under EMIR. Legislators rejected proposals to exempt FX derivatives from the scope of EMIR. However, EMIR recognises that derivatives exposed primarily to settlement risk, as in the case of FX derivatives, may not be suitable for the same treatment as those exposed primarily to counterparty risk. ESMA will make the final determination, but EMIR states that the regime for such contracts should rely notably on preliminary international convergence and mutual recognition of the relevant infrastructure. As a first step, firms will need to prepare a clearing plan for all OTC derivative contracts they trade which are likely to be deemed clearing eligible. Firms will need to assess the costs and operational and commercial considerations of becoming a CCP clearing member or becoming a client of another CCP member firm. Then firms will be able to assess how the collateral requirements of their CCP or clearing firm differ from the current OTC collateral requirements that they operate, for

example to comply with International Derivatives and Swaps Association (ISDA) master agreements which are widely used by most derivative counterparties. Under CCP clearing, firms will have the option to maintain omnibus or individual client segregated accounts, against which collateral will be posted. Margin calls will be made intra-day, at least when pre-defined thresholds are exceeded. Legislators and commentators have fiercely debated the type of collateral required for CCP initial margin and variation margin. Table 1 below compares bilateral and cleared trading arrangements. Some stakeholders are concerned that new collateral requirements will be expensive and difficult to meet. In particular, there is a risk that OTC dealing firms may seek alternative and unregulated trading and hedging techniques, to avoid CCP requirements that they deem too expensive or difficult to fulfil.

Table 1: Bilateral trading and cleared trading compared

Bilateral transactions Counterparty risk lies with each trading partner Margin requirements based on individual valuation methods and varying ISDA Master Agreement/collateral support agreements Margin is held by counterparty or third party custodian Cleared transactions Trade execution remains bilateral; but once a trade is agreed, it is novated to the CCP The CCP intermediates the trade, replacing the bilateral contract between the counterparties with two contracts: one between each counterparty and the CCP The CCP has standard non-variable margin requirements and rules based on the CCPs margin model Initial and variation margin are posted with the CCP at certain collateral locations Buy-side firms are not expected to become direct clearing members of CCPs, instead access will be established via a designated clearing member or clearing broker

EU introduces clearing and reporting regime for OTC derivatives

Risk management requirements for uncleared contracts

EMIR requires counterparties to hold additional capital to manage risks which are not covered by an appropriate exchange of collateral. The joint discussion paper issued on 6 March 2012 by the ESAs suggests that firms subject to the Capital Requirements Directive (CRD) (i.e. banks and investment firms) or insurance companies subject to Solvency II are deemed to be sufficiently capitalised to cover the risks associated with OTC derivatives trading and that no additional capital requirements should be imposed on these firms. However, the ESAs indicated that firms subject to the UCITS directive or the Alternative Investment Fund Managers Directive (AIFMD) are not adequately capitalised to cover the risks of uncleared trades through posting appropriate collateral. UCITS and AIFMD do not provide a legal basis on which the ESAs could prescribe additional capital requirements for those types of firms. If ESMA deems a type of derivative to be insufficiently liquid or not sufficiently standardised to be centrally cleared, in addition to capital and collateral requirements it will impose enhanced risk management procedures to those types of contracts: trade confirmation requirements reconciliation requirements daily mark-to-market or mark-to-model valuation collateral segregation requirements reporting requirements. We will see further details on the confirmation, reconciliation procedures, procedures relating to intra-group exemptions and criteria for reporting third country trading activities as the RTS emerge.

Commission proposal in relation to central securities depositories, the European Central Banks Target2Securities initiative, and the SEPA regime for payments. These initiatives seek to improve clearing and settlement systems resiliency and efficiency. From a trading perspective, EMIR is closely linked to the proposed MiFID II and the Market Abuse Directive revisions which will require many OTC derivatives to be traded onexchange and will bring trading in these instruments into the scope of the EU market abuse regime. We are also awaiting proposals from the European Commission to amend the Securities Law Directive to address investor rights and safekeeping issues. Developing deep regulatory reforms like EMIR poses significant challenges maintaining coherence and consistency with the reforms mentioned above and the wider prudential reform agenda, including CRD IV and Solvency II is essential, and further work on EMIR may be required to ensure we achieve that. These factors reinforce the complexity of the current regulatory environment and the need for firms to assess regulatory change as a package of reforms, not as isolated sets of requirements.

Third country issues

EU firms carrying out OTC derivatives trades with counterparties in non-EU countries (i.e. third countries) will have to comply with clearing requirements. Further, OTC derivative transactions carried out between two or more counterparties in third countries will be subject to EMIR clearing requirements if the trades have a direct, substantial and foreseeable effect within the Union or where it is deemed necessary or appropriate to prevent evasion of any provision of EMIR. It is still unclear exactly which OTC derivative trading activities will be captured by these broad requirements. The European Commission will also need to undertake third country equivalence assessments with regards to CCPs located outside of the EU. All of these standards will be addressed in RTS and will be critical requirements for firms which conduct cross-border business outside of the EU. Convergence of internal clearing and reporting standards will be critical to the long-term success of the international clearing regimes introduced under the G20 mandate. The benefits that regulators anticipate obtaining through greater standardisation, such as increased trading volumes, will be limited unless CCPs are able to cross-clear and net positions. Also, establishing a universal standard for TR reporting is essential for regulators to view a firms aggregate trading activity.

Reporting obligations
Firms and CCPs are required to report all OTC derivative contact transactions to a TR (or ESMA in the absence of TR arrangements) no later than one working day following the conclusion, modification or termination of the contract. This requirement will apply to all existing on-exchange derivatives trading as well as all cleared and uncleared OTC dealing. Firms must keep records of trades for five years from the date of the termination of the contract. ESMA will develop data and format requirements through RTS.

Coordination with other legislative initiatives

Reform of OTC trading practices in the EU is closely linked to other financial market reforms. On the European front many other regulatory initiatives to improve financial market infrastructures are already underway, including the recent European

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Key issues for firms

The Parliaments passage of EMIR on 29 March 2012 has cleared the way for final Council vote and EMIR will come into force 20 days after it is published in the Official Journal. Although the implementation date of the regulation is pending, because of the very tight deadlines firms will need to proceed with preparations before the first draft RTS are published in summer 2012 and separately come into force. Firms must manage many legislative and commercial uncertainties as they develop strategic and operational programme plans: Implementation requirements not yet released to the market. Regulators still need to produce twenty-five sets of RTS defining some of the key requirements (see Table 2 for full list of expected RTS). Notably, technical standards will clarify which OTC derivative contracts are subject to mandatory central clearing. Complexity around third country issues. The European Commission will identify critical details on third country application and equivalence standards. This aspect will be particularly important to understand the implications for global firms. Multiple pricing outcomes. Firms will need to anticipate which derivatives transactions will be bilateral or centrally cleared. For business which remains uncleared, firms must anticipate the new capital, collateral and costs associated with the additional risk management processes. For cleared business, firms must assess the choice of various CCPs or clearing brokers and the margin requirements and pricing options

presented by each option. Clearing brokers need to consider how to set margin requirements to ensure that they are consistent with those of different CCPs and incorporate those costs in their commercial clearing rates. Transition to standardised collateral requirements. In addition, RTS will specify the types of assets which meet CCP initial and variation margin requirements. These requirements are expected to have a dramatic effect on firms collateral funding abilities, and in turn could also impact other commercial activities, such as securities lending. Further, the standardisation of collateral requirements and loss of re-hypothecation opportunities may result in a shortage of high quality collateral. Application of intra-group exemptions. RTS will also clarify how intragroup exemptions within groups of financial and non-financial firms will apply. Those exemptions will not be automatic, they will require pre-approval by regulators. Establishment of reporting arrangements. New reporting requirements will apply to all derivative transactions including those which remain bilaterally traded. This requirement will put more demands on firms data management and reporting systems, particularly on client onboarding and data capture processes.

EMIRs passage and implementation dates will arrive quickly during the next year. Firms which have not already developed reporting and clearing strategies, budgets, IT and resourcing plans must do so as a matter of urgency. We advise firms to monitor the final stages of the legislative process and draft their project plans around the requirements in late stage proposals, but be prepared to accommodate any late legislative changes.

How we can help

We have extensive experience assisting clients with clearing and collateral management activities: developing a client clearing strategy designing business and operational clearing processes building collateral management business and technical IT architecture advising on a collateral optimisation strategies and implementation approaches designing, implementing and testing regulatory and transaction reporting systems providing assurance over controls for client services, such as prime brokerage and clearing services. Given the short time frames, time is of the essence. We have multi-disciplinary teams of experts who can help you assess and respond to the many compliance, technology and operations challenges presented by EMIR and other derivatives reform rules which are fundamentally reshaping the international capital markets.

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EU introduces clearing and reporting regime for OTC derivatives

Table 2: List of RTS that ESMA has to submit to the European Commission by 30 September 2012
1 Criteria for transactions conducted by counterparties outside the EU which are subject to EMIR clearing requirements, types of indirect contractual arrangements that do not increase counterparty risk and ensure adequate protection Details in notifications from competent authorities about OTC derivative contracts approved for clearing Classes of OTC derivatives to be cleared on EU-wide basis and date(s) from which clearing obligation takes effect Details to be included in public register Notion of liquidity fragmentation Details of trade reports Format and frequency of reports, dates for commencement of reporting Criteria for which derivative contracts qualify as hedge contracts, value of clearing thresholds for intra-group transactions that trigger clearing requirements (European Securities Authorities) Procedures for approving counterparty risk management, including mark to market techniques, intra-group exemption notice information requirements, contracts considered to have a direct, substantial, foreseeable effect within the Union or cases where it is necessary or appropriate to prevent the evasion of any provision of EMIR (European Banking Authority) Risk management procedures, including levels and types of collateral and segregation arrangements, level of capital required for compliance, procedures for counterparties when applying for exemptions, and criteria for what is prompt legal transfer of own funds (European Banking Authority) Rules regarding capital and retained earnings and reserves of a CCP Conditions under which Union currencies are relevant to assessment of which central banks should be included in EMIR colleges CCP information that applicant 3rd country CCP shall provide ESMA in application CCP minimum contents of corporate governance arrangements CCP record keeping requirements CCP BCP and disaster recovery plans CCP appropriate percentage and time horizons for the liquidation period and the calculation of historical volatility to be considered for different classes of instruments CCP framework market conditions to be used to define size of default fund and other financial resources CCP liquidity fund framework CCP methodology for calculating and maintaining CCP own resource to be used CCP highly liquid collateral standards, haircuts and conditions under which commercial bank guarantees may be accepted as collateral CCP highly liquid financial instruments, highly secured arrangements and condensation limits CCP stress testing requirements TR application standards TR frequency and content of data to be shared among regulators to aggregate and compare data

2 3 4 5 6 7 8 9

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11 12 13 14 15 16 17 18 19 20 21 22 23 24 25

The ESAs are tasked with drafting some 25 RTS and must submit these to the Commission by 30 September 2012. The European Commission has up to three months to endorse the RTS, and then the Council and European Parliament have a further three months to review the finalised versions. Thus, the final RTS may be in place by March 2013.

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Contacts

Crispian Lord Partner

crispian.lord@uk.pwc.com +44 (0) 20 7804 8148

Mathew Oswald Director

matthew.oswald@uk.pwc.com +44 (0) 20 7213 4048

Laura Cox Partner

laura.cox@uk.pwc.com +44 (0) 20 7721 1579

James Chrispin Director

james.chrispin@uk.pwc.com +44 (0) 20 7804 2327

Justin Malta Director

justin.a.malta@uk.pwc.com +44 (0) 20 7213 8246

Cedric dAlbis Director

cedric.dalbis@uk.pwc.com +44 (0) 20 7212 3089

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