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|Portfolio reconciliation requirements under EMIR|
Portfolio reconciliation provides a means of ensuring that parties' books and records remain synchronised and that effects of trade events, such as novations, amendments and other activities, are accurately captured (ISDA's Recommended Practices for Portfolio Reconciliation).
Pursuant to the regulatory technical standards (Commission Delegated Regulation (EU) No 149/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP (OJ L 52, 23.2.2013, p. 11- ‘Commission Delegated Regulation on Clearing Thresholds’ or ‘RTS’)) there is an obligation imposed on financial and non-financial counterparties to an OTC derivative contract to agree in writing or other equivalent electronic means with each of counterparties on the arrangements under which portfolios will be reconciled.
Such agreement must be reached before entering into the OTC derivative contract, which is specific to EMIR while, for instance, the US CFTC rules do not specify the timing of agreement regarding portfolio reconciliation.
Purpose and object of portfolio reconciliation
The main purpose of the portfolio reconciliation is to identify at an early stage any discrepancy in a material term of the OTC derivative contract, including its valuation.
The portfolio reconciliation must cover key trade terms that identify each particular OTC derivative contract and must include at least the valuation attributed to each contract arising from the requirement to mark-to-market (or to-model where applicable).
Thus the key trade terms that identify each particular OTC derivative contract that must be acknowledged while portfolios are reconciled, may be specified as follows:
- the valuation attributed to each contract in accordance with Article 11(2) of EMIR,
- the effective date,
- the scheduled maturity date,
- any payment or settlement dates,
- the notional value of the contract,
- currency of the transaction,
- the underlying instrument,
- the position of the counterparties,
- the business day convention,
- any relevant fixed or floating rates of the OTC derivative contract,
- any other relevant details to identify each particular OTC derivative contract as provided for in Article 13 of RTS.
When it comes to practical instruments for fulfilling EMIR portfolio reconciliation requirements, for instance ISDA master agreement standard envisioned two alternate methods: "Exchange of Portfolio Data" and " One-Way Delivery of Portfolio Data". They differ mainly in the level of activity of the parties to the agreement in executing the portfolio reconciliation, where under the former scenario both parties initiate the procedure, while under the latter only the one.
Required frequencies for portfolio reconciliation
EMIR specifies the minimum frequencies at which the parties should reconcile portfolios. The frequency of portfolio reconciliation depends on the status of the counterparty (FC, NFC+ or NFC-) and on the number of outstanding contracts the counterparties have with each other.
For a non-financial counterparty below the clearing threshold portfolio reconciliation is required to be performed once per quarter when the counterparties have more than 100 OTC derivative contracts outstanding with each other at any time during the quarter and once per year when the relevant number is 100 or less (for other specific reconciliation frequencies see box).
The practical effect of the new requirements is, however, that the firms will have to carefully count their outstanding contracts not to overlook the relevant reconciliation thresholds.
It is also noteworthy that, as opposite to earlier versions of the draft RTS, the definitive text requires the relevant frequencies for portfolio reconciliation be measured "at any time" during, respectively, the week, quarter etc.
This amendment resolves earlier ambiguities, when and how often the portfolio size should be measured.
Considering, as was said above that the frequency of portfolio reconciliation depends on the status of the counterparty (FC, NFC+ or NFC-) and on the number of outstanding contracts the counterparties have with each other, it is noteworthy that those two elements may change in time and therefore modify the frequency of the portfolio reconciliation requirement. At this point an ambiguity arose, at which frequency should the status of the counterparty and the number of outstanding contracts be reassessed.
In that regard the European financial regulator ESMA has explained that the frequency of the portfolio reconciliation requirements should be reassessed at each portfolio reconciliation date. If for example a NFC- is subject to a quarterly reconciliation with Counterparty X and performs the first portfolio reconciliation on 15 December 2013, the date of the next portfolio reconciliation should be: −15 March 2014 (quarterly requirement) if the NFC- is still a NFC- on 15 December 2013, and if the number of its outstanding contracts with Counterparty X was above 100 at any time in the previous reconciliation period, i.e. from 15 September 2013 to 15 December 2013. This should be assessed on the reconciliation date, i.e. on 15 December 2013. −15 December 2014 (yearly requirement) if the NFC- is still a NFC- on 15 December 2013, and if the number of its outstanding contracts with Counterparty X was below 100 at all time during the previous reconciliation period, i.e. from 15 September 2013 to 15 December 2013. This should be assessed on the reconciliation date, i.e. on 15 December 2013.
Scope of the responsibility for the reconciliation requirements
Some ambiguities relate to the scope of the responsibility for the reconciliation requirements where a counterparty does not provide its data for reconciliation. This case may typically concern smaller non-financial counterparties but it is also noteworthy that definitions of 'financial counterparty' and 'non-financial counterparty' under EMIR are limited to EU entities and appear, therefore, not to cover transactions between EU entities and non-EU entities.
This leads to legal uncertainty in respect of the extra-territorial application of the all risk mitigation requirements, including portfolio reconciliation. In that way the EU counterparty, be it financial or non-financial may be particularly exposed to risk that the other party to the transaction, being non-EU counterparty, refuses to co-operate in meeting the deadlines for timely confirmation.
Similar difficulties with enforcing portfolio reconciliation requirements may be encountered in relation to transactions between financial counterparties and non-financial counterparties on the one hand and:
- counterparties in the EU that are not classified as financial counterparties or non-financial counterparties e.g. natural persons and sovereign entities which are not 'undertakings' and which are not subject to obligations under Article 11;
- certain particular counterparties listed in Article 1(4) and (5) of EMIR who are exempt from obligations under Article 11.
It was therefore suggested that a negative affirmation process could efficiently be used when dealing with such circumstances. If the counterparty returns a portfolio, the reconciliation will be carried out, but if the counterparty does not return a portfolio (within a suitable timeframe), it will be deemed to have agreed with the data sent to it for the purposes of the reconciliation. Such arrangements would of course have to be subject to an appropriate contractual framework between the parties.
ESMA in its Questions and Answers on EMIR as updated on 5 August 2013 observed that Article 11 of EMIR, which provides the basis of these requirements, applies wherever at least one counterparty is established within the EU. Therefore, where an EU counterparty is transacting with a third country entity, the EU counterparty would be required to ensure that the requirements for portfolio reconciliation are met for the relevant portfolio and/or transactions even though the third country entity would not itself be subject to EMIR.
However, if the third country entity is established in a jurisdiction for which the Commission has adopted an implementing act (under Article 13 of EMIR), the counterparties could comply with equivalent rules in the third country.
The clarification on the above issue of negative affirmation can be found in the regulatory guidance on legal responsibility for the portfolio reconciliation obligation where the trade takes place with a calculation agent (both the EU EMIR rules as well as the US CFTC arrangements allow portfolio reconciliation to be performed not only bilaterally but also by a third party). In that regard ESMA has explained that:
"[c]ounterparties can agree that the calculation agent will be in charge of performing the portfolio reconciliation. In any case, each counterparty remains legally responsible for the portfolio reconciliation obligation. The processes under which a counterparty is deemed to have perform portfolio reconciliation after a fixed deadline has expired would be compliant provided that both counterparties have agreed in advance to perform portfolio reconciliation by this process".
The said stance of ESMA may be of importance to firms that are unable to compel their counterparties to provide their portfolio data to perform reconciliation. However, regulated entities must as always be prepared to demonstrate that good faith and commercially reasonable efforts have been made to procure the cooperation of their counterparies with respect to the relevant EMIR requirements.
Starting date for the portfolio reconciliation requirements
There is also a question regarding the starting date for the portfolio reconciliation requirements. ESMA in its Questions and Answers on EMIR clarified portfolio reconciliation requirements apply to the portfolio of outstanding OTC derivative contracts. Therefore as the relevant technical standards enter into force on 15 September 2013, the requirements apply to the portfolio of outstanding contracts as of such date.
Thus, for counterparties having to perform their portfolio reconciliation annually, the first one should be made within one year from the entry into force of the RTS on OTC derivatives, i.e. before 15 March 2014.
EMIR and the US CFTC regime applicable to swap dealers and major swap participants (in the meaning of CFTC rules) have been assessed by ESMA as equivalent (the final decision thereon being reserved to the European Commission's implementing act). There are no equivalent provisions under the US SEC regime.
There are also no legally binding requirements on timely portfolio reconciliation in Japan.
Practically, for non-financials that have 100 or less OTC derivative contracts outstanding with each other the required frequency of the portfolio reconciliation is only once per year, which does not appear overly burdensome and particularly disrupting business processes carried out so far.
The requirement to agree before entering into the OTC derivative contract on the arrangements under which portfolios will be reconciled practically also would not pose any real difficulty. Moreover, if the counterparties mandate the said service to the qualified third party, the new EMIR's requirement to reconcile portfolios would not involve too much additional work on the part of non-financial market participants.
|Last Updated on Tuesday, 25 February 2014 19:56|