The Proposal for a Regulation of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories (commonly referred to as the European Market Infrastructure Regulation - EMIR) provides for some new obligations envisioned to be imposed on non-financial counterparties (among others commodity firms) acting also on the emission market. The impacts are far-reaching and may require mayor organisational changes among market participants. There are also ambiguities regarding the practical implementation of the new measure.
The scope of the draft for a new legislative proposal being revealed by the Commission on 15 September 2010 (COM(2010) 484 final) is wide and lays down requirements covering all categories of OTC (traded over-the-counter) derivative contracts set out in Annex I Section C numbers (4) to (10) of the MiFID Directive (let’s remind that derivatives contracts relating to emission allowances are explicitly mentioned as financial instruments by point 10 of the Annex I Section C of the MiFID Directive).
The draft of the Regulation deals generally with financial counterparties, but there are a few exceptions. As the Commission stresses, leaving systemically relevant non-financial counterparties whose failure may have a significant negative effect on the market completely outside the scope of regulatory attention would not be an acceptable course of action, could lead to regulatory arbitrage and, finally, is necessary to ensure global convergence with third countries (mainly the US legislation). It seems that these exceptions should, however, be carved out carefully bearing in mind far less strict regulatory regime (in comparison with financial market legislation) applying to the non-financial counterparties.
Non-financial counterparties are generally covered by the new EMIR Regulation where certain thresholds (to be determined by the Commission in collaboration with the relevant authorities, including ESMA) are exceeded. Thresholds will be defined taking into account the systemic relevance of the sum of net positions and exposures by counterparty per class of derivatives. Specifying the thresholds will need to be tailored to the characteristics of the different markets, in case of energy markets for instance, there is envisioned cooperation between ESMA and the ACER (Agency for the Cooperation of Energy Regulators established by Regulation (EC) No 713/2009) in order to ensure that the particularities of the energy sector would be fully taken into account. The purpose of the thresholds is to identify systemically important positions in OTC derivatives taken by some non-financial counterparties.
Information and clearing thresholds
So, if the new Regulation materialises, commodity firms taking positions in OTC derivative contracts above information threshold will have to:
1) notify the competent authority,
2) provide justification for taking those positions,
3) report the details of any derivative contract they have entered into and any modification
thereof (including novation and termination) to a registered trade repository.
The draft further states that where a non-financial counterparty takes positions in OTC derivative contracts exceeding the clearing threshold it shall be subject to the clearing obligation with regard to all its eligible OTC derivative contracts.
The Regulation states in Article 7(4) that in calculating the positions for the clearing threshold OTC derivative contracts entered into by a non-financial counterparty that are ‘objectively measurable as directly linked to the commercial activity of that counterparty shall not be taken into account.’
It follows that for non-financial counterparties to be covered by the clearing obligations there are two prerequisites:
1) entry into a contract that isn’t ‘directly linked to the commercial activity’ of the counterparty,
2) clearing threshold exceeded.
As was observed in Explanatory Memorandum to the said legislative proposal, the clearing obligation will only apply to those OTC contracts of non-financial counterparties that are particularly active in the OTC derivatives market and if this is not a direct consequence of their commercial activity. For example, this may be the case for energy suppliers that sell future production, agricultural firms fixing the price at which they are going to sell their crops, airlines fixing the price of their future fuel purchases or any commercial companies that must legitimately hedge the risk arising from their specific activity.
Taking into account the wording of the draft of the Regulation, for the information threshold the character of the contract (commercial or speculative) is not relevant (Article 7(4) refers only to the paragraph 2 mentioning clearing threshold). Such a conclusion has also support in some parts of the Explanatory Memorandum.
Contracts not eligible for clearing
If some of contracts at issue happen to be not eligible for CCP (central counterparty) clearing, then the non-financial counterparty will be subject to the capital or collateral requirements specified in the Regulation. Where a non-financial counterparty takes positions in OTC derivative contracts exceeding the clearing threshold and the said contracts are not cleared by a CCP, a non-financial counterparty is obliged to introduce appropriate procedures and arrangements to monitor and mitigate operational and credit risk, including at least:
1) where possible, electronic means ensuring the timely confirmation of the terms of the OTC derivative contract;
2) robust, resilient and auditable processes in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them, and to monitor the value of outstanding contracts.
The value of outstanding contracts must be marked-to-market on a daily basis and risk management procedures must require the timely, accurate and appropriately segregated exchange of collateral or the appropriate and proportionate holding of capital. As can be seen from the above the proposed measures are far-reaching. The Regulation will force the non-financial counterparties to have complex risk-management departments. The only premises for such requirements will be:
1) taking positions in OTC derivative contracts exceeding the clearing threshold and
2) the finding that the said contracts are not cleared by a CCP.
It is ambiguous whether the third premise (speculative i.e. non-commercial character of the contract) is also applicable for qualifying under the said requirements, because Article 8(1) of the Regulation (defining entities subjecting to the new obligations) makes referral only to the Article 7(2) and not to the Article 7(4).
Similarly to specifying the details for the thresholds, also in the area of non-clearing–eligible derivatives the Commission is given powers to adopt regulatory technical standards. The said standards will relate to arrangements and levels of collateral and capital required for compliance with the said requirements and to specifying the maximum time lag between the conclusion of an OTC derivative contract and the confirmation referred to above.
So, the especially the collateral and capital requirements are sensitive to the market participants because if they are set on an excessively ambitious levels may force some weaker firms out of the market. In parallel, the Regulation leaves the said levels to the discretion of the Commission thus creating additional market risk in the longer perspective.
Ambiguities regarding implementation
The draft legislative proposal rises also some general doubts.
Commodity firms taking positions in OTC derivative contracts above information threshold will have to inter alia provide the competent authority “justification for taking those positions”.
EMIR does not, however, specify what will be legal effects of providing such justification.
What will be the consequences, if the non-financial counterparty changes its mind after providing the competent authority the said justification for a specific transaction? Will it be allowed to execute transaction in a different way, than described in the justification?
And, generally, the information required has ex-post or ex-ante character? Will the ‘insufficient’ justification be sanctioned in any way? Will the competent authority have the power to forbid the non-financial counterparty to enter into transaction or to execute a contract if the competent authority considers the transaction systemically important and dangerous to the financial stability of the system?
The EMIR doesn’t provide sufficiently clear answers for the above ambiguities. The regulatory technical standards to be adopted by the Commission with the support of the relevant authorities may be helpful.
But taking into account the strict requirements of the EMIR Regulation the question arises as to the ongoing work and consultation on the emission market oversight measures – are more stringent oversight measures additionally needed?