Short overview of basic requirements in view of the urgent need to implement operational and risk-management procedural changes.
EMIR imposes generally three key requirements (for some additional remarks see Scope of EMIR):
1) to report derivative contracts to a trade repository,
2) to clear your OTC derivative contracts that are subject to the clearing obligation if the clearing threshold is exceeded,
3) to apply risk mitigation techniques to OTC derivative contracts if the clearing threshold is not exceeded (or - if the threshold is exceeded - to those OTC derivative contracts that are not subject to the clearing obligation).
Thus, it may be concluded that if the clearing threshold is not exceeded, the non-financials should pay attention:
1) to the obligation for reporting derivative contracts to the trade repository, as well as
2) to certain risk mitigation techniques with respect to OTC derivatives (not all, however, as same of them apply only when the clearing threshold is exceeded).
Pursuant to EMIR the risk mitigation techniques belonging to the second group (i.e. that non-financials apply only when the clearing threshold is exceeded), are:
- the requirement to mark-to-market on a daily basis the value of outstanding contracts (where market conditions prevent marking-to-market, reliable and prudent marking-to- model are used),
- requirement for the timely, accurate and appropriately segregated exchange of collateral.
Taking into account these preliminary differentiations it may be useful to make a short overview of these other EMIR requirements on risk mitigation techniques that are applied irrespective of the clearing threshold. Given the fact of the European Commission’s endorsing on the 19 December 2012 the relevant regulatory technical standards (RTS), this document is also taken into account.
Pursuant to EMIR financial counterparties and non-financial counterparties that enter into an OTC derivative contract not cleared by a CCP should ensure that “appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk and counterparty credit risk”. Among these arrangements RTS enumerates the following minimum requirements:
1. The timely confirmation of the terms of the relevant OTC derivative contract
Article 12 of the RTS contains a patchwork of specific regulations differentiating the timelines for contract confirmations depending on the type of entity (financial or non-financial) and the derivative’s class.
Considering, however, that from the entire scope of derivatives non-financials are particularly interested in derivatives on commodities, it is noteworthy, such derivatives being concluded up to and including 31 August 2013 are required to be confirmed by the end of the seventh business day following the date of execution of the derivative contract (the relevant deadline for derivatives concluded after 31 August 2013 up to and including 31 August 2014 is the end of the fourth business day following the date of execution of the derivative contract and for derivatives concluded after 31 August 2014 the end of the second business day following the date of execution).
So, the conclusion is, the non-financials should now take due care to have procedures in place requiring the relevant contracts be confirmed within the above timelines. For timelines regarding other classes of derivatives (for instance credit default swaps and interest rate swaps) see Article 12 of the RTS.
2. EMIR requires the non-financials below the clearing threshold to have “formalised processes which are robust, resilient and auditable 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.”
RTS in that regard elaborates specific points on portfolio reconciliation, portfolio compression and dispute resolution arrangements.
(a) 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).
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.
Furthermore, there is an obligation imposed 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.
An easement has been also envisioned since the portfolio reconciliation may be performed by the counterparties to the OTC derivative contracts itself or by a qualified third party duly mandated to this effect.
To conclude this part of an issue, if the non-financials 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. If the counterparties mandate the said service to the 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.
It is necessary to add that for a financial counterparties and for a non-financial counterparty that excess the clearing threshold the required frequency of the portfolio reconciliation is greater and it must be performed:
(i) each business day when the counterparties have 500 or more OTC derivative contracts outstanding with each other;
(ii) once per week when the counterparties have between 51 and 499 OTC derivative contracts outstanding with each other at any time during the week;
(iii) once per quarter when the counterparties have 50 or less OTC derivative contracts outstanding with each other at any time during the quarter.
b) Portfolio compression
Pursuant to EMIR RTS financial counterparties and non-financial counterparties with 500 or more OTC derivative contracts outstanding with a counterparty which are not centrally cleared must have in place procedures to regularly, and at least twice a year, analyse the possibility to conduct a portfolio compression exercise in order to reduce their counterparty credit risk and engage in such a portfolio compression exercise.
Moreover, financial counterparties and non-financial counterparties must ensure that they are able to provide a reasonable and valid explanation to the relevant competent authority for concluding that a portfolio compression exercise is not appropriate.
It is striking from the above regulatory language that the requirement for portfolio compression has not been formulated in the overly prescriptive manner. In fact, the obligation to “have in place procedures to regularly, and at least twice a year, analyse the possibility” of the portfolio compression and to be “able to provide a reasonable and valid explanation” for not conducting this task requires in my opinion only minor supplement to the existing documentation.
c) Dispute resolution
Pursuant to the EMIR RTS, when concluding OTC derivative contracts with each other, financial counterparties and non-financial counterparties must have agreed detailed procedures and processes in relation to:
(a) the identification, recording, and monitoring of disputes relating to the recognition or valuation of the contract and to the exchange of collateral between counterparties. Those procedures should at least record the length of time for which the dispute remains outstanding, the counterparty and the amount which is disputed;
(b) the resolution of disputes in a timely manner with a specific process for those disputes that are not resolved within five business days.
The particular term appears in the above provision, namely five business days as a deadline above which the process should be “specific”. This is a new issue to include in the drafting for the contracts.
The issues relating to the intra-group exemptionunder EMIR are not touched in this simplified overview.