Emission OTC derivatives pricing: the differences between NFCs+ and NFCs-
Monday, 18 March 2013 07:48

 

Emissions derivatives market participants are required under the EMIR rules to calculate whether they cross the clearing threshold. The status of being below the relevant threshold should effect for these counterparties in more favourable pricing of the respective products.

 

 

So, we definitively have a new element of the emissions market infrastructure, namely: “NFCs+” and “NFCs-“.

 

These terms are obviously created in the context of EMIR requirements and are already present in the standard trading documentation (see ISDA EMIR protocol). The above abbreviations mean non-financial counterparties, respectively, above or below the clearing threshold.

 

The said classification will have crucial importance for applying the respective EMIR requirements, and, consequently, for pricing OTC derivatives having emission allowances as its underlying.

 

Under EMIR provisions the clear-cut alternative is fundamental: either the transaction is cleared by the approved CCP or the relevant risk mitigation techniques are to be applied.

 

However, the level of sophistication of the said risk mitigation techniques depends on whether non-financial counterparty (NFC) qualifies as NFC+ or NFC-.

 

The key provisions in that regard can be found in the 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, hereinafter referred to as “RTS”).

 

The differences between the levels of the required risk mitigation of the OTC derivative contracts, which influence the pricing of the relevant product, are visible at least with respect  to the standards for:

1) portfolio reconciliation,

2) contract confirmation deadlines,

3) marking-to-market (or to-model) of value of outstanding contracts,

4) collateral.

 

The standard for the portfolio reconciliation

 

The differences between the required frequency of the portfolio reconciliation of the OTC derivative contracts concluded with NFC+ and NFC- pursuant to RTS are set out in the box.

 

 

The required frequency of the portfolio reconciliation of the OTC derivative contracts pursuant to RTS:

 

1. For a financial counterparty or a NFC+

 

(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;

 

2. For a NFC-

 

(i) once per quarter when the counterparties have more than 100 OTC derivative contracts outstanding with each other at any time during the quarter;

(ii) once per year when the counterparties have 100 or less OTC derivative contracts outstanding with each other.

 

 

Recital to the RTS states that more demanding requirements should apply to both financial counterparties and non-financial counterparties that exceed the clearing threshold “while lower reconciliation frequency should apply for non-financial counterparties that would not exceed the clearing threshold irrespective of the category of its counterparty who would also benefit from this less frequent reconciliation for that part of its portfolio.”

 

The above language clearly indicates that the provider of the OTC emission derivative product benefits from less frequent reconciliation for that part of its portfolio which is allocated to the NFC-. The logical consequence of this differentiation should be more favourable pricing of emission allowances derivative OTC product for NFC- in comparison to the valuation of the analogous contract offered to the NFCs+.

 

Confirmation standard

 

Also the required deadlines of the confirmation of the OTC derivative products differ pursuant to the RTS depending on whether the NFC+ or NFC- is a party to the contract. The specific confirmations’ timeframes are as follows:

 

1. For contract concluded between financial counterparties or NFCs+:

 

(a) for credit default swaps and interest rate swaps that are concluded up to and including 28 February 2014, by the end of the second business day following the date of execution of the OTC derivative contract;

(b) for credit default swaps and interest rate swaps that are concluded after 28 February 2014, by the end of the business day following the date of execution of the OTC derivative contract;

(c) for equity swaps, foreign exchange swaps, commodity swaps and all other derivatives not provided for in point (a) that are concluded up to and including 31 August 2013, by the end of the third business day following the date of execution of the derivative contract;

(d) for equity swaps, foreign exchange swaps, commodity swaps and all other derivatives not provided for in point (a) that are concluded after 31 August 2013 up to and including 31 August 2014, by the end of the second business day following the date of execution of the derivative contract;

(e) for equity swaps, foreign exchange swaps, commodity swaps and all other derivatives not provided for in point (a) that are concluded after 31 August 2014, by the end of the business day following the date of execution of the derivative contract.

 

2. For contract concluded between financial counterparties or NFC-:

 

(a) for credit default swaps and interest rate swaps that are concluded up to and including 31 August 2013, by the end of the fifth business day following the date of execution of the OTC derivative contract;

(b) for credit default swaps and interest rate swaps that are concluded after 31 August 2013 up to and including 31 August 2014, by the end of the third business day following the date of execution of the OTC derivative contract;

(c) for credit default swaps and interest rate swaps that are concluded after 31 August 2014, by the end of the second business day following the date of execution of the OTC derivative contract;

(d) for equity swaps, foreign exchange swaps, commodity swaps and all other derivatives not provided for in point (a) that are concluded up to and including 31 August 2013, by the end of the seventh business day following the date of execution of the derivative contract;

(e) for equity swaps, foreign exchange swaps, commodity swaps and all other derivatives not provided for in point (a) that are concluded after 31 August 2013 up to and including 31 August 2014, by the end of the fourth business day following the date of execution of the derivative contract;

(f) for equity swaps, foreign exchange swaps, commodity swaps and all other derivatives not provided for in point (a) that are concluded after 31 August 2014, by the end of the second business day following the date of execution.

 

Although confirmations may be made also via electronic means, more frequent confirmations, however safer from the systemic point of view, may occur more costly for providers of emission derivatives OTC products. Thus, also considering the less stringent frequency of the product-confirmation standard, NFCs- logically should benefit from more favourable pricing of the relevant product.

 



 

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