|Portfolio compression requirements under EMIR|
Legal definition, economic sense and significance of portfolio compression
The definition for portfolio compression can be found in the MiFIR. Accordingly, portfolio compression is a risk reduction service in which two or more counterparties wholly or partially terminate some or all of the derivatives submitted by those counterparties for inclusion in the portfolio compression and replace the terminated derivatives with another derivative whose combined notional value is less than the combined notional value of the terminated derivatives.
The economic meaning of portfolio compression lies in that it reduces notional outstanding by eliminating matched trades or trades that do not contribute risk to a dealer's portfolio. Operation of compression services can create new replacement contracts, for example where a contract is replaced by a new, smaller contract to allow the removal of an offsetting exposure.
The notional reduction (assessed at portfolio level and not at the level of individual transactions within a portfolio) forms the necessary element of the portfolio compression.
This means, in particular, the process to simplify the management of the portfolio by aggregating positions into fewer contracts without reduction of the notional value (with a view, for instance, to standardise the coupons and coupons period, to make them eligible for clearing or to facilitate the management of the contract) is not included in the scope of portfolio compression.
The European financial regulator opinion (draft advice of 19 December 2014 - see below), however, sees one exception to the requirement that the notional value of the portfolio submitted by each participant to compression should decrease.
The said exception is that the notional value of the portfolio of a participant could remain at the same level as before compression, if the notional value of the portfolio of other participant(s) decreases.
As MiFIR underlines, portfolio compression reduces non-market risks in existing derivatives portfolios without changing the market risk of the portfolios.
Portfolio compression is widely used in practice among economic operators as ISDA Year-End 2012 Market Analysis observes that during 2012, $48.7 trillion in notional amount of OTC derivatives were eliminated via portfolio compression, including $44.6 trillion of interest rate derivatives (IRD). A total of $214.3 trillion of OTC derivatives has been eliminated in the past five years via portfolio compression.
Portfolio compression technicalities
The required elements of portfolio compression are not at the moment addressed in the prescriptive way at the EU law level, but MiFIR contains the empowerment for the European Commission to specify these points by means of delegated acts.
ESMA recommends that counterparties exchange simulation of the compression outcome so that each counterparty can ensure that its risk framework would be complied with.
It is also proposed that the investment firm and market operator, which provide portfolio compression would give at least one business day to the participant to add transactions that would increase the pool of trades eligible for termination, to adjust the limit to the counterparty risk, to market risk, the cash payment tolerance, and update the mark-to-market value of the selected transactions, to obtain an updated rehearsal unwind considering such adjustments.
The new trades must be marked as "resulting from compression" in EMIR trade reporting (as stipulated in the Commission Delegated Regulation (EU) No 148/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards on the minimum details of the data to be reported to trade repositories (OJ L 52, 23.02.2013, p. 1)).
There can be differentiated a bilateral compression - when one counterparty attempts compression directly with another - and the multilateral service involving several parties, viewing the trades between all of the counterparties in a group, and then reducing them down as much as possible using a combination of trades and closures.
While bilateral compression is the process whereby two parties agree to perform portfolio compression between the two of them, and on the terms of such compression, multilateral portfolio compression allows a broader range of counterparties to participate in the compression and therefore a possibly higher number of contracts to be compressed.
Multilateral compression is usually a service provided by a third party service provider within a legal and contractual framework that applies to all participants in the compression (see ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA /2014/1569, p. 441).
Multilateral compression can be significantly more effective than the bilateral service, the more parties are involved in a compression, the more benefit it can potentially bring. However, the timeframe applicable to bilateral compression could be shorter as the exercise is expected to be less complex than when multiple counterparties are involved.
The service of portfolio compression, which reduces non-market risks in derivative portfolios without changing the market risk, does not constitute a multilateral system under MiFID II by itself.
However, if a firm operates a system that comes within the definition of a multilateral system under MiFID II without taking into account these activities, any portfolio compression services that it provides for that system can form part of the multilateral system that the firm is operating (Financial Conduct Authority, Markets in Financial Instruments Directive II Implementation – Consultation Paper I (CP15/43), December 2015, p. 265).
The third type of portfolio compression sometimes differentiated involves a compression with a CCP also called "unilateral compression". It is indicated this service could be offered in the future. The above ESMA Technical Advice explains the process of compression with a CCP would allow counterparties to reduce the notional value of contracts in their books against that CCP.
Another distinction made is a differentiation between portfolio compression performed between two or more parties with a service provider and performed directly between counterparties.
EMIR Regulation in Article 11(1) requires that counterparties that enter into an OTC derivative contract not cleared by a CCP, must have, exercising due diligence, appropriate procedures and arrangements in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least formalised processes which are robust, resilient and auditable, for the timely confirmation, where available, by electronic means, of the terms of the relevant OTC derivative contract.
The said requirement applies equally to:
- financial counterparties and
- non-financial counterparties (irrespective of whether they exceed the clearing threshold or not).
Pursuant to EMIR 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 - ‘Commission Delegated Regulation on Clearing Thresholds’ or ‘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 seem to require only minor supplement to the existing documentation.
"Reasonable and valid explanation"
Referring once more to the EMIR's regulatory text, from practical point of view there are ambiguities how to interpret the term "reasonable and valid explanation" and what criteria might be used to judge whether an explanation is "reasonable and valid" or not.
The regulatory stance in that regard is the explanation the countErparty needs to be able to provide to the competent authority when they are requested to do so, should adequately demonstrate that portfolio compression was not appropriate under the prevailing circumstances. Depending on the circumstances, the justification could include that:
In the above Q&A document it was also explained that the requirement on portfolio compression does not prevent an offsetting transaction to be concluded with a counterparty different from the counterparty to the initial transaction.
Clearing obligation as a result of portfolio compression
An ambiguous case appears when as a result of the portfolio compression a non-financial counterparty crosses a clearing threshold and becomes subject of the clearing obligation.
There is no formally inscripted exemption from the clearing obligation for such an occurrence, however, taking into account issues of practicality and analogies from other significant jurisdictions, it seems that such cases shouldn't be covered by the clearing requirement. This legislative shortcoming can't be resolved without regulatory guidance.
The more likely situation is, however, that by compressing enough trades, a non-financial counterparty may be taken away from the clearing threshold, which could be considered as an advantage.
However, as is reported (EU rules threaten swaps compression), the problem of costs persists:
"[t]he issue stems from the fact that the mechanism for compressing trades results in additional transactions at the end of the process. Market participants note that counterparties may have to complete a number of swap transactions to neutralise the risk. The cost of clearing those trades under EMIR – and ultimately trading them through registered venues once MiFID II kicks in – could outweigh the capital benefits for some counterparties."
The comparisons with the analogous US scheme are also made where no-action relief from mandatory clearing is granted on amended and replacement swaps entered into in connection with multilateral portfolio compression.
Also ISDA observes that compressions generating new trades in many cases can no longer be booked outside of a CCP, thus reducing the tools available to manage the bilateral non-cleared portfolio (International Swaps and Derivatives Association (ISDA) comments on the ‘EMIR Refit’ proposal, 18 July 2017).
ISDA proposes, as a risk-mitigant, the revision of EMIR "to include the facility to allow a suitably approved and regulated compression service provider meeting the definitions and terms of MIFID 2 to generate trades that could be exempted from the clearing obligation."
"Such a service would, as a result, be highly constrained such that changes to the total market risk exposure of any given party should be zero, therefore ensuring no market impact from such a service. However by enabling the booking of overlay trades in legacy portfolios it would enable firms to have a simple and easy solution to manage their credit risk exposures.
Without such a service, such risks could go unmanaged, or firms could resort to increasingly complex structures which (while offsetting credit risk) might also represent a more onerous approach with operational risk implications. MiFIR allows for a comparable exemption of trades resulting from Portfolio Compression exercises from the derivatives trading obligation," ISDA said.
This proposition is fully supported by the FIA (FIA Response of 18 July 2017 to the European Commission EMIR Review Proposal – Part 1 (REFIT Proposals), p. 13).
Portfolio compression reporting under EMIR rules
According to provisions stipulating EMIR derivatives reporting framework i.e.:
- Commission Delegated Regulation (EU) No 148/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories with regard to regulatory technical standards on the minimum details of the data to be reported to trade repositories,
- Commission Implementing Regulation No 1247/2012 of 19 December 2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories,
the "compression" flag was populated initially in the Field 11 of the Table 2 (Common data).
Commission Implementing Regulation (EU) 2017/105 of 19 October 2016 amending Implementing Regulation (EU) No 1247/2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories requires the compression flag to be indicated in Field 16.
The prescribed way of filling in this field has not changed and consists in inserting either "Y" if the contract results from compression or "N" for the opposite case.
Proposals for legislative amendments to the EMIR reporting architecture, as expressed in the ESMA's Final Report Review of the Regulatory and Implementing Technical Standards on reporting under Article 9 of EMIR of 13 November 2015 (ESMA/2015/1645), do not envision other major modifications with regard to portfolio compression reporting, description and population of the relevant fields.
Transactions with third-country entities
ESMA in its Questions and Answers on EMIR also 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 compression 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 (see below).
Eligibility to provide portfolio compression services
Portfolio compression may be provided by a range of firms which are not regulated as such by MiFID II or MiFIR, such as CCPs, trade repositories as well as by investment firms or market operators.
Systems providing portfolio compression are beyond OTF's category since there is no genuine trade execution or arranging taking place within such systems (MiFIR Recital 8).
Another reason is, portfolio compression reduces non-market risks in existing derivatives portfolios without changing the market risk of the portfolios.
Requirements for firms providing portfolio compression services pursuant to MiFIR
Requirements for firms providing portfolio compression services have been stipulated in particular in Article 31 MiFIR and Articles 17 and 18 of the Commission Delegated Regulation (EU) 2017/567 of 18 May 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions (see boxes below).
It is noteworthy, pursuant to MiFIR investment firms providing portfolio compression are not subject in that regard to the best execution obligation as provided for in MiFID and the MiFIR transparency obligations.
The termination or replacement of the component transactions of a portfolio compression will not be subject to obligation to trade on regulated markets, MTFs or OTFs as stipulated by Article 24 of MiFIR.
Investment firms providing portfolio compression must make public through an Authorised Publication Arrangement (APA) the volumes of transactions subject to portfolio compressions and the time they were concluded within the time limits specified in MiFIR (relating to post-trade transparency requirements for trading venues in respect of bonds, structured finance products, emission allowances and derivatives - further details for publication to be specified by delegated acts of the European Commission).
Investment firms and market operators providing portfolio compressions are required to keep complete and accurate records of all portfolio compressions which it organises or participates in. These records must be made available promptly to the relevant competent authority or ESMA upon request.
The above Commission Delegated Regulation of 18.5.2016 contains specifications on:
1. the elements of portfolio compression such as the obligations:
- to consider participant's criteria for risk tolerance,
- to allow for the application of the relevant risk framework, and
- to establish links between transactions submitted for compression;
2. the required documentation of portfolio compression and method for determining whether the combined notional value following compression is less than the combined notional value before compression;
3. the publication requirements in relation to portfolio compression.
Special treatment for C6 energy derivatives contracts
Pursuant to MiFID II Directive EMIR portfolio compression requirements will not apply during the 42-month transitional period (counted from the entry into application of the said Directive) to C6 energy derivatives (i.e. physically settled coal and oil traded on an OTF) entered into:
- by non-financial counterparties below EMIR clearing threshold, or
- by non-financial counterparties that will be authorised for the first time as investment firms as from the date of entry into application of the MiFID II.
Timely confirmation requirement with respect to portfolio compression
One should be mindful of the fact, portfolio compression is subject to the EMIR timely confirmation requirements.
The European financial regulator's stance is the timely confirmation of OTC derivative contracts "applies wherever a new derivatives contract is concluded, including as a result of novation and portfolio compression of previously concluded contracts."
Portfolio compression as a type of a physical settlement for the purposes of Sections C6 and C7 of Annex I to the MiFID Directive
A portfolio compression has been also analysed as the separate delivery method in the context of ESMA's Guidelines on the application of the definitions in Sections C6 and C7 of Annex I of Directive 2004/39/EC (MiFID) of 6 May 2015 (ESMA/2015/675).
There were views that practices like portfolio compression (along with operationial netting) should also be mentioned explicitly in the Guidelines as type of physical settlement.
As follows from the aforementioned Guidelines, ESMA once more underlined portfolio compression is a risk reduction technique applied to a contract but that it does not change the legal nature of a contract and its specifications, and cannot be described as a "delivery method" from the outset.
Therefore ESMA has not included portfolio compression as a separate delivery method in the Guidelines (for details see commodity derivatives and contracts 'that must be physically settled' under MiFID II and MiFID I regulatory frameworks).
Portfolio compression reporting under REMIT and MiFID
The rules for the reporting of lifecycle events, like, among others, portfolio compression, may, theoretically, diverge between different pieces of the EU legislation, hence each legal framework must be considered separately.
When it comes to REMIT and MiFID II transactions reporting frameworks the situation is, however, similar.
Portfolio compression is not expected to be reported under REMIT reporting framework as the compression is not an activity related to the execution or modification of a transaction entered into on the wholesale energy market.
Under the MiFID II, compression, in the sense defined in the above-mentioned MiFIR provisions, is excluded from the scope of the term: "transaction" - see Article 2(5)(f) of the Commission Delegated Regulation (EU) of 28.7.2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to regulatory technical standards for the reporting of transactions to competent authorities.
Hence, it effectively means, compression is not subject to reporting under both REMIT as well as MiFID II reporting schemes.
The reason for this is portfolio compressions "are not susceptible to market abuse" (ESMA's Consultation Paper, MiFID II/MiFIR of 19 December 2014 (ESMA/2014/1570), p. 561).
Comparison of EMIR portfolio compression rules with other jurisdictions - equivalence
The process for granting equivalence status to the US legal framework governing compressions has been finalised by the Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories.
The US counterpart CFTC issued the parallel media report: CFTC Comparability Determination on EU Margin Requirements and a Common Approach on Trading Venues, Release: pr7629-17, October 13, 2017).
The portfolio compression requirements as a operational risk mitigation technique for OTC derivative contracts not cleared by a CCP are added in a section 4s(i) to the Commodity Exchange Act (CEA) by section 731 of the Dodd-Frank Act and apply to swap dealers and major swap participants, as defined in the CEA.
Consequently, it should be noted that the said Commission Implementing Decision (EU) 2017/1857 of 13 October 2017:
- covers the legal, supervisory and enforcement arrangements regarding portfolio compression applicable to swap dealers and major swap participants established in the USA that are authorised and supervised in accordance with the CFTC Regulations;
CFTC Regulations on operational risk mitigation techniques for OTC derivative contracts not cleared by a CCP contain similar obligations to those provided for in Article 11(1) EMIR.
In particular, Subpart I of Part 23 of the CFTC Regulations contains specific detailed requirements regarding, among others, portfolio compression applicable to OTC derivative contracts not cleared by a CCP.
The requirements set out in the CFTC Regulations are equivalent to the EMIR requirements for portfolio compression on a ‘comply or explain’ basis.
The said Commission Decision (EU) 2017/1857 concludes in Recital 9 that in relation to swaps that are under the jurisdiction of the CFTC, as defined in section 1a(47) of the CEA, the CFTC's legal, supervisory and enforcement arrangements applicable to swap dealers and major swap participants are equivalent to the portfolio compression requirements set out in the EMIR applicable to OTC derivative contracts not cleared by a CCP, as laid down in Article 11(1) EMIR.
The effect of the above statement is that market participants are allowed to comply with only one set of rules and to avoid duplicative or conflicting rules, i.e. where at least one of the counterparties is established in the US, it is deemed to have fulfilled EMIR portfolio compression requirements by complying with the requirements set out in the US legal regime.
However, it is noteworthy, the CFTC’s equivalence determination applies only where both the entity and the transaction are otherwise subject to both the CFTC and EU regulations on portfolio compression, and not when a swap dealer voluntarily complies with the respective regime.
Starting date for EMIR portfolio compression requirements
ESMA in its Questions and Answers on EMIR clarified portfolio compression 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.
Although portfolio compression may be perceived as a mechanism for controlling of systemic risk by reducing the number of outstanding trades on an individual entity portfolio level as well as on the macro scale, the impact of this process on the counterparty credit risk associated with the portfolio is limited.
The interesting observation is also that while portfolio compression reduces the size of the market, the continued growth in central clearing of OTC derivatives, partly in effect of the EMIR implementation, has the opposite effect because of the double-counting of cleared trades (in a cleared transaction one bilateral trade becomes two centrally cleared trades, which doubles the notional amount).
Last but not least, one should be mindful of the fact "portfolio compression may carry some disadvantages specific to a party's legal, tax, accounting and/or operational status and may therefore not be appropriate in all circumstances" (IOSCO Risk Mitigation Standards for Non-centrally Cleared OTC Derivatives FR01/2015 of 28 January 2015 p. 14).
EMIR Regulation, Article 11(1)
Commission Delegated Regulation (EU) 2017/567 of 18 May 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council with regard to definitions, transparency, portfolio compression and supervisory measures on product intervention and positions, OJ L 87, 31.3.2017, p. 90–116, Articles 17, 18, Recitals 16, 17
Commission Implementing Regulation (EU) 2017/105 of 19 October 2016 amending Implementing Regulation (EU) No 1247/2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories, Field 16
Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories
ESMA's draft advice to the European Commission on portfolio compression - the extract from the above-mentioned ESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA /2014/1569, p. 443 - 446)
|Last Updated on Saturday, 28 October 2017 19:57|