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.

 

"Compression will result in some derivative transactions to be reduced or terminated and replaced by other transactions with a reduced notional value"

 

(ESMA Consultation Paper on MiFID II/MiFIR of 22 May 2014 - ESMA/2014/549).

 

 

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)).

 

 

Bilateral/multilateral/unilateral compression

 

 

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 approach

 

 

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 (OJ L 52, 23.2.2013, p. 11‘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.

 

Article 14 of the Commission Delegated Regulation on Clearing Thresholds

Portfolio compression

Financial counterparties and non-financial counterparties with 500 or more OTC derivative contracts outstanding with a counterparty which are not centrally cleared shall 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.

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.

 

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:


- the portfolio is purely directional and does not allow any offsetting transactions;


- multilateral compression services are not available in the relevant markets, for the relevant products, or to the relevant participants and that compression on a bilateral basis would not be feasible;


- compression would materially compromise effectiveness of the firm's internal risk management or accounting processes (see: ESMA's Questions and Answers on EMIR).

 

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.

 

 

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).

 

 

MiFIR Recital 8

 

"... Portfolio compression may be provided by a range of firms which are not regulated as such by this Regulation or by Directive 2014/65/EU, such as central counterparties (CCPs), trade repositories as well as by investment firms or market operators. It is appropriate to clarify that where investment firms and market operators carry out portfolio compression certain provisions of this Regulation and of Directive 2014/65/EU are not applicable in relation to portfolio compression. Since central securities depositories (CSDs) will be subject to the same requirements as investment firms when providing certain investment services or performing certain investment activities, the provisions of this Regulation and of Directive 2014/65/EU should not be applicable to firms that are not regulated thereby when carrying out portfolio compression."

 

 

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).

 

 

Article 31 of MiFIR

 

1. When providing portfolio compression, investment firms and market operators shall not be subject to the best execution obligation in Article 27 of Directive 2014/65/EU, the transparency obligations in Articles 8, 10, 18 and 21 of this Regulation and the obligation in Article 1(6) of Directive 2014/65/EU. The termination or replacement of the component derivatives in the portfolio compression shall not be subject to Article 28 of this Regulation.

 

2. Investment firms and market operators providing portfolio compression shall make public through an APA the volumes of transactions subject to portfolio compressions and the time they were concluded within the time limits specified in Article 10.

 

3. Investment firms and market operators providing portfolio compressions shall keep complete and accurate records of all portfolio compressions which they organise or participate in. Those records shall be made available promptly to the relevant competent authority or ESMA upon request.

 

4. The Commission may adopt by means of delegated acts in accordance with Article 50, measures specifying the following:

(a) the elements of portfolio compression,

(b) the information to be published pursuant to paragraph 2,

in such a way as to make use as far as possible of any existing record keeping, reporting or publication requirements.

 

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.

 

 

Commission Delegated Regulation (EU) 2017/567 of 18.5.2016 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 position

 

Recitals 16 and 17

 

(16) In order to specify the elements of portfolio compression, so as to delineate it from trading and clearing services, it is necessary to identify the process whereby derivatives are wholly or partially terminated and replaced by a new derivative, in particular the steps of the process, the content of the agreement and the legal documentation supporting the portfolio compression.

 

(17) To ensure that suitable transparency of portfolio compression performed by counterparties is achieved, it is necessary to specify the information which should be made public.

 

Article 17
Elements of Portfolio compression
(Article 31(4) of Regulation (EU) No 600/2014)

 

1. For the purposes of Article 31(1) of Regulation (EU) No 600/2014, investment firms and market operators providing portfolio compression shall fulfil the conditions in paragraphs 2 to 6.

 

2. Investment firms and market operators shall conclude an agreement with the participants to the portfolio compression providing for the compression process and its legal effects, including identifying the point in time at which each portfolio compression becomes legally binding.

 

3. The agreement referred to in paragraph 2 shall include all relevant legal documentation describing how derivatives submitted for inclusion in the portfolio compression are terminated and how they are replaced by other derivatives.

 

4. Before each compression process is initiated, investment firms and market operators providing portfolio compression shall:


(a) require each participant to the portfolio compression to specify the participant's risk tolerance including specifying a limit for counterparty risk, a limit for market risk and a cash payment tolerance. Investment firms and market operators shall respect the risk tolerance specified by the participants in the portfolio compression;

 

(b) link the derivatives submitted for portfolio compression and submit to each participant a portfolio compression proposal that includes the following information:
(i) the identification of the counterparties affected by the compression,
(ii) the related change to the combined notional value of the derivatives,
(iii) the variation of the combined notional amount compared to the risk tolerance specified.


5. In order to adjust the compression to the risk tolerance set by the participants to the portfolio compression and in order to maximise the efficiency of the portfolio compression, investment firms and market operators may grant participants additional time to add derivatives eligible for termination or reduction.


6. Investment firms and market operators shall only perform the portfolio compression once all participants to the portfolio compression have agreed to the portfolio compression proposal.

 

Article 18 


Publication requirements for Portfolio compression


(Article 31(4) of Regulation (EU) No 600/2014)

 

1. For the purposes of Article 31(2) of Regulation (EU) No 600/2014 investment firms and market operators shall make the following information public through an APA for each portfolio compression cycle:

(a) a list of derivatives submitted for inclusion in the portfolio compression,
(b) a list of derivatives replacing the terminated derivatives,
(c) a list of derivatives changed or terminated as a result of the portfolio compression,
(d) the number of derivatives and their value expressed in terms of notional amount.
The information referred to in the first subparagraph shall be disaggregated per type of derivative and per currency.

 

2. Investment firms and market operators shall make public the information referred to in paragraph 1 as close to real-time as is technically possible and no later than the close of the following business day after a compression proposal becomes legally binding in accordance with the agreement referred to in Article 17(2).

 

 

 

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

 

 

US

 

EMIR's scope of application for portfolio compression rules is broader than the analogous US CFTC regime for swap dealers and major swap participants (within the CFTC meaning).

On the other hand, to the extent that the rules are applicable to swap dealers and major swap participants, they are considered by ESMA as broadly equivalent (the final decision thereon being reserved to the European Commission's implementing act).

In turn, when it comes to the US SEC regime there is no equivalency to EMIR compression rules.

  

Japan

 

Japan portfolio compression regime is not eqivalent to EMIR compression rules.

 

 

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.

 
 

Concluding remarks

 

 

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).

 

 

Documentation

 

 

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 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

 

ESMA's draft advice to the European Commission on portfolio compression - the extract from the above-mentionedESMA's Technical Advice to the Commission on MiFID II and MiFIR of 19 December 2014, ESMA /2014/1569, p. 443 - 446)

 

 

 

 

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Comments (1)
1 Friday, 07 August 2015 14:51
Diana Higgins
Thanks for this very good summary. I just twitted your link @portcompression.

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