Under the European Market Infrastructure Regulation (EMIR), the obligation for financial institutions to clear certain OTC products is fast approaching. Only last month new guidance was issued for rates products. This guidance will provide the parameters for other products, however there still appears to be confusion in the market about what OTC products should or should not be cleared. Financial institutions must decide quickly their strategy to address these new regulatory obligations.
The main driver for clearing under EMIR is to eliminate bilateral counterparty risk through use of central counterparties. The Regulatory Technical Standards (RTS) around clearing have to-date been in a state of flux, as regulators and industry participants have not been able to develop clear rules. This has resulted in confusion around what should or should not be cleared. For example:
The timeline confusion
Financial institutions will have to clear trades executed between when a central counterparty is authorised and the date of a clearing obligation determination, known as frontloading. The European Securities and Markets Authority (ESMA) set both dates.
Frontloading for Non Financial Counterparties plus (NFC+) entities was then dropped completely and phased clearing dates were introduced – 6 months for clearing members, 18 months for Financial Counterparties (FCs) and 36 months for NFC+s.
The final draft RTS, released on 1 October 2014 adjusted the timeline further, giving ‘high activity’ FCs just 12 months to clear. These on-going shifts in timing, for both the mandatory clearing and frontloading obligations, have continued to cause confusion in the market.
The frontloading confusion
Frontloading creates uncertainty about how bilateral OTC trades should be priced. Should OTC trades be priced as cleared trades, as un-cleared trades, or somewhere in between? Clearing was introduced to reduce risk in OTC trades not create risk around how OTC trades should be priced.
The shifting obligations confusion
Another issue caused by the continuous revision of clearing requirements is the shifting obligations created for clients and banks. The fact that NFC+ clients were initially expected to frontload could have led them to seek a clearing relationship much earlier than necessary (causing inconvenience and unnecessary premature expense for the client). Moreover, the recent split of Category 2 (previously all FCs) into Category 2 (high-activity FCs) and Category 3 (low-activity FCs) leads to shifting obligations within this bracket for clients and banks alike. The distinction between categories will be based on whether they have non-centrally cleared derivative exposure of over €8bn on average between Nov 2014- Jan 2015. This amount cannot yet be quantified.
Further there will need to be additional communication from banks to FC clients to clarify clients who are high activity and those who are low activity (Categories 2 and 3). The logistics of this are especially complicated, because which category a client falls into will not be known until February 2015 after the 3month window.
Although ESMA redrafting the guidelines has been positive, as it showed ESMA’s willingness to listen to market participant’s feedback, the overall impact of moving timelines, frontloading requirements and shifting obligations based on new categorisations has done little to clarify the situation. Firms will need to decide quickly on their strategy to meet the new regulations, develop their own interpretation of the rules, and then implement the right infrastructure to monitor compliance.