Emir Changes Could Raise Systemic Risk

Shanny Basar

The lifting of derivatives clearing obligations for smaller financial companies, pensions, and non-financial companies in the European Union could push them into default in times of extreme market stress and increase systemic risk according to consultancy Sapient Global Markets.

Valdis Dombrovskis, vice president in charge of financial services at European Commission, said in a speech yesterday that it is proposing some changes to the European Market Infrastructure Regulation, which covers central clearing.

Since the financial crisis, regulators have been trying to improve transparency for over-the-counter derivatives and the European Market Infrastructure Regulation came into effect in 2012. Emir mandated central clearing of certain OTC derivatives to reduce the risk of default, and introduced mandatory reporting of both OTC and exchange-traded derivatives. As a result, the share of centrally cleared interest rate OTC derivatives rose from 36% to 60% according to Dombrovskis. He said: “Emir is doing well overall. However, there is room for targeted adjustments to make it more proportionate and efficient.”

Valdis Dombrovskis, European Commission

Proposed changes include streamlining reporting rules to alleviate reporting requirements for non-financial counterparties and small financial counterparties; and pension funds being given three years to develop technical solutions for taking part in central clearing.

Joshua Satten, director of business consulting at Sapient Global Markets, said in an email that the proposed lifting of clearing obligations for non-financial counterparties, small financial counterparties, and pension funds is the most noteworthy part of the proposals.

“This puts the European Commission in a position of needing to establish consistent, constant methods for the measuring and definition of related thresholds and characteristics that would deem a company “non-financial” or “small”, which feels wholly unnecessary,” said Satten. “Meanwhile, pension funds getting a blanket exemption for three years regardless of size and market importance is ludicrous.”

The Commission said that exempting businesses could save them up to €1.1bn ($1.2bn) in operational costs and up to €5.3bn in one-off costs and exempting pensions saves them up to €1.6bn. “If this is true, isn’t the European Commission implicitly noting that clearing and associated rules are making trading more/prohibitively expensive in general for all market participants?,” Satten added.

The proposals also include granting power to  European Supervisory Authorities to develop their own risk and collateral models for non-cleared derivatives.

“Not only are both of these points wholly opaque, but if the ESA’s can develop their own collateralization models for non-cleared derivatives, and the EC is also simultaneously proposing that three important, opaquely-defined market segments should not be mandated to clear clearable derivatives, are we not opening the door wide open for risk?,” said Satten. “Smaller financial companies, pensions, and non-financial companies could under-collateralize, overleverage, and be in an overwhelmed position that would push them into default in times of extreme market stress. They are re-inviting in systemic risk.”

However, organisations representing more than European 8,000 companies, including the European Association of Corporate Treasurers, EuropeanIssuers and Deutsches Aktieninstitut, said in a statement that the proposals are an important step in relieving burdens for businesses which use derivatives to manage commercial and financing risks.

“We have long called for the Commission to uphold the commercial hedging exemption and to tackle the disproportionate burdens for Europe’s businesses from Emir’s current dual-sided reporting regime,” said the statement. “European companies currently face an estimated €2.4bn to €4.6bn reporting cost annually.”

Another proposal from the Commission is that single-sided reporting of exchange-traded derivatives by central counterparties should be introduced, rather than each side of the transaction having to report as at present. The Commission said: “While CCPs will face a slightly higher burden, they are well equipped for this task and the overall reporting burden will decrease as the reporting requirement concerning exchange-traded derivatives will be eliminated for all other counterparties.”

Sattan added: “The leading rule change they’ve been looking to publicise  and list is related to reporting of exchange-traded derivatives, which is probably the least important of the proposals and the rule that should have never come to fruition as it did in the first place.”

He continued that this will streamline reporting requirements but also opens the door for potential higher risk if CCPs report incorrectly.

“It also opens up the question of how regulators harmonize CCP data standards (or don’t), and means little to no insight of the book of record of the buyer and seller of the trade,” said Sattan. “Just because a CCP reports correctly, it doesn’t mean each side of the trade has recorded it in their book correctly.”

Reporting platform Abide Financial, which is part of Nex Group, said in an email that some clarification will be required as to the treatment of non-EU exchange-traded derivatives and the downstream back-to-back trades between clearing members and the trading members or clients, which are reported now but not referenced by the proposal.

Abide noted that trade repositories will also be held to a higher standard when it comes to ensuring quality of data accepted from reporting firms and the reconciliation process between trade repositories. “This will be backed up by a more stringent penalty regime, with higher potential fines, in the event that the new standards are not achieved,” Abide added.

Sattan said the Commission’s proposed rule changes are both overdue and telling as there have been constant issues related to data integrity, data consistency, upholding of  industrywide data standards, the enforcement of reporting requirements and truly effective utilization of the collected data.

“With the advent of reporting requirements introduced by SFTR and those about to be introduced under MiFID II, not to mention a lack of harmony with other regulatory standards, most notably Dodd-Frank, the European Commission has basically been forced into a position where they must not only propose, but fast-track rule amendments,” he said. “Not doing so would could push firms into having wholly over-burdensome, non-aligning regulatory requirements across regimes within the same jurisdiction, opening the door for human errors and issues related to maintaining multiple views of the same data; for one, what would constitute the golden source?”

Abide added: “All of these changes, and other more politically charged non-reporting adjustments, will need to go through a lengthy process of consultation and approval before taking effect.  We will be monitoring this process closely and ensuring that both Nex Regulatory Reporting and clients are fully prepared before any reporting changes come into force.”

As expected, Dombrovskis also said the Commission will set out a process to consider changes in the supervision of critical clearing infrastructure as a result of the UK leaving the European Union. The Commission intends to propose further legislative proposals on CCPs in June, based on an impact assessment.

For third-country CCPs which play a key systemic role for the EU, the Commission could ask for enhanced supervisory powers for EU authorities over third-country entities or ask such CCPs to be located within the EU.

“While minimising the risk of market fragmentation, the EU needs to be able to ensure supervisory oversight over such key CCPs,”Dombrovskis added.

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