RegTech Intelligence 
The sheer scale of the EU regulatory reform agenda means that it is easy to miss key details in new requirements which, viewed in isolation, are not major implementation issues, but viewed in context of the wider reform package can cause significant headaches. The counterparty classification cross-over between EMIR and CRD IV is one of these headaches.
CRD IV, coming into force 1 January 2014, will compel firms to hold capital against their counterparty exposures as part of the credit risk reform module. As part of this, firms are able to discount the credit valuation adjustment (CVA) risk from their capital for all OTCD trades with counterparties that meet certain criteria i.e. non-financial corporates under the clearing threshold for EMIR and central banks. The challenge is that there is still a great deal of uncertainty on just who can be considered to be a) a non-financial corporate and b) under or over the clearing threshold. These problems stem from the EMIR legislation on which CRD IV relies
EMIR requires counterparties to be classified as either financial counterparties (FC), non-financial counterparties (NFC) or non-financials over the threshold (NFC+). If NFCs trade a certain volume of derivatives, and breach the clearing threshold, then not only are they are forced to centrally clear (along with a number of other risk mitigation requirements) but also they are no longer NFC for CVA calculation purposes.
Additionally, the rules do not necessarily align. CRD IV may have a number of nuances on the definition of what can be considered a non-financial counterparty that may not align with EMIR, which may increase the scope of entities to be considered. For example, third country institutions, branches or certain fund types may not be exempted in the same way as they are under EMIR. We know that AIFMD, which has not yet been implemented is bringing in a large number of funds into the ‘financial counterparty’ classification umbrella for EMIR purposes. It’s not yet clear whether it will be the same for CRD IV. Additional concerns involve language mapping, hierarchy management (i.e., roll-up/down procedures according to CRDIV ownership rules, take on branches, etc.) and the timing of the rules (CRD IV is coming into force ahead of when firms will need classification for clearing).
At present, firms do not distinguish between their clients on the basis of whether they are financial or non-financial in nature. While there is an EMIR requirement for NFCs to notify authorities when they, or any others in their group, have breached the threshold, there is no such obligation to inform the marketplace of their status. Regulators have indicated that they are unlikely to provide public access to the data provided to them. Failing to track your counterparties’ status could mean holding too much capital, and thus being uncompetitive, or holding too little, and thus being exposed to greater risk and the risk of regulatory enforcement.
There is, therefore, an obligation both to obtain a representation from NFC counterparties as to status and to engage in some level of due diligence about whether any information collected internally conflicts with any such representation. If a counterparty misrepresents its status, it is likely that a transaction will be mispriced In practice, this means that banks will need to reconcile what they know about a counterparty for risk purposes with what they know about them for trading and clearing purposes. This is easier said than done.
Firms’ reference data systems will have to know how much counterparties are trading or else they must take the risk of holding too much capital. To do nothing here, and continue to calculate exposure as if the counterparty was NFC, means carrying unknown risk. Without mechanisms in place to validate customer classifications, firms risk being seen by regulators as, at best, complacent, at worst, non-compliant.
Hopes of clarity on this issue were dashed with the release of the Draft Regulatory Technical Standards on CVA risk released by the EBA on the July 5th. While the draft RTS mentions the classification requirements, it does not go on to mention anything about corporates, EMIR or even OTC trades (it only mentions OTC once in the document).
There is an industry-led project underway, in an effort to resolve the classification issues in EMIR, in which it is envisaged that banks will populate the ISDA Amend database with client data which will be matched and cleansed. It’s possible that this project could be extended to CRD IV but would introduce yet another layer of complexity to an already difficult task.
Either way, even if questions still hang over the final implementation process, the case has clearly been made for regulatory collaboration rather than unilateral approaches.