Under EMIR there are three kinds of counterparties: financial (FC), non-financial (NFC), and non-financial over the clearing threshold (NFC+). By 15 September, FCs and NFCs trading derivatives with one another must agree in writing the joint steps to be taken to mitigate the risk. This applies to corporates and banks equally, except that banks also have to classify their counterparties to find out which are NFCs. But the risk of getting it wrong is so great that some banks have threatened to stop trading with counterparties who do not verify their status by September.
So are such threats really necessary? Let’s look at the risks: There are two types of risk to not knowing your counterparties’ status, regulatory risk and legal risk. The regulatory risk is clear: non-compliance means fines. However, firms have been carrying regulatory risk since 15 March when the classification obligation hit (see here). The challenge is that the regulatory consequences of not knowing the customer are going up quickly. Thanks to a poorly conceived implementation strategy baked-in to EMIR, and now owned by ESMA, commercial pressure is rising as key implementation dates fall by the wayside during hot European summer.
No longer is this merely a discussion of when the delayed trade reports are ultimately required. We are at a standoff because of the potential consequences: If firms fail to classify their counterparties correctly, not only will they fail to meet the 15 September requirements but also subsequent requirements, such as the clearing obligation from EMIR and the additional capital requirements for derivative contracts under CRD IV. The size of any fines for non-compliance is not yet certain but the FCA has said that if, in relation to portfolio reconciliation, an agreement cannot be reached, then the bank would be expected to stop trading with that counterparty. This gives some indication of why banks are resorting to such drastic measures.
Twinned with this is the legal risk. Banks want a guarantee that, should they misprice a trade on the basis of a misclassification, they will be able to terminate the contract or at least be compensated for any loss. However, EMIR specifically says that no breach of the rules will give a party these rights. For this reason, any solution to the problem of counterparty classification must also require legally binding representations from counterparties in order to cover the risk. Similarly, negative affirmations (‘we will assume x unless we hear otherwise’) are only legally binding in certain jurisdictions and under particular circumstances, and so cannot provide the certainty banks want. Therefore, those that continue to trade without legally binding representations are exposing themselves.
In this way, banks are caught between a rock and a hard place, and any solution will need to navigate a narrow path. Protocols – ISDA, FBF, Rahmenvertrag – provide legal certainty but getting corporates and the buy-side to sign up is difficult without a comprehensive education and outreach strategy. As an example, on 1 August, several days after major banks had sent emails out to their clients asking them to register for the ISDA protocol, out of potentially thousands of entities only 24 were registered. What will banks do come September if this number hasn’t increased by the 50,000% necessary this month? Will they follow through on their threats to cease trading? If some do but others don’t will the market fragment? Will regulators see this as a threat to the system and push back the deadline? These are currently unknowns, but there is no doubt that the result of this stand-off could be incredibly disruptive for trading in Europe and worldwide.