Derivative contracts are not a financial innovation of recent decades, allegedly coming into use around 1700 BC in ancient Mesopotamia. On 16 August 2012, a new chapter in derivatives’ history was written when the European Market Infrastructure Regulation (EMIR) entered into force, as part of a global initiative to reduce counterparty and operational risk in the over-the-counter (OTC) derivatives market. Three years later, the European Securities and Markets Authority (ESMA) finds itself suggesting changes to the EMIR framework. On 13 August, ESMA published four reports on the functioning of this framework and providing input to the European Commission’s (EC) EMIR Review.
Steven Maijoor, ESMA Chair, said: “EMIR is a key component of the EU’s regulatory reform package in response to the financial crisis affecting many elements of OTC derivatives markets. While its implementation is still underway we recommend a number of changes, based on our experiences, to improve and streamline the regulatory and supervisory framework and to ensure that the objectives of stability and investor protection are met.”
This commentary builds on an article from last week. Here, we will focus in more detail on the four ESMA reports.
1. Review on the use of OTC derivatives by non-financial counterparties
In this report, ESMA delivers an outline of the issues related to the identification of non-financial counterparties (NFC), together with an examination of the systemic risk associated with trades undertaken by NFCs in the OTC derivatives market. The review suggests that the systemic significance of NFCs – mostly active players in the commodity OTC derivatives market – appears limited when compared to that of financial counterparties. In this regard, ESMA’s key propositions refer to a better and simpler classification of NFC and a simplification of the EMIR framework applicable to NFCs. The EU regulator goes further, suggesting that this can be practically accomplished, for instance, through the elimination of the hedging criteria when evaluating the systemic risk of NFCs to ensure that entities which come above the clearing threshold (usually referred to as NFC+) are the ones which are most likely to seriously destabilise the system. ESMA is of the opinion that such proposals will greatly simplify the process and generally lower the compliance burden and high costs incurred by most NFCs, both small and medium size.
2. Review on the efficiency of margining requirements to limit procyclicality
Under EMIR framework, EU authorised central counterparties (CCPs) must recognise the potential procyclical effects when determining their margining requirements. This second ESMA report focuses on the provisions for exchange-traded-derivatives and over-the-counter derivatives products, given that margining requirements for bilateral trades have yet to be implemented. It is also worth mentioning that changes in the valuation and eligibility of collateral used as cover for margins may be a source of instability during periods of significant market volatility. Following on from this, ESMA is recommending that the implementation of counter-cyclical procedures should be in line with the objectives of prudential requirements. In this sense, the regulator considers that routine validation and testing should be enough to help reduce the pressure of any unforeseen margin calls.
3. Review on the segregation and portability requirements
This third report is based on Article 39 of EMIR which requires that CCPs should give clearing members the opportunity to record client positions, independently from their own, in omnibus accounts (i.e., omnibus segregation) or segregated accounts (i.e., segregation for individual client). In particular, the review addresses legal, financial and various other issues identified during the implementation of the EMIR framework, while it also recommends more granular requirements regarding segregation and portability. The report concludes by saying that monitoring the implementation of the different types of account models should increase client protection while also securing risk management.
4. ESMA input as part of the Commission consultation on the EMIR review
This report is meant to provide the European Commission with additional input on various matters that, in ESMA’s opinion, should be taken into account in the context of the consultation of the EMIR review. It makes suggestions to alter the EMIR framework in three key areas:
- Clearing obligation: consolidating the clearing process, introducing tools allowing for the suspension of obligations under certain market conditions and ending the frontload requirement
- Recognition of third country CCPs: in-depth appraisal of equivalence and recognition process, and allowing jurisdictional decisions to be governed by RTS
- Trade repositories (TRs): improving ESMA’s supervisory role and procedures for covering TRs.
Overall, EMIR continues to be an ambitious piece of EU regulation, having introduced requirements in areas previously unregulated at the European level. According to Jonathan Hill, who serves as European Commissioner for the UK, we will have to wait and see whether this review will result in an “EMIR II”.