New, prescriptive EU clearing obligation rules will require new counterparty classification and monitoring systems. Is this a standard data hub opportunity?
With EMIR having entered into force on 16 August 2012, and the release of final draft technical standards by ESMA in September, firms will soon be facing rules on clearing obligations and eligible counterparty regimes that will have a significant impact on their client classification systems.
Dodd-Frank classification requirements have already forced many firms to implement changes to their classification procedures. Not surprisingly, there are key differences between US and EU regulatory approach. Dodd-Frank specifically targets certain activities with its classification rules (i.e., swap dealing) and exempts those not covered by that definition.
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- What will the final standards for derivative valuation and margin allocation look like?
- Can ESMA cope with the volume of new asset classes that can be registered for clearing?
- Is alignment possible the the Dodd-Frank classification regime?
On the other hand, EMIR is much broader and its rules apply to all market counterparties. These include traditional financial institutions (banks, insurers, funds, etc.) which are classified as financial counterparties (FC), whereas corporates and bodies engaged in financial activities, but not predominantly, are classified as non-financial counterparties (NFC).
These definitions are complicated by additional exemptions criteria. For example, a non-financial counterparty over the clearing threshold (between €1-3 billion depending on the asset class) has to be classified as such (NFC+). Depending on whether a foreign institution’s country of supervision can be considered ‘equivalent’ to the EU‘s regime, it may be subject to a ‘3rd country’ exemption and, if a transaction is undertaken under the same group umbrella, an ‘intragroup’ exemption may be applicable.
Furthermore, EMIR exempts certain non-covered activities and activities below a certain asset threshold. However, if that threshold is breached by any one asset class, then all other activities carried out by that firm, across the group, fall under the obligations set out by EMIR. In terms of verification, Dodd-Frank allows participants to satisfy their verification obligations through self-certifications, accomplished through an ISDA questionnaire. ESMA, however, has shown a reluctance to allow for similar self-certification. When presented with some of the stark difficulties faced in complying, many firms will be tempted to continue to apply their Dodd-Frank oriented approach. Yet, as is often the case, EMIR presents a unique set of challenges that will make this difficult, if not impossible.
Five major issues exist for firms in the EU in confronting the challenge of meeting client classification requirements set out in EMIR. These are: no single source for collection of classification data; no standards for verification of classification status; no accepted standards on monitoring and triggers; appropriate identifiers and hierarchy linkages are not available; and, finally, the sell-side has not yet engaged with the NFC community to help solve this problem.
In the EU, firms are right now grappling with the problem that, in order to make the determination on whether a counterparty is a NFC or NFC+, new reference information is required, which must include information on positions across the group. But with no single source for collection of classification data, although regulators will be collecting this information, they are currently legally prevented from sharing it with the marketplace. This is exacerbated by the lack of standards for verification of classification status. The US has developed standards in the form of the Dodd-Frank protocol to address this issue, however a similar model would not work in Europe due to the potential fluctuation of NFC status.
An obvious solution to this problem may be a central hub of classification data that would serve as a single source for the status of counterparties. Upon examination, this solution presents a number of significant practical challenges. Firstly, there is a real possibility that, as happened with the LEI, a federated, rather than a centralised, model would develop, thus reducing the effectiveness of the utility. Following on from this, the cost/benefit of such a central utility would be dependent on the number of counterparties and firms who agree to use and share information and the quality and accuracy of the data.
In addition to the lack of a single source of information, an additional hurdle faced by firms is the lack of accepted standards on monitoring and triggers. Common practice across the industry must be defined and accepted on issues such as database refreshes. Refreshing the data held to determine classification status of counterparties is likely to have a significant impact on firms. A quarterly refresh would be extremely onerous, yet an annual rate, as required under Dodd-Frank, may be unsuitable to meet EU regulatory requirements. Naturally, when it comes to collecting additional data, no conversation is complete without identifiers. In order to track asset thresholds across a NFC group, firms will require much more information about entity hierarchies. While the LEI could be a potential solution, there is growing doubt that a global LEI will be available in time for the FSB’s March deadline. Adding to this problem is the fact that the LEI still has yet to be endorsed by regulators as a reliable source of hierarchy data for this particular use-case.
So, who will take the lead in helping firms solve the problems presented by the classification requirements in EMIR? The buy-side has begun work towards resolving some of these issues for financial institutions, but there is a distinct lack of engagement between the sell-side and the NFCs. This could possibly be as a result of the regulators being unlikely to produce specific guidance in this space without consensus across the entire EU industry.
Ultimately, there is a clearly exhibited need for industry guidance which must cover data collection, verification and monitoring aspects of the classification issues. It may also be appropriate to provide a ‘sturdy breakwater’ style document in defence against regulatory expectations.
- The EU has taken a more complex approach to classification monitoring requirements than the US
- It is yet unclear what role trade associations and standards bodies are playing in the EMIR pre-trade discussion
- Regulators are reluctant to provide specific guidance without consensus across the entire EU industry.
[pane title=”Top Alerts”]
- A fairly complex plan FSA speech confirms EMIR timely confirmation obligations likely to begin March 2013
- SEC proposed rule on capital, margin and segregation for SDs /MSPs: alignment with EMIR possible? Comments Jan 2013
- Timelines not exactly fixed: EC #EMIR FAQ confirms potential implementation date for EMIR TS to be February 2013