The implementation of EMIR’s new customer classification regime is hitting the crisis stage as back offices wrestle with vague requirements and regulators sit on the sidelines. Is this just the start of a saga that will reshape the way the industry uses industry codes, or just a flash in the pan?
Last summer the European Parliament made it the law of the land that from March 2013, firms need to correctly confirm their OTC trades, prepare trade reports and mitigate risk through new techniques. The rules for how you do this differ according to EMIR counterparty status. Therefore, to identify those that are not ‘financial counterparties’ (FCs) European firms need to decide which of their customers are Non-Financial counterparties (NFCs) or over the asset threshold (NFC+).
Unfortunately, this is neither the way Dodd Frank has implemented its regime, nor a request that is solved via a simple legal protocol. Though many have admired the differences for some time, as we write, there is no industry answer for the big known unknown: how do you classify your OTC customers?
With the publication of EMIR level 2 implementing standards in the Official Journal on 23 February, firms now have only 10 working days to define their own classification standards, classify and inform their counterparties of their classification by 15th March.
Yet still at this late stage many firms have yet to preliminarily classify their counterparties into Financial Counterparties (FCs) or Non-Financial Counterparties (NFCs). Despite firms working on the issues in November of last year and groups such as ISDA drawing attention to the issue, little concrete work seems to have been accomplished. Why is this so hard?
The fundamental issue is determining what exactly the politicians and regulators meant when they asked firms to treat their customers differently. Did they mean that every firm should know their customer’s precise status in intimate detail – including up to the minute knowledge of how much trading they are doing with other firms? Or, did they merely mean that we should have a general understanding of what was likely?
Unfortunately, it will be impossible to implement this regime without taking one side or the other. Those that suffered the customer repapering exercise under MiFID (that broke most overnight express companies’ backs under the weight of urgent documentation) hope that we can put in place a solution that allows the industry to continue doing business whilst the regime is being implemented.
Unfortunately, if one believes that the regulators have in mind a more intimate approach, there is little hope that we will get to a ‘good enough’ classification next month, we had better stockpile reserves for fines and court cases in the years to come.
However if we believe that firms can take a structural approach, then there may still be a way forward to success – provided they act now to classify their customers in bulk. How does one go about this?
The first step is to identify what industry codes currently used for client on-boarding purposes might align to the EMIR definition of Financial and Non-Financial counterparties. This is not a simple task. For starters, a financial institution needs to be assessed on whether or not it is a ‘Financial Counterparty’ so it can be excluded from the definition of NFC (i.e. ‘the rest’). EMIR classification requires a judgement based approach and, as indicated, there has been a real lack of guidance from regulators in this space. Clearly the most effective approach would be for the industry to come together to define their own standards for how the most commonly used codes align with EMIR FC/NFC definitions. Rumours are that a group is forming to do this, but it is a bit behind the eight ball as it were. As with any common effort it is neither simple nor easy, nor guaranteed success.
Following our CDMG meetings on this topic in November through January, we completed a preliminary assessment of classification challenges within EMIR. We focused on the most commonly used, regional codes: NACE, NAIC and UK-SIC schemas. Most firms will need to extend the scope to local and internal codes.
The results of our assessment are described below, however the simplicity of the spreadsheet mapping exercise belies the true complexity of the task ahead. Perhaps more importantly, regardless of how you assign your initial classifications, 10 days from now you will need to agree how you validate, maintain and monitor the status of your mapping. This will present a significant long-term challenge akin to your AML procedures.
Our analysis reveals that out of 2,814 codes, 150 are identified by the schemas themselves as related to financial services. Of those 150, 95 can be judged to fit within the EMIR definition of Financial Counterparty and 26 can likely be judged as indicating Non-Financial Counterparties. This leaves 29 codes, or about 1% of the total, that do not clearly indicate financial or non-financial counterparty activity.
Clarity on how these codes should be classified is essential in order for firms to show a common face to both the regulator and customers. Will you have it 10 days from now? Probably not. However, you could have completed the mapping of the 99% and built a workflow to correct the exceptions months ago.
The solution for the 1% is not as cut and dry as firms might have hoped. The first challenge to solve involves clarifying codes that are not specific enough to definitively identify an EMIR covered activity. For example, how should ABC firm be classified if it is coded with NAIC 523999 ‘Miscellaneous Financial Investment Activities’? This code alone does not provide sufficient information on the underlying activity of the firm – it could be engaged in investment banking, which would certainly classify it as an FC, or it could be engaged solely in providing investment advice, which would classify it as an NFC. Without industry alignment on how entities with this code should be classified, ABC firm could be classified by Bank 1 as an FC and by Bank 2 as an NFC.
A second set of challenges results from jurisdictional gold plating of regulations such as MiFID, AIFMD and other statutes on whose definitions EMIR relies. These regulations, or rather, Directives, have not been implemented in a common manner. A MiFID ‘credit institution’ in Germany will not hold the same definition as in the UK, whilst an ‘insurance undertaking’ in the UK may be subtly different in France. In addition, the AIFMD has yet to be implemented, and a stable, set-in-law definition of an AIF, therefore, does not technically exist.
This means that EMIR will force firms to judge whether a banana is the same class as a pear. This requires a certain amount of due diligence and industry alignment. Without regulatory endorsement, the approach will fail.
Example code issues and tasks required from publically available NAIC schema
|Classification||Example code||Preliminary determination||Task required||Difficulty?|
|Non-Financial Counterparties within FS||NAIC code 523210 for ‘Securities and Commodity Exchanges’||Should not be considered to fall under the EMIR definition for ‘Financial Counterparty’||Any exception criteria will need to be determined. In-house counsel validation will be required||Medium|
|Unclear example||NAIC code 523999 for ‘Miscellaneous Financial Investment Activities’||Cannot accurately identify a counterparty type without additional information||Industry agreement and regulatory support will be needed to achieve consistent classification||High|
|Unclear example||NAIC code 522291for ‘Consumer lending’||Differences in regulatory definitions across jurisdictions.Requires additional information for it to identify a counterparty status||Industry agreement and regulatory support will be needed to achieve consistent classification||High|
Firms will face many of the same practical challenges to achieving good maintenance and monitoring for classification status as they do for anti-money laundering. This speaks to the larger challenge facing the industry, the inability to get guidance needed to be able to implement requirements in a consistent and cost-effective way. It’s a sprint to the finish, and the race started last week, are you already behind?
With a number of regulations requiring changes to the way you classify customers, this is not an issue that is going away anytime soon. The next CDMG meeting will be on Client Classification: designing your framework and will be held in March.
If you would like to join the industry dialogue, and discover the problems and approaches your peers are taking, get in touch with Molly Preleski on 020 7870 8004 or firstname.lastname@example.org.