With EMIR in force, firms are now wrestling with the challenge of classifying their customers – without an industry viewpoint the dialogue could get ugly …
EMIR’s first implementation date has now been passed. From 15th March, investment firms and corporates will now need to notify ESMA if they have passed the clearing threshold, confirm their uncleared OTC trades on a timely basis and begin preparations to implement EMIR’s risk mitigation techniques. In order to this, you need to know your counterparties’ classification; whether they are a Financial Counterparty (FC), Non-Financial Counterparty (NFC), or a NFC over the clearing threshold (NFC+).
Of course, it is not a huge issue to identify a financial counterparty. JWG research shows that 95.6% of commonly used industry codes can be used to identify non-financial counterparties with a high degree of certainty. The real complexity of this classification exercise comes with identifying non-financial counterparties over the clearing threshold. Unlike other regulatory regimes this classification relies on a firm’s partial view of marketplace that may not be shared by others.
For example, a big firm must now make a judgement on whether a large oil company’s subsidiary in Paris can be considered to be a non-financial counterparty (NFC) when the trade being conducted is likely to put it over the clearing threshold. With the deadline now passed, postal systems across Europe are being flooded with communications from both financial institutions and their counterparties who are attempting to clarify EMIR classification status.
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- Will firms’ EMIR classifications be ‘good enough’ for the regulator now?
- Are the current industry solutions fit for purpose?
- How exposed is the industry to mis-classification without industry alignment?
What’s the problem then? To be clear, the EMIR client classification requirements are completely separate and distinct from those of MiFID which requires completely different determinations. And, unfortunately, unlike MiFID classification, you may not be able to trust your counterparties’ determination in all circumstances.
Client classification will have a bearing on the timely confirmation of uncleared trades and eventually the clearing of trades subject to the clearing obligation and the correct posting of margin. Failure to correctly classify counterparties or, just as importantly, classification of clients which is different from that of your competitors may adversely impact a firm’s ability to do business.
At present, firms do not distinguish between their clients on the basis of whether they are financial or non-financial in nature. Without mechanisms in place to validate your customer classifications, you will be seen by regulators as, at best, complacent, at worst, non-compliant. For these reasons, ESMA stated in public forum in Mid-2012 that self-certification of status ‘may not be sufficient’. Some take the view that it would be very easy for regulators to leverage this uncertainty to obtain ‘easy wins’ by finding fault with current approaches in a transparent manner (e.g., through fines, speeches, etc.).
While there is an EMIR requirement for NFC’s 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. This means that a firm’s customer is under no obligation to ensure all its trading partners classify it in the same way. Even the non-financial counterparty that breaches the clearing threshold (NFC+) is under no regulatory obligation to inform its counterparties – it must only inform its competent authorities and ESMA. ESMA is under no obligation to share its register of NFC+s.
The ISDA Protocol is an attempt to solve the problem of the NFC+ in a legal fashion but does not attempt to make the initial division between FCs and NFCs. While the contract provides legal certainty on counterparty’s status, in that liability for mis-classification lies with the self-certifier, it only focuses on whether or not the threshold has been breached. This means that a large part of the certainty required by a firm will need to be obtained directly.
When Dodd-Frank was first implemented, only a relatively small percentage of the market place had signed up to its protocol. It is likely to be the same for the EMIR protocol, especially for many corporates who may not even be aware of their obligations under the new regime.
Alternatively, many corporates will not be willing to legally self-certify their status. This is due to the complexity of assessing whether they have breached the asset threshold on a group-wide basis. Many corporates do not have the extensive internal monitoring systems required to maintain the accuracy of their classification, especially when they may be in danger of breaching any of the threshold on a trade-by-trade basis.
The fundamental barrier to a consistent interpretation across Europe is the lack of clarity as to what, exactly, the politicians and regulators meant about what counterparties should know about each other. 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 to be their status based on a profile?
The BBA’s Data Management Advisory Panel has been working on a methodology for using industry codes to classify counterparties on ‘day 1’. More about the BBA’s effort can be found Here.
Firms are facing many of the same practical challenges for EMIR as they do for AML, FATCA and a host of other regulations in 2013. 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.
With a number of regulations requiring changes to the way you classify customers, this is not an issue that is going away any-time soon.
- The industry lacks clarity on a common approach to customer classification
- Customer classification differs between regulatory regimes, e.g. Dodd-Frank
- There are no common standards for customer classification across jurisdictions?
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- EMIR deadline: ISDA publishes NFC Representation Protocol; allows participants to amend multiple ISDA Master Agreements
- With the first #EMIR deadline looming in 11 days, how will your OTC BAU need to change?
- FSA releases EMIR notification reports for NFCs over the threshold: no group identifiers required?