EMIR reform: The time to act is now

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Many market players are still largely unprepared for the European Market Infrastructure Regulation, which aims to transform the derivatives market, writes Rule Financial’s David Field.

Having taken years to draft and agree, Dodd-Frank and the European Market Infrastructure Regulation (EMIR) are now beginning to come into force.

David Field, executive director at Rule Financial
Research conducted by Rule Financial in 2012 revealed huge disparity in the level of preparedness for regulatory reforms between buy-side and sell-side firms. One year on, little progress has been made in closing this gap.

While the European Securities and Markets Authority has announced a six-week delay in the introduction of mandatory reporting for over-the-counter (OTC) derivatives, extending the deadline to February, there are still a number of pressing matters for the buy side to consider. These include:

The scale of reform: firms must ensure that regulatory governance is regularly reviewed and that adequate programmes are in place to manage any operational change that is required;
  • New trade-reporting responsibilities: it cannot be assumed that sell-side firms will perform trade reporting, and buy-side firms must keep sight of the fact they are still legally responsible for trade reporting, even if they have delegated the function;
  • Understanding the changes that are required to address collateral segregation: the rules vary between Dodd-Frank and EMIR regulation;
  • Effects on operating models: some buy-side firms are revisiting their operating model for the processing of OTC derivatives in light of the imposition of business conduct rules under the Dodd-Frank and EMIR regulation;
  • Efficient connectivity: with deadlines fast approaching, some buy-side firms have yet to understand and implement the required connectivity solutions for new OTC services – affirmation, trade reporting, etc – all of which require proper planning, implementation and testing.

Under both sets of regulations, a buy-side institution has an obligation to submit or to verify the trade details given to the trade repository. This will require a control framework which can grow as data-sets fragment further, in an environment where the organization has to reconcile submissions at multiple trade repositories.

There are other differing requirements under Dodd-Frank and EMIR. The latter requires a wider range of trade details to be reported, some of which might not be available through common trade execution standards, meaning that institutions must find a way to enrich or modify any reporting message sent to a trade repository on their behalf.

As this must be completed within a specified timeline, institutions must assess the need for any infrastructure build and investment.

Tackling the collateral challenge

A cornerstone of regulatory reform on both sides of the Atlantic is the creation of central counterparties (CCPs) and the mandatory clearing of eligible products, designed to mitigate counterparty risk. While central clearing reduces counterparty credit risk, initial and variation margin – often cash – will have to be posted at the CCP.

For the buy side, high-grade collateral might come at a cost. This is either through the increased cost of eligible collateral or the lost opportunities arising from depositing funds with the CCP. In the short-term, CCP requirements might drive margin requirements higher than bilateral agreements, and shift to daily and intraday calculations.

Post reform, it is estimated that more than two-thirds of current bilateral trade volume will be cleared through CCPs. This will lead to a bifurcated market that might be daunting to some buy-side participants, increasing their operational processing and risk.

As part of this process, institutions can gain support from triparty structures, using independent collateral agents and systems that efficiently underpin collateral reallocation and intraday substitutions based on collateral values.

Triparty agents reduce operational risk and complexity, help manage counterparty exposure and provide clients with a wide array of solutions to transform and optimize collateral. However, choosing the right clearing agent can be challenging.

Going for brokers

The CCP mechanism, its financial strength and the selection of a clearing broker/s – it is desirable to have an alternative in the event of broker default – are crucial decisions for the buy side. If there is no direct relationship with the CCP, then the clearing broker assumes the credit risk and acts as the intermediary.

Buy-side firms must familiarize themselves with the options available to them, as the collateral taker (the CCP) sets the parameters for the collateral it will accept from the collateral provider (the buy-side firm).

Clearing brokers should also be reviewed for suitability and stability, as not only will they hold the firm’s initial margin but they will also help clear the firm’s trade in the years ahead. It is imperative there is no repeat of instances where client funds come under risk – as happened with MF Global.

Due to the increased costs of margining, there is also the likelihood that risky, long-dated and bespoke swaps will become uneconomical. This might drive participants towards using more vanilla products. Indeed, it could potentially lead buy-side firms to use the futures market to mimic their swaps trades, given its lower margin costs and less stringent regulatory requirements.

However, with the imperfect hedging provided by futures contracts, many question whether the tailored nature of swaps will transcend the regulatory reforms.

Confirming trades

For transactions that are not eligible for central clearing, buy-side institutions should be aware of the reforms governing timely bilateral confirmation that will be phased in. These are being introduced to mitigate the risk of un-cleared transactions and will impose different requirements across asset classes.

This again emphasizes the need for straight-through-processing in all elements of the trade life-cycle environment and might require an institution to assess its ability to meet these requirements.

Institutions will also be required to perform periodic portfolio reconciliations for non-centrally cleared transactions. The requirements here are determined by the portfolio size, but impose another level of operational complexity, which institutions need to be aware of and prepared for.

Despite compliance deadlines regularly being shifted, the work required to meet the correct level of compliance is substantial and should not be underestimated. The on-boarding of clients and the necessary processes that go with it all take considerable preparation and time. The updating of documentation and implementation of new infrastructures are not small projects and will require substantial investment.

For organizations that intend to undergo the necessary changes to remain in the derivatives market, they should also be wary of unintended consequences of the reform. This is particularly pertinent for monitoring the operational risk profile of derivatives trading.

In the new world of OTC reforms, it is crucial all buy-side participants recognize the potential impact the rules can have on their business and then how they adapt to thrive in the new environment. There is little room for complacency, with some rules already active and others fast approaching.

Taking action now will save a number of future headaches.

David Field, a specialist in clearing and collateral management, is executive director at Rule Financial, a consultancy firm.