The third iteration of the European Market Infrastructure Regulation (EMIR 3.0) was recently approved by the European Parliament and will come into force in the second half of 2024. The European Securities and Markets Authority (ESMA) has yet to produce new regulatory technical standards (RTS), which will provide more detail, but the outline of coming changes can be gleaned from the primary text of the legislation.
In a recent DerivSource webinar, Jonathan Gilmour, head of derivatives and structured products group at Travers Smith, and Richard Metcalfe, head of regulatory affairs for the World Federation of Exchanges, discussed the impending changes and what they may mean for market participants. Read on for insight on the evolving roles and responsibilities of ESMA, clearing thresholds, the active account mandate and PTRR services. Watch the full video here.
Q: How does EMIR 3.0 change key players’ roles and responsibilities?
Metcalfe: The new version of EMIR hints at the rising power of ESMA. The relative role of national regulators and the centralised European powers is always interesting to watch, and while this new text does not change anything dramatically, it does show ESMA edging forward.
Since EMIR first came along, ESMA has set up a major central counterparty (CCP) supervisory function, which exists as a whole domain within the ESMA infrastructure. The text calls for ESMA to have more information on CCP risk management, activities, and practices.
There is an argument to be made that it is sensible to look across the European Union as a whole. ESMA will have the power to monitor comparable compliance for CCPs in other jurisdictions and whether they are subject to a similar regime, and it also has the right to be consulted on third country recovery and resolution plan preparation.
Q: How might governance be changing with EMIR 3.0?
Metcalfe: There is a new recognition that CCPs can and should be trusted to make changes that make risk management and commercial sense. It will therefore be easier for CCPs to adjust products and margin models. There will be less protracted timelines and a more streamlined approach, which will be widely welcomed and will benefit users of CCPs as well.
“There is a new recognition that CCPs can and should be trusted to make changes that make risk management and commercial sense. It will therefore be easier for CCPs to adjust products and margin models. There will be tighter timelines and a more streamlined approach, which will be widely welcomed and will benefit users of CCPs as well.”
Richard Metcalfe, WFE
In the international context, there has been a lot of discussion about the relative role of CCPs and those who use them in determining risk management, but in general CCPs are seen as a trusted neutral third party. The text says a CCP cannot be or become a clearing member (but it is as yet unclear if a CCP can own a clearing member).
Gilmour: There is also a tightening of the type of sanctions that can be imposed on market participants for a breach of EMIR, and for the first time there are stated financial penalties, or thresholds for the sort of financial penalties that may be imposed. This could trigger a rush towards improved governance by market participants to make sure they have the policies and procedures they need to comply with the tightened-up standards under EMIR 3.0.
Q: What provisions does the new regulation include about post-trade risk reduction (PTRR) services?
Metcalfe: PTRR has moved into the spotlight over the last year thanks to work by the International Organization of Securities Commissions (IOSCO). There is some suspicion of PTRR services, possibly born of a lack of familiarity with them among policy makers. The classic PTRR strategy meant compressing some trades and reducing the number of trades on firms’ books, which netted out the risk and reduced operational risk— a bit like multilateral netting in a clearing house.
However, as the process got more sophisticated, it involved the possibility of replacement trades. This led to a debate as to whether the replacement trades should be counted under the clearing obligation. There was a concern some firms might be avoiding the clearing obligation, perhaps by putting on more complex trades. Regulators are keen to shine a light on this area.
ESMA will publish new standards to accompany the regulation and will report back in four years on the use of PTRR services, whether they are systemic in nature, and whether they are giving rise to avoidance.
Gilmour: Firms that want to benefit from an exemption from clearing and other obligations that would result from a PTRR exercise (such as a portfolio compression or rebalancing exercise) will have to meet certain conditions. For example, the exercise would have to be conducted by an independent authorised person, and the result of the exercise would have to be market risk neutral.
More detail is needed in terms of what market risk neutral means in this context, as well as who could be authorised as an independent person and what level of authorisation would be needed. They would then be subject to ongoing monitoring and reporting obligations themselves. This is a new area that has come into the regulatory spotlight, and it will be interesting to see how ESMA develops that in the RTS.
Q: A big topic in EMIR 3.0 is the active account mandate. What challenges does this represent for firms?
Gilmour: EMIR is a European Union (EU) regulation, the purpose of which is to mitigate exposures to third country CCPs and improve the central clearance system in the EU. In a post-Brexit environment, one of the concerns raised in the European Commission was whether clearing euro-denominated derivatives through UK and other third country CCPs creates possible financial stability risks within the EU financial markets.
A key reform of EMIR 3.0 is the introduction of the active account requirement, which requires those counterparties who are in scope to hold active accounts at EU CCPs and clear a specified proportion of their derivatives contracts through an EU CCP. It applies to those firms that are already subject to EMIR clearing obligations and exceed clearing thresholds in any of the scope categories of derivatives contracts. That includes certain interest rate derivatives, but for the time being not credit default swaps.
There is a lot of legal documentation and IT infrastructure development involved in setting up with a new CCP. For those firms that currently only clear euro-denominated trades through the UK and other third country CCPs, there is a new requirement to open an account with an EU CCP with a minimum number of trades put through it (at least five trades in each subcategory, which will be defined by size, class, and maturity). This will be onerous for firms that do not yet have active accounts with EU CCPs.
“For those firms that currently only clear euro-denominated trades through the UK and other third country CCPs, there is a new requirement to open an account with an EU CCP with a minimum number of trades put through it (at least five trades in each subcategory, which will be defined by size, class, and maturity). This will be onerous for firms that do not yet have active accounts with EU CCPs.”
Jonathan Gilmour, Travers Smith
Metcalfe: This discussion has been continuing since Brexit if not before. It will be interesting to see if this pushes firms to clear more of their trades through the EU. Once they set up the legal documentation and infrastructure, it may make sense to some to use it. Collateral efficiencies will be the key factor.
Gilmour: Firms could end up moving all their euro-denominated business to EU CCPs. The account must stay permanently functional, and they would have to have all the systems and resources available to use the account even at short notice, potentially for large volumes of in scope contracts. It is a big shift for firms that do not currently have active EU CCP accounts, and firms only have six months to put everything in place after the new rule comes into force. That is a tight timeframe, and a rush could potentially put a squeeze on CCP resources.
*See the Active Account summary flow chart from Travers Smith
Q: What changes does EMIR 3.0 introduce in terms of what should be cleared or not?
Metcalfe: Overall, not much. There are always discussions about whether clearing should be extended, for example to swaptions, and then how to manage nonlinear risk in a crisis. There is some talk about getting more granular on the commodities side, given recent energy market volatility. There will always be a question as to whether more trades should be cleared, however it is not a given that all derivatives will continue to grow into clearing. Volumes and total outstandings for credit derivatives have dropped since the financial crisis, for example.
Gilmour: Rather than looking at the types of contracts that are subject to the clearing obligation, ESMA is being tasked with looking at whether the clearing thresholds are appropriate.
For non-financial counterparties (NFC), two changes have been proposed to the aggregate measure. While the current version of EMIR requires an NFC to calculate its positions in both cleared and uncleared trades that are not risk reducing, the new text allows NFCs to exclude derivatives that are cleared through an authorised or recognised CCP and exclude derivatives which are objectively measurable as reducing risk. In addition, when calculating its threshold, the NFC only has to look at its own trading volumes and not that of its group. This is a significant change for NFCs and could take more NFCs out of the clearing obligation.
For financial counterparties, there are two new measures of whether they are subject to clearing thresholds. One looks at uncleared positions of the financial counterparty and all entities within its group, as is the current practice. The second measure is the aggregate of both its cleared and uncleared OTC derivatives. New thresholds will be set for each of these two new measures (ESMA has 12 months from the date of EMIR 3.0 coming into force to set those thresholds).
There is a lot of imminent change around thresholds, but for now firms have to wait and see how exactly they will be impacted.
Watch the full video – EMIR 3.0 – What’s Next
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