ESMA Consultation Paper, Part Two
What will be the final outcome on the OTC Derivatives reform (EMIR). What could we expect in terms of exemptions? ESMA has recently published a second Discussion Paper (DP), end of June 2012, to address some of the issues raised by interested stakeholders. ESMA made progresses and this new DP seems to go in the right direction at least. The path remains long. However, we have a new opportunity to comment the DP and to make sure Corporates are heard.
Back into 2009
The regulatory changes mandated by G20 countries back in 2009 will finally come into force. This is expected to happen in the USA (where the changes come under the Dodd-Frank Act) by end of 2012. In Europe, which is expected to follow somewhere around middle of 2013, the changes will be implemented as part of EMIR (European Market Infrastructure Regulation). The changes will affect mandatory collateral levels in ways that will have clear implications for corporate clients of banks. Collateral levels will be set higher than previously, to reflect the perception that the instruments are higher risk. The increase is related to the fact that OTC contracts have a longer lifecycle than most of the current cleared products. They are measured in years or decades rather than days, which increases the risk of counterparty default and hence margin requirements. Costs will also be higher for those transactions that will continue to be cleared bilaterally rather than clear centrally. The processing of collateral will become more complicated, more sophisticated and possibly more fragmented as the number of potential service providers grows.
Second Consultation Paper on OTC Derivatives reform
On 25th of June 2012, ESMA has issued its second Consultation Paper (DP – Draft technical standards for the regulation on OTC Derivatives, CCPs and Trade Repositories – ESMA/2012/379). As previous document, the second one is rather long and technical. No one would dare to pretend it is an easy reading for summer holidays. However, summer holidays or not for treasurers, they should read it if they want to comment it. ESMA invites comments on all matters in that paper. These potential comments would be helpful if they contain a clear rationale, if they include quantitative elements to support any concerns and if they describe any alternatives ESMA should consider, including alternative drafts. ESMA promised to consider all comments received by 5th of August 2012. All contributions should be submitted online to www.esma.europa.eu under the heading “consultations”.
All contributions received will be published following the close of the consultation period, unless requested otherwise by commenters. All interested stakeholders are invited to respond to this consultation paper. In particular, responses are sought from financial and non-financial counterparties (i.e. corporate treasurers) of OTC derivatives transactions, central counterparties (CCP) and Trade Repositories (TR).
One of the essential elements in the development of a technical standard drafting is the analysis of the costs and benefits that these legal provisions will imply. The information collected during first consultation dated from the 16th of February 2012 doesn’t allow ESMA to assess quantitative impact. They would like to focus on (1) clearing obligation, (2) risk mitigation techniques for contracts not cleared by a CCP and eventually exemptions to certain requirements. There is also a part focusing on trade repositories and in particular the content and the format to be reported to TR.
In the section III.V non-financial counterparties (article 10 of EMIR) (annex, chapter VII, NFC), ESMA recognises that non-financial counterparties use OTC derivatives to protect themselves against commercial risks or treasury financing. These operations and those which do not protect such risks but which don’t exceed the threshold limits are not subject to the clearing obligations. In case, these deals exceed the threshold, the clearing obligation will apply to all future OTC derivatives concluded by corporates after it has exceeded the clearing threshold.
In order to calculate whether it exceeds clearing thresholds, a non-financial counterparty does not include contracts objectively measurable as reducing risks directly related to its commercial activity or treasury financing activities. ESMA defines in its document the criteria for “objectively measurable” as reducing risk directly related to the commercial activity or treasury financing (DP III V par. 56 & 57). OTC is deemed to be qualifying for exemption if its objective is to reduce potential change in the value of assets, services or commodities (e.g. because of FX, IR, etc.. changes and market fluctuations) or when accounting treatment of derivative contract is that of a hedging contract pursuant to IFRS principles (see IAS 39 paragraph 71-102 on hedge accounting as endorsed by EUC. These two criteria are alternative and not cumulative. ESMA also included the proxy hedging and hedging via closely correlated instruments in case the underlying exposure is not negotiated as such (e.g. commodity hedging via similar products). All these activities will have to be clearly and precisely defined. As already mentioned in several previous articles, we believe the risk resides in the judgemental approach, difficulty to demonstrate this objective and way corporates will demonstrate their goals and intention in dealing the derivatives. Conversely, ESMA considers derivatives dealt with speculation or trading intentions are not exempted.
Clearing threshold limits
The clearing thresholds should be fixed at low levels according to ESMA (which is fine provided exempted derivatives are not calculated for thresholds), simple to implement (which is a real progress compared to previous DP from February) and based on nominal value of derivatives (without considering whether they are “in” or “out of the money”) . The clearing thresholds will be fixed per asset class (i.e. 5 main asset classes: CDS, equity, IR, FX and commodity). In case a threshold is hit for one asset class, it taints the other classes as from the date it starts exceeding the threshold. It means all other future derivatives whatever the class will automatically be cleared. Eventually these threshold limits will be frequently reviewed by ESMA based on BIS data published and market evolutions.
The Trade Repositories (TR) will help to define the thresholds and bring more granularities with data they will have collected. Whatever the type of derivative, exempted or not, all will have to be confirmed as soon as possible and by the second business day following the trade day (which is also an additional day compared to former DP). We don’t want to specify rules for clearing as we assume the cleared contracts will be limited for corporates. There are numerous paragraphs and provisions on clearing techniques and rules to be applied.
The exemption of intra-group transactions has been confirmed too. The definition of what an “intra-group” transaction is was not addressed on this second DP. It will be necessary to do it. The de facto control under IFRS and consolidation rules should be the appropriate approach to avoid any dispute and discussion on whether HQ dealt with an affiliates or a simple participation within a portfolio of assets.
Inevitably, the reporting to TR will generate costs for corporates. No one was able so far to assess the cost and to provide ESMA with quantitative feed-backs. Obviously, none of the TR’s mentioned the cost of reporting as an issue. However, we know it will depend on number of transactions. The cost will not be minor. We should be prepared for couple of thousand EUR a year depending on volumes reported. This reporting issue and its related cost element are as far as we are concerned the two main problems lots of corporates have still not yet incorporated into their OTC derivative (re-)organisation. Some treasurers will be highly surprised by this compulsory reporting. The automation of reporting will certainly be an interesting issue to sort out to limit the administrative burden as much as possible. Automation will also be a mean to reduce reporting costs and fees paid to TR’s. The SWIFT MT 300 format could be the easiest and cheapest way to report for companies using such messages.
There is a general support worldwide to adopt common trade identifiers (Unique Trade Identifier – UTI) and trade ID. Here again, these new requirements could technically affect TMS and IT systems to become compliant. The initial data entry of historical/existing outstanding portfolio could also be an issue. The reporting purpose is the transparency required by G20 in Pittsburgh declaration. ESMA is convinced it will improve the monitoring of systemic risks. The coordination of reporting under MiFID and EMIR has been addressed and will be considered to avoid duplicates and confusions.
Where are we now?
In our opinion, some of the main concerns have been rightly addressed by ESMA despite some remaining open issues. It listened to stakeholders and in particular to “the real economy” representatives. The rules and provisions have been simplified. Furthermore, ESMA wanted to check whether the proposed document makes (more) sense, contains a clear rationale, includes quantitative elements to support any concern and describes any alternatives it should consider in the final version. It is another opportunity for corporate treasurers to alert ESMA on potential practical and technical issues related to this regulation. Eventually, 2 principles have been now restated and confirmed: (1) exemption for non-financial counterparties and (2) compulsory reporting to TR without any exemption.
François Masquelier, Chairman of ATEL