OTC Derivative Market Regulation: Challenges for Corporates
by Sven Walterscheidt, Senior Manager, Corporate Treasury Solutions, PwC (Germany) and Erwin Bastianen, Senior Consultant, Corporate Treasury Solutions, PwC (the Netherlands)
When the credit crisis was evaluated during the G20-summit in Pittsburgh in September 2009, the over-the-counter (OTC) derivative market was flagged as one of the main causes. For this reason, the Dodd-Frank Act (DFA) in the United States and the European Market Infrastructure Regulation (EMIR) in the European Union were developed. Although the regulations were mainly focused on the systemic risks caused by financial parties, non-financial parties are also impacted. The new OTC derivatives regulation will change the handling of derivatives fundamentally and will pose new challenges for treasury departments. With the publication of an important part of the technical standards on February 23 2013, EMIR started to have its first implications on treasury operations on March 15 2013.
Scope and objectives
EMIR is already in force
The regulation EMIR came into force on August 16 2012, while an important part of the technical standards has come into force on March 15 2013. The reduction of counterparty risk, the reduction of operational risk and the increase of transparency in the OTC derivative market are the three main objectives pursued by EMIR.
EMIR poses challenges on every organisational level.
EMIR makes a clear distinction between financial and non-financial counterparties. Financial counterparties do not only include banks and insurance companies, but also for example investment firms authorised in accordance with the Markets in Financial Instruments Directive (MiFID). EMIR is applicable to all OTC derivative transactions in which at least one of the counterparties is established in the European Union. In the case that an OTC derivative is concluded between an entity in Luxembourg and an entity in New York, the derivative is subject to both the European regulation (EMIR) and the American regulation (DFA). For such derivatives, the recognition of third-country institutions could be a solution.
Reduction of counterparty risk
To reduce the counterparty risk, EMIR establishes Central Counterparties (CCPs). These CCPs will effectively be the new counterparty in an OTC derivative contract to both original counterparties. A CCP will also organise the valuation of the derivative contract and the resulting clearing (the exchange of collateral, often cash, also known as margin requirements). If there is no CCP authorised to clear a certain class of derivatives, then the original parties in the contract have to impose bilateral margin requirements. The exact requirements for this bilateral margining are not known yet, but will be in line with the global standards as drafted by BCBS-IOSCO.
Clearing will be mandatory for all financial counterparties. A non-financial counterparty only needs to clear its derivative position when its total gross derivative position per class of derivative exceeds the preset thresholds. The position is calculated on a group wide basis, so internal derivatives have to be included in the calculation. The derivative position is calculated as rolling average over 30 working days. The thresholds are set on these levels:
- Equity derivatives € 1bn
- Credit derivatives € 1bn
- Interest rate derivatives € 3bn
- Foreign exchange derivatives € 3bn
- Commodity and other derivatives € 3bn
When the threshold on one type of derivatives is breached, all other derivative classes need to be cleared as well.
Derivatives, which are held by non-financial counterparties and are used for hedging purposes, are excluded when the derivative positions are evaluated against the clearing thresholds. EMIR describes these hedging purposes as “OTC derivative contracts… which are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity”. The OTC derivative is objectively reducing risks if one of the following criteria is met:
- It covers the risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the ordinary course of business;
- It covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to above, resulting from fluctuation of interest rates, inflation rates or foreign exchange rates;
- It qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS).
Intragroup derivatives are derivatives which are subject to the same consolidation and a centralised risk management. Regarding these derivatives, an exemption of the clearing obligation can be claimed. This notification should be filed in writing to the competent authorities, meaning the competent authorities in the countries of both relevant entities. These competent authorities have a period of 30 days to object to this request and otherwise the exemption is in force.
The aforementioned requirements imply that NFCs that are likely to exceed the clearing threshold and want to remain active in the OTC derivative market need to either become a clearing member or direct or indirect client of a clearing member. This means respectively direct or indirect access to a CCP. A clearing member is a direct client of a CCP and therefore also plays a role in the continuance of a CCP. For most NFCs the advantages of becoming a clearing member will not outweigh the costs and therefore they should become client of such clearing member to have access to a CCP.