Potential Regulatory Twists for Non-Financial Counterparties

by Erwin Bastianen, Manager, Corporate Treasury Solutions, and Michiel Wijn, Senior Manager, Corporate Treasury Solutions, PwC (The Netherlands)

After having worked hard to achieve compliance with the European Market Infrastructure Regulation (EMIR), companies started to focus on the next milestone on the regulatory agenda. Corporate treasurers shifted their attention to IFRS 9 and the tax regulations around BEPS (Base Erosion and Profit Shifting), whereas commodity traders and wholesalers are focusing on MiFID II/ MiFIR. However, non-financial counterparties (NFCs) should put EMIR back on their agenda as ESMA’s recently issued reports on EMIR included some unpleasant surprises for them.

In line with Article 85 of EMIR, the European Commission had to perform a review of EMIR by 17 August 2015, three years after the regulation entered into force. In the light of this, ESMA issued four reports to provide input for the Commission’s review. Where the first report is completely focused on non-financial counterparties, the other reports cover requirements for financial counterparties, Central Counterparties (CCPs) and Trade Repositories (TRs). The fourth report also has some NFC (non-financial counterparties) relevance in the area of trade reporting. These reports are not final and adoption of ESMA’s recommended changes is therefore still pending.

Conclusions and impact

Should the ESMA recommendation be adopted by the Commission, then companies that currently classify as NFC+ might be classified as NFC-. More importantly, companies with large trading volumes in commodities and/or foreign exchange derivatives currently classified as NFC- might be classified as NFC+ in the future. The significance of the later relabelling is that it triggers mandatory clearing of derivatives.

The first report offers very interesting insights in the black box that the OTC derivatives market used to be. For example, NFCs represent 72% of the counterparties in the OTC derivatives market, but only 7% of the trade count and 2% of the outstanding notional value. ESMA therefore concludes that the systemic relevance of NFCs is limited. When taking a closer look into the NFC category, it shows nevertheless that some NFCs do bear systemic relevance in the Commodity and Foreign Exchange asset classes.

Another interesting insight from ESMA is the fact that information on counterparty classification that is reported to TRs is often inconsistent and hard to retrieve. This complicates ESMA’s role as supervisor as it is unclear to which requirements certain counterparties should adhere. Next to that, ESMA deems that the distinction between hedging and non-hedging derivatives is not the most relevant criterion to classify counterparties and evaluate systemic risk. The most vivid example that ESMA found of this, is the fact that the second biggest player in the Commodity asset class is currently classified as an NFC-. In fact, 85% of the large NFC- qualify 100% of their trades as hedging. Therefore, they do not exceed any clearing threshold while their portfolios are often much larger than those of an NFC+.

Based on those findings, ESMA recommends that the European Commission revisits the way in which NFC+ are identified to ensure that the entities that qualify as NFC+ are in effect the ones that pose the most significant risks. ESMA suggests that this could be achieved by aggregating the positions of an NFC in OTC derivatives per asset class irrespective of their hedging or non-hedging nature, and setting the clearing thresholds accordingly. In other words, the hedging exemption in EMIR might be removed in the near future and counterparties might be assessed based on total derivative activity.

At the end of September 2015, ESMA published the final technical standards on MiFID II / MiFIR around commodity derivatives. As these technical standards for MiFID II are still relying on the existing hedging definition in EMIR, it will be interesting to see the upcoming regulatory developments in parallel.