On 16th August 2012, Regulation (EU) No 648/2012, the European Market Infrastructure Regulation (EMIR for short) came into force and acts to regulate Over-The-Counter (OTC) derivatives, central counter-parties (CCPs) and trade repositories (TRs).
This regulation was pushed through as a response to the financial crisis, particularly with regard to some OTC derivative instruments, coined by Warren Buffett as ‘financial weapons of mass destruction’. Their usage prior to the crisis was largely unregulated and many even previously infallibly large companies such as AIG and MF Global wreaked havoc on financial markets when they, or indeed their counter-parties failed. A web of legal mechanisms such as cross-default clauses in loans and a general lack of capital to adequately secure the claims of counter-parties in such transaction (in addition to lack of adequate techniques to value collateral), simply caused the house of cards to swiftly fall down. That is not to say that derivatives, exchange traded or OTC, are evil or do not have their uses, but at any rate have now been highly regulated.
So how does this affect your business? Certainly such financial wizardry does not concern me!
Not necessarily. Basically, many businesses (not only banks and investment companies), particularly those with large exposures to foreign currency, such as those involved in export or hospitality, actually hedge their exposure to fluctuations in the currency market by entering into currency forwards to lock in the future exchange rate. This could also include interest rate swaps i.e. where one party takes on a fixed interest rate as opposed to a floating rate, contracts for difference, commodity derivatives, or even securing an option on an advanced shipping rate.
So here are some things to look out for:
- Transactions Encompassed by EMIR: EMIR relates to derivative transactions (exchange traded and OTC) entered into modified or terminated after 16th August 2012. Therefore:
– Derivative transactions entered into and terminated prior to 16th August 2012 are not contemplated under EMIR;
– Derivative transactions entered into after 16th August 2012 are subject to EMIR;
– Derivative transactions entered into before 16th August 2012 and still in effect or modified after 16th August 2012 are subject to EMIR.
- Check for your Classification: the classifications under EMIR refer to:
– Financial Counterparties (FCs) which include investment firms, insurance/reinsurance undertakings, pension schemes, credit institutions, collective investment schemes;
– Non-Financial Counterparties (NFCs) being counterparties which are not listed as FCs, which are further classified into two categories: i) NFC+: NFCs whose OTC derivative transactions exceed the clearing thresholds, and ii) NFC-: NFCs whose OTC derivative transactions do not exceed the clearing thresholds. The clearing thresholds established in EMIR are: €1 billion Gross Notion Value (GNV) for credit derivatives and equity derivatives; and €3 billion for interest rate, foreign exchange, and commodity derivatives.
- Trade Repositories (TRs):
– As of yet, there are no TRs authorised in Malta, therefore reporting obligations have not yet commenced, and are expected to start at earliest 12th February 2014, pending further information from the MFSA;
– TRs are to be authorised by class of derivative in relation to the underlying asset i.e. credit derivative reporting will be to credit derivative TRs, and so on…
- Reporting Obligations: Note that all derivative transactions must be reported to TRs by a counterparty, on pain of penalties.
– There should not be double reporting, therefore the counterparties must determine which counterparty shall be reporting the transaction – this function may be delegated.
- When Transactions Should be Reported:
– Contracts executed after 16th August 2012 but terminated before the authorisation of a TR shall be reported to the relevant TR within three years of the execution of the contract;
– Contracts which have been entered into after the authorisation of the relevant TR must be reported within 1 working day of execution termination or modification;
– Contracts which are still in force and have been entered into after 16th August 2012 but before the authorisation of the relevant TR must be reported within 90 days of authorisation of the relevant TR;
– If by June 2015, there are no TRs authorised for the particular asset class, reporting will be directly to European Securities and Markets Authority (ESMA).
- Clearing: clearing refers to OTC derivative transactions exceeding the clearing threshold which must be transacted through a Central Counterparty (CCP). This obligation will start from March 2014 at the earliest for transactions entered into between FCs, or between FCs and NFC+s or between NFC+s.
- Risk Mitigation: NFCs entering into OTC derivative transactions which are not cleared through a CCP must have in place Risk Mitigation procedures and policies. These should include relevant policies relating to: Portfolio Reconciliation, Dispute Resolution, and Disclosure.
- Check List:
– In order to report derivative transactions to a TR, the counterparty requires a Legal Entity Identifier (LEI) code. This can be obtained by contacting one of the authorities listed by the MFSA.
– Ensure that from a corporate governance point of view, that the Memorandum and Articles of Association of the relevant companies in the group specifically allow the company to enter into derivative transactions.
– You must maintain your own Portfolio Reconciliation, Dispute Resolution, and Disclosure procedures (which should have been in place by 15th September 2013).
– For future reference for transactions with other counterparties, confirm which party shall be reporting the transaction going forward.