Rules to counter systemic risk in the over-the-counter (OTC) derivatives market are creating headaches for market participants and tech providers alike, finds Dan Barnes in this bobsguide feature on the European Market Infrastructure Regulation (EMIR), which assesses the opinions of Omgeo, Fidessa, ISDA, Electrolux and many others. The impact on the financial markets’ way of working, its trading, risk, clearing, collateral and other methodologies are all examined in this in-depth feature.
The European Market Infrastructure Regulation (EMIR) is the unloved child of post-crisis reform and European market unification. It is being rolled out right now, with the move towards centralised trade repositories (TRs) starting on 12 February and many more aspects to follow. The regulation’s primary function is to deliver Europe’s interpretation of the agreed G20 mandate agreed on 25 September 2009 (see text box 1), to make over-the-counter (OTC) derivatives trading less systemically risky.
EMIR is Europe’s contribution to the centralised reporting, clearing, and enhanced transparency requirements demanded post-crash and apes the US Dodd-Frank rules in many aspects, if not all with some regional differences still obfuscating the long-desired global harmony and opening up the possibility of regulatory arbitrage.
The somewhat choppy and incomplete delivery of the EMIR rules so far, with delay talk a constant accompaniment, is also making things hard for the IT teams at trading firms, asset managers and all financial market participants as they have to decide how to automate processes, capture and report data under this new post-crash regulatory environment. Provide the connectivity which will ultimately deliver the hoped for transparency in the market is not an easy task.
“The level of uncertainty isn't specific to one issue, so while reporting requirements and the collateral margin process between a clearing broker and their clients is challenging for us, firms that provide risk solutions will tell you pre-trade risk is the challenge,” says Ted Leveroni, managing director for strategy at post-trade technology provider, Omgeo. “Everything is changing at the moment.”
The problems that were apparent in the pre-2008 OTC derivatives market included substantial underinvestment in technology by market participants. A programme of reform was started in 2005 (see text box 2) but this only tackled the lack of transparency that banks faced, missing that their lack of insight had already set them on the path to collapse as the credit crunch escalated into a full blown financial crisis in 2008.
The next six years were to demonstrate that dealers’ booking of unconfirmed trades and paper piles of post-trade documents were the tip of the iceberg. Without keeping track of positions or risk, there was no adequate oversight of the market and firms such as global broker Lehman Brothers and insurance giant AIG were able to create untenable positions which ultimately bankrupted them.
EMIR and its US equivalent rules in the Dodd-Frank Act are a continuation of the immediate post-crash reform commitments, expanded with hindsight. Of the 18 banks involved in the programme only 13 still operate, one of which is state-owned by the UK government, as a direct result of the ensuing financial crisis.
The EMIR of Regulation
The goal of the European Market Infrastructure Regulation (EMIR) is to ensure that the infrastructure is in place to create transparency over financial market transactions and to mitigate the systemic risk that was created by firms building enormously risky positions, which bankrupted them within very short spaces of time. While risk taking cannot be discouraged, its negative effects can be isolated by ensuring that bankruptcy does not spread.
The requirement for these safety measures has grown more pressing since the crisis. Despite the decrease in dealers, the notional value of positions has increased since 2008.
According to the International Swaps and Derivatives Association (ISDA), an industry lobby group, the notional amount outstanding of OTC derivatives, excluding foreign exchange (FX) transactions, increased by 25.6% from US$511.1 trillion to US$642.1 trillion over the five-year period ending 31 December 2012; the last period for which annual figures were released. That the effects of the 2008 crisis have not subsided emphasises the importance of a secure market.
The New Model and Rules: Centralised Clearing
The European regulations create a framework for trading derivatives that fulfils and goes beyond the G20 commitment. It requires that all OTC derivatives be centrally cleared or be subject to a higher capital charge – the latter fulfilled by the Basel III capital adequacy requirements. It requires that all derivatives trades be reported, whether exchange-traded or OTC. It also sets up the rules for the central counterparties (CCPs) and trade repositories to function.
The centralised clearing model allows firms to trade with one another without exposing themselves to counterparty risk. It does this by requiring each side of a trade to give the CCP some collateral to cover their trade (the initial margin) and to cover any changes in the price of the contract traded (variation margin), until the contract expires.
The collateral is used by the CCP if one of the traders is bankrupted and defaults on their liabilities. Rather than leaving that trader’s counterparties to accept losses, the CCP takes on all of the bankrupt firm’s positions and trades them on to other parties. Doing so is an expensive business. The operational costs of trading and depreciation in value of the instruments held could cause significant losses. A ‘default waterfall’ determines when particular capital reserves held by the CCP can be used; the defaulting firm’s collateral is expended first, then typically that of other clearing members, then the CCP’s own reserves, then insurance. The high quality of collateral – cash and well-rated government bonds – that are typically required, make it easier on the CCP to fund itself as they are easy to sell, and retain value.
If a trade for an OTC derivative is not centrally cleared, higher costs of capital are imposed upon the broker for holding an uncleared position. National competent authorities will begin authorising CCPs from 15 March 2014. Regulatory technical standards have to be drafted by the European Securities and Markets Authority (ESMA), approved by the European Commission and given the all clear by the European Parliament and the Council of the European Union.
Trade reports are required for all derivatives that are traded; the responsibility of each counterparty to make. However, reporting can be delegated to a single counterparty – a broker – if agreed. To file a report, firms have to aggregate data from across their own operations and those of other firms including counterparties and CCPs. As of 12 February 2014, when TRs came in, reports have to be filed for each distinct event that occurs during the lifecycle of a trade. As Europe has allowed multiple repositories to exist and compete, multiple potential routes exist that a report can take.
The intention is that ESMA should be able to use the reports to unpick who has bought what and from whom. It should make unwinding trades in the event of another Lehman’s easier, at the very least.
The Technical Challenge: Derivatives
For participants in the derivatives market, automation has at last been imposed. New models have been built to assist with the changes in post-trade operations. The impact on technology differs between types of market participant says Steve Grob, director of group strategy at trading system supplier, Fidessa.
“There are a variety of things that need to be done. At one end, the more pure-play futures commission merchants (FCMs) are very comfortable with futures and so favour futurisation of swaps, constant maturity futures and swap futures, as it fits their existing business models. At the other end are the OTC execution dealers who would rather the swaps market stayed as it is. Depending upon who we are talking to we get quite a different requirement; some firms who deploy Fidessa screens to their clients to trade futures may now have a requirement to list swaps on that same screen, so there is a convergence.”
Market infrastructure providers have been required to offer fully segregated accounts to ensure that clients can have their collateral ported directly from one broker to another, rather than having it held by the broker and placed at risk in event of default, or having different assets of an equivalent value being transferred, as had been the case under previous models.
In quad-party arrangements this requires the assets to be held via a custodian in an account that both a clearing member and its buy-side client have access to in certain circumstances, based on the communication with the CCP. They, in turn, have had to automate processes to move and manage collateral.
Protecting the investor
For end investors, sourcing the collateral in the first place is challenging, as is the speed at which it may be required. Intraday calls on variation margin require accessible, short-term cash injections and withdrawals. For the firms that post collateral, both buy- and sell-side, this requires them to use accounting systems that can track where collateral is held and its value.
Buy-side firms that only use derivatives for hedging – typically funds and corporates – are particularly vulnerable to the impact of collateral requirements; their long positions must be hedged with derivatives, such as interest-rate swaps to hedge a bond portfolio, over long periods. That locks up collateral for extended periods. Other firms, that buy and sell derivatives, are able to net off the collateral of long positions against that of short positions, reducing their total requirements.
They are also less able to access the instruments that are required for margin. This raises questions about the way the rules are repositioning risk.
Jonas Christoffersson, head of treasury control for Electrolux, which primarily uses FX forwards and swaps, used to hedge commercial flows, says: “If you have to clear trades, you get rid of pre-settlement risk but then take on liquidity risk. We have regular commercial flows in and out of the bank, but for firms working on a project basis they could face serious risks as a result of clearing.”
While Electrolux uses system supplier TradeTech for monitoring of post-trade activity, checking the reports of external trades will be challenging he says; as the firm has around a dozen core banks using different repositories, creating a fragmented data picture.
“I don’t know if we will use a third party system such as TriOptima or if we will have to build a system here to merge the information,” he says, adding that the firm’s ambition is to report all derivatives trades via TradeTech’s EMIRIS platform.
“When this is solved we won't need any third part solution, as EMIRIS will take care of the reconciliations as well,” he says.
With many firms having struggled – and failed – to meet the 12 February deadline for reporting, regulators in many European countries indicated that they would be lenient with firms that showed they were on course for compliance. However, uncertainty in areas like compliance impacts business beyond the regulation itself.
Martin Donovan of the Association of Corporate Treasurers (ACT) trade body notes that credit agreements, in which firms state that they are in compliance with all regulations and that are deemed to be effective each time a draw down is made, could be breached by such looseness. “Firms take those agreements seriously,” he says, as should others.
As such the long-term stability that EMIR hopes to create is undermining short-term stability for many firms, particularly those on the buy-side. Corporates who want to use hedging strategies are therefore facing uncertainty, the same as other financial market participants. The uncertainty is likely to continue for much of the rest of this year as EMIR unfolds.
G20 Leaders’ Post-crash Statement, 25 September 2009 at Pittsburgh in the US
“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end of 2012, at the latest. OTC derivative contracts should be reported to trade repositories (TRs). Non-centrally cleared contracts should be subject to higher capital requirements. We ask the Financial Stability Board (FSB) and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.”
The Fed Letters
In 2005, the Federal Reserve of New York (The Fed), America’s independent central bank hosted a meeting of OTC derivatives market participants and regulators to tackle the “inadequate infrastructure” that existed for the rapidly expanding derivatives markets.
From 2005 to 2011 the largest 18 banks in the derivatives business wrote letters to the Fed, outlining their commitments to reform the manual processing of enormous numbers of derivatives trades which were generating very large profits for them.
On 27 March 2008, the Fed wrote in a statement: “Since OTC derivative dealers started addressing credit derivative processing issues in 2005, they have reduced confirmations outstanding more than 30 days by 85%, increased electronic processing to more than 90% of all credit derivative trades and eliminated the risk of novations causing dealers not to know their counterparties. Nevertheless, volume surges in mid-2007 underscored the processing challenges that persist in the OTC credit derivatives market. To support long-term growth, the processing infrastructure must be capable of processing transactions efficiently through periods of sustained high volume and market volatility.”