Energy trading firms face an anxious race against time to comply with new EU reporting rules for derivatives. Fortunately there are solutions -- but the time to act is now.
By James Brown
Less than four weeks have passed since the start of mandatory trade reporting under the European Market Infrastructure Regulation (EMIR) – and the market still isn’t ready. After months of delay and re-think during the rollout, a host of ‘energy market participants’ now find themselves playing catch up and trying to understand how to meet the new reporting requirements, restrictions and definitions. Needless to say that’s a risky position to be in.
How did we get here? In the aftermath of the global financial crisis, the G20 agreed a series of reforms to improve transparency in over-the-counter (OTC) derivative markets. Dodd-Frank marked the first major salvo to boost accountability in OTC energy trading, followed by EMIR in the European Union. A central feature of these was to mandate reporting of trade activities to trade repositories.
In December, the European Securities and Markets Authority (ESMA), the EU body responsible for derivatives regulation, announced its final deadline for EMIR – giving market participants just three months to be in full compliance with the new reporting requirements. As of early February less than 10 per cent had registered for their EMIR ‘LEI’ or legal entity identifier, which is required to report both OTC and listed trades.
Most companies have hesitated to act for fear of investing in solutions that turn out to be expensive dead ends. Given the wide-ranging applicability of EMIR, that has resulted in thousands of European companies at risk of penalty. Firms that breach the requirements could be fined, a responsibility ESMA has delegated to national authorities.
It’s a remarkable situation and yet easy to understand. Lack of agreement on data formats, complicated by privacy laws and further confused by the growing number of active repositories participating in the reporting scheme, has made the rollout of EMIR a stop-start affair. Regulators have pressed on regardless, holding companies accountable on short notice and for changes the regulators themselves haven’t always been able to fully explain. Even now we are waiting for finalised technical standards and there are gaps in business logic definitions like ‘UTI’ that were introduced with the legislation. We are also missing clarity on definitions for key terms like ‘derivatives’.
Aside from fines for non-compliance, with so many companies in regulatory limbo the industry faces the possibility of reduced trading volumes due to an inability to meet EMIR’s requirements. Since exchanges can offer relatively hassle-free reporting services, we may also see a move away from OTC trading to exchange-based trades.
Who is at risk?
The EMIR rules make off-exchange traded derivatives, similar to credit default swaps, more transparent, and will affect any firm dealing in:
- Options, futures and swaps on interest rates, securities, credit and indices
- Commodity derivatives and derivatives on underlyings, including rates, freight rates, emission allowances and climatic variables
- Contracts for gas and electricity, as well as transportation derivatives
Essentially, all energy market participants have to register with their respective national regulators. Under EMIR, manufacturers and other energy-intensive businesses that use these hedging techniques now become ‘non-financial counterparties’. As energy trades in this category only need to be centrally cleared after a clearing threshold has been reached, an active monitoring capability is needed to signal when the threshold is looming.
At the end of the day, any firm affected now needs to have in place proper means of reporting, clearing and risk mitigation in order to both comply and continue operating under a hedging strategy. Further, if operations cross regulatory borders then specialised processes need to be in place, as in most cases, harmony among the various regulatory bodies will be the exception rather than the rule.
Despite the urgency for EMIR compliance there are viable alternatives for what companies can do in the short-term to get beyond tick-box compliance. Managing the process manually isn’t one of them. EMIR’s electronic reporting and data storage requirements will quickly overwhelm any approach based on spreadsheets.
Outsourcing may be a solution, but it comes with its own costs and risks. There is the added overhead of an ongoing contract to manage, so how active you are in the energy trading arena will determine your breakpoints financially. But in the end, do you really want to outsource a liability you will ultimately be held accountable for should any errors or delays in compliance occur? A third-party provider will most likely not be responsible for paying fines. Even if you could negotiate a contract that held them financially liable, what would an infraction mean to your brand reputation? The collateral cost of cleaning up a public relations nightmare could be devastating.
That leaves accepting higher prices by abandoning a hedging strategy altogether – not a good thing for the bottom line – or automating the process. From my perspective the best business decision rests with automation.
Automating regulatory processes requires a basic commodity trading and risk management (CTRM) system. A regulatory solution for commodity trading and corporate financial compliance is generally not a stand-alone application. Contract data, hedge accounting, revenue allocation in line with regulatory reporting requirements and other special functions do not happen in a vacuum.
At minimum, an effective CTRM system should be able to:
- Ensure trade compliance
- Efficiently execute trades
- Enhance market intelligence
- Improve decision-making
There are software vendors with long tenures in the business of risk managing large energy purchases. In light of the evolving standards for EMIR you will want to choose a solution that allows you to upgrade and manage your regulatory compliance process quickly. Another qualifier to consider is the ability to install software on a captive system and maintain it internally, or purchase a software-as-a-service (SaaS) contract and maintain it virtually in the cloud. Implementing this option could affect your overall total cost of ownership as you integrate the system into other areas of the business.
Direct connectivity to trade repositories should also be a core capability, including all required regulatory identifiers and formats. The system should be able to simplify the threshold monitoring for non-financial counterparties (e.g. energy intensive businesses operating a hedging strategy) and facilitate risk mitigation obligations, including EMIR’s requirement for periodic portfolio reconciliations.
Energy traders need to address EMIR compliance today. Given the evolving standards and timelines that define today's regulatory environment, an automated solution offers the best and fastest approach to meeting the requirements.
On August 16, 2012, ESMA put into legislation the European Market Infrastructure Regulation EMIR, requiring all transactions involving exchange-traded and over-the-counter derivatives to be reported to trade repositories for the purpose of ensuring public transparency and marketplace accountability. The first obligations, requiring financial and certain non-financial counterparties to provide daily valuation and timely trades confirmation to ESMA, went into effect March 15, 2013. With input from the industry, still more detailed EMIR standards and legislation are expected to take effect, including certain capital, margin and collateral rules for non-centrally cleared trades, extra-territorial applications, identifying clearing mandatory contracts and third country equivalence. EMIR’s first reporting deadline was 12 February 2014.