EMIR Refit may have regulators seeing double
23 June 2020
Last week鈥檚 EMIR Refit implementation day brought in delegated reporting rules for OTC derivatives despite a host of lingering operational challenges. And, further problematic waves are not far ahead
Image: Image by frankie's/shutterstock.com
Last year, the European Commission published a series of amendments to the European Market Infrastructure Regulation (EMIR), known as Refit, aimed at streamlining and updating the ageing framework first implemented in 2012.
The purpose of Refit is to address disproportionate compliance costs, transparency issues and insufficient access to clearing for certain counterparties. Its aim is to simplify the rules and reduce regulatory and administrative burdens where possible, especially for non-financial counterparts (NFCs), without compromising the regulatory goal of EMIR.
Tomas Bremin, head of business product management at REGIS-TR, an EU trade repository, explains that EMIR Refit has been implemented in multiple phases to reengineer EMIR with lessons learned over the past six years as well as borrowing several concepts developed under Securities Financing Transactions Regulation (SFTR).
However, some of the regulation鈥檚 constituents are voicing concerns that it鈥檚 fallen short of achieving all it could have if a bolder stance was taken by regulators to address the problems and inconsistencies.
鈥淲hat came out of Refit was severely watered down, what market participants were hoping would be addressed and what actually has been addressed are quite some distance apart,鈥� says John Kernan, senior vice president and head of product management and business development at REGIS-TR.
For example, market participants were enthusiastic about initial proposals to shift the responsibility for reporting exchange-traded derivatives (ETD) to central counterparties (CCPs). However, CCPs were 鈥渘ot overly keen on assuming responsibility,鈥� Kernan explains and the proposal was eventually dropped.
Elsewhere, David Nowell, senior regulatory reporting specialist at Kaizen Reporting, adds: 鈥淯ndoubtedly this [EMIR Refit] is a worthy aim and the regulators should be applauded for this intention. Unfortunately, when it comes to trade reporting, many firms are bitterly disappointed with the outcome, as they were hoping for more fundamental changes to ease the compliance burden.鈥�
Refit reporting
EMIR Refit first began its implementation in June 2019 by redefining what is considered a financial counterparty (FC) and NFC and also introducing the category of a small FC (FC-) and an NFC- based on a clearing threshold for over-the-counter (OTC) derivatives.
As we slide along the legislative timeline, we鈥檝e come up against the next phase, which went live on 18 June, and brought in rules that handed the responsibility for reporting OTC derivatives trades to FCs on behalf of their NFCs that are deemed NFC- under regulation鈥檚 new designations.
In a nutshell, FCs are only obligated to report OTC derivative trades on behalf of an NFC-, not the NFCs above the clearing thresholds; ETDs are excluded from this rule change.
Although simple in principle, many market participants under EMIR鈥檚 remit believe unanswered questions around certain elements of the rules leave the door open to messy unintended consequences that undermine the rule鈥檚 effectiveness.
The clearing obligation requires all counterparties, including those already subject to it, to calculate the notional month-end average positions for the previous 12 months for each asset class to determine whether any asset classes cross the clearing threshold. If any asset class exceeds the threshold, related trades must be cleared and reported to the relevant national competent authority (NCA) via a trade repository (TR).
An NFC- may choose to continue reporting trades itself either by asset class or in total, but it鈥檚 FCs need to be kept aware of whether they are required to report on an NFC鈥檚 behalf or not 鈥� and therein lies the problem.
While many FCs have done considerable work to prepare for the reporting obligation, they are very dependent on the responsiveness of their NFC counterparties. The NFC needs to confirm whether it intends to self-report to prevent the risk of double reporting, or a failure to report by either party. Flaws in the data transfer methods and general shortcomings in the average level of communication between NFCs and FCs means that this system is expected to lead to issues with duplicated reporting. At the same time, the COVID-19 pandemic is also expected to compound these challenges for both the FCs as well as NFC- to provide the required reporting information.
If an NFC and its FC report to the same TR any double reporting should be caught by the TR鈥檚 infrastructure, but if they don鈥檛 then that error will only be caught during a national competent authority鈥檚 (NCA) reconciliation of reported data.
Nowell, highlights: 鈥淭he main concern is that the NFCs and FCs might end up reporting to different TRs. In a perfect world, this process would be seamless; in real life, there is plenty that could go wrong, leading to rejections from the trade repositories and resource-intensive investigations by firms.鈥�
Ian Thomas, a regulatory solutions specialist at financial services consultancy at Quorsus, agrees. There鈥檚 plenty of talk on the real risks of duplicate reporting, both when the rules are implemented or in future should a counterparty鈥檚 classification move between NFC+ and NFC-, as it will have to communicate effectively with its FC and may have to go through the porting process. In each case the risk of over and under-reporting is key,鈥� Thomas adds.
In extreme examples, it has been suggested by industry experts that some NFCs will simply stop reporting and leave everything to their FCs. REGIS-TR鈥檚 Bremin points out that this will include 鈥渢he maintenance of their outstanding reports which won鈥檛 work without some action on behalf of the NFC. There will be some double reporting by the NFC that hasn鈥檛 informed their FC that they will report for themselves, and consequently by the FC that follows the Refit mandatory delegation requirement.鈥�
To address these concerns several trade bodies, including the International Swaps and Derivatives Association, the Association for Financial Markets in Europe and Securities Industry and Financial Markets Association, among others, wrote to EU regulatory authorities in April to request clemency.
The letter, addressed to the chair of the European Securities and Markets Authority (ESMA) Steven Maijoor, called for NCAs to be advised to 鈥渘ot prioritise supervisory actions in relation to the EMIR Refit mandatory delegated reporting requirement鈥� for five months after 18 June.
As well as the technical challenges of reporting and sharing information, the letter also highlights the on-going business disruption caused by the pandemic as another reason for regulators to look the other way.
It also points out that given that reporting is already taking place, a failure to move to the new method on time does not necessarily lead to a reduction in transparency, since the old method will still be in place.
At the time of writing, ESMA is yet to publicly state if it will acquiesce to this request.
TR troubles
In the instance where the NFC and the FC use different TRs, ESMA is suggesting that the TRs use a process called 鈥榩ortability鈥� to migrate the open trades across from the NFC鈥檚 TR to the FC鈥檚 TR.
However, Bremin explains that a high volume of portability events will 鈥渃onsume time and resources for the TRs for a long period of time鈥�.
鈥淚n some cases, the NFC has FCs that don鈥檛 all use the same TR, and this requires partial portability which until now has not been in scope of the inter-TR procedures for portability,鈥� he adds.
Thomas reinforces this concern, concluding that 鈥減ortability was not designed for this reason and EMIR Refit has potentially very messy and complicated consequences鈥�.
Recipe for distress
While in principle the regulation鈥檚 upgrade is necessary to better manage and monitor risks arising from derivatives markets, the flaws in the rules could extend to future phases of EMIR Refit.
ESMA is currently consulting on changes to implementing technical standards to bring them into line with international standards proposed by the Committee on Payments and Market Infrastructure of the International Organization of Securities Commission. This, Nowell says, 鈥渨ould be good from a regulatory point of view as it can facilitate a global view of systemic risk (if the individual regulators can agree to share data)鈥�.
The potential for EMIR Refit to achieve its aims of building upon EMIR and SFTR for the benefit of the whole market is still there. But, indicators of how the rule-writing has gone so far have left some believing the worst is yet to come.
Nowell says: 鈥淲e will have new implementing technical standards, probably next year, which are set to add unwanted additional complexity to reporting and will make 18 June seem like a minor blip in comparison.鈥�
The purpose of Refit is to address disproportionate compliance costs, transparency issues and insufficient access to clearing for certain counterparties. Its aim is to simplify the rules and reduce regulatory and administrative burdens where possible, especially for non-financial counterparts (NFCs), without compromising the regulatory goal of EMIR.
Tomas Bremin, head of business product management at REGIS-TR, an EU trade repository, explains that EMIR Refit has been implemented in multiple phases to reengineer EMIR with lessons learned over the past six years as well as borrowing several concepts developed under Securities Financing Transactions Regulation (SFTR).
However, some of the regulation鈥檚 constituents are voicing concerns that it鈥檚 fallen short of achieving all it could have if a bolder stance was taken by regulators to address the problems and inconsistencies.
鈥淲hat came out of Refit was severely watered down, what market participants were hoping would be addressed and what actually has been addressed are quite some distance apart,鈥� says John Kernan, senior vice president and head of product management and business development at REGIS-TR.
For example, market participants were enthusiastic about initial proposals to shift the responsibility for reporting exchange-traded derivatives (ETD) to central counterparties (CCPs). However, CCPs were 鈥渘ot overly keen on assuming responsibility,鈥� Kernan explains and the proposal was eventually dropped.
Elsewhere, David Nowell, senior regulatory reporting specialist at Kaizen Reporting, adds: 鈥淯ndoubtedly this [EMIR Refit] is a worthy aim and the regulators should be applauded for this intention. Unfortunately, when it comes to trade reporting, many firms are bitterly disappointed with the outcome, as they were hoping for more fundamental changes to ease the compliance burden.鈥�
Refit reporting
EMIR Refit first began its implementation in June 2019 by redefining what is considered a financial counterparty (FC) and NFC and also introducing the category of a small FC (FC-) and an NFC- based on a clearing threshold for over-the-counter (OTC) derivatives.
As we slide along the legislative timeline, we鈥檝e come up against the next phase, which went live on 18 June, and brought in rules that handed the responsibility for reporting OTC derivatives trades to FCs on behalf of their NFCs that are deemed NFC- under regulation鈥檚 new designations.
In a nutshell, FCs are only obligated to report OTC derivative trades on behalf of an NFC-, not the NFCs above the clearing thresholds; ETDs are excluded from this rule change.
Although simple in principle, many market participants under EMIR鈥檚 remit believe unanswered questions around certain elements of the rules leave the door open to messy unintended consequences that undermine the rule鈥檚 effectiveness.
The clearing obligation requires all counterparties, including those already subject to it, to calculate the notional month-end average positions for the previous 12 months for each asset class to determine whether any asset classes cross the clearing threshold. If any asset class exceeds the threshold, related trades must be cleared and reported to the relevant national competent authority (NCA) via a trade repository (TR).
An NFC- may choose to continue reporting trades itself either by asset class or in total, but it鈥檚 FCs need to be kept aware of whether they are required to report on an NFC鈥檚 behalf or not 鈥� and therein lies the problem.
While many FCs have done considerable work to prepare for the reporting obligation, they are very dependent on the responsiveness of their NFC counterparties. The NFC needs to confirm whether it intends to self-report to prevent the risk of double reporting, or a failure to report by either party. Flaws in the data transfer methods and general shortcomings in the average level of communication between NFCs and FCs means that this system is expected to lead to issues with duplicated reporting. At the same time, the COVID-19 pandemic is also expected to compound these challenges for both the FCs as well as NFC- to provide the required reporting information.
If an NFC and its FC report to the same TR any double reporting should be caught by the TR鈥檚 infrastructure, but if they don鈥檛 then that error will only be caught during a national competent authority鈥檚 (NCA) reconciliation of reported data.
Nowell, highlights: 鈥淭he main concern is that the NFCs and FCs might end up reporting to different TRs. In a perfect world, this process would be seamless; in real life, there is plenty that could go wrong, leading to rejections from the trade repositories and resource-intensive investigations by firms.鈥�
Ian Thomas, a regulatory solutions specialist at financial services consultancy at Quorsus, agrees. There鈥檚 plenty of talk on the real risks of duplicate reporting, both when the rules are implemented or in future should a counterparty鈥檚 classification move between NFC+ and NFC-, as it will have to communicate effectively with its FC and may have to go through the porting process. In each case the risk of over and under-reporting is key,鈥� Thomas adds.
In extreme examples, it has been suggested by industry experts that some NFCs will simply stop reporting and leave everything to their FCs. REGIS-TR鈥檚 Bremin points out that this will include 鈥渢he maintenance of their outstanding reports which won鈥檛 work without some action on behalf of the NFC. There will be some double reporting by the NFC that hasn鈥檛 informed their FC that they will report for themselves, and consequently by the FC that follows the Refit mandatory delegation requirement.鈥�
To address these concerns several trade bodies, including the International Swaps and Derivatives Association, the Association for Financial Markets in Europe and Securities Industry and Financial Markets Association, among others, wrote to EU regulatory authorities in April to request clemency.
The letter, addressed to the chair of the European Securities and Markets Authority (ESMA) Steven Maijoor, called for NCAs to be advised to 鈥渘ot prioritise supervisory actions in relation to the EMIR Refit mandatory delegated reporting requirement鈥� for five months after 18 June.
As well as the technical challenges of reporting and sharing information, the letter also highlights the on-going business disruption caused by the pandemic as another reason for regulators to look the other way.
It also points out that given that reporting is already taking place, a failure to move to the new method on time does not necessarily lead to a reduction in transparency, since the old method will still be in place.
At the time of writing, ESMA is yet to publicly state if it will acquiesce to this request.
TR troubles
In the instance where the NFC and the FC use different TRs, ESMA is suggesting that the TRs use a process called 鈥榩ortability鈥� to migrate the open trades across from the NFC鈥檚 TR to the FC鈥檚 TR.
However, Bremin explains that a high volume of portability events will 鈥渃onsume time and resources for the TRs for a long period of time鈥�.
鈥淚n some cases, the NFC has FCs that don鈥檛 all use the same TR, and this requires partial portability which until now has not been in scope of the inter-TR procedures for portability,鈥� he adds.
Thomas reinforces this concern, concluding that 鈥減ortability was not designed for this reason and EMIR Refit has potentially very messy and complicated consequences鈥�.
Recipe for distress
While in principle the regulation鈥檚 upgrade is necessary to better manage and monitor risks arising from derivatives markets, the flaws in the rules could extend to future phases of EMIR Refit.
ESMA is currently consulting on changes to implementing technical standards to bring them into line with international standards proposed by the Committee on Payments and Market Infrastructure of the International Organization of Securities Commission. This, Nowell says, 鈥渨ould be good from a regulatory point of view as it can facilitate a global view of systemic risk (if the individual regulators can agree to share data)鈥�.
The potential for EMIR Refit to achieve its aims of building upon EMIR and SFTR for the benefit of the whole market is still there. But, indicators of how the rule-writing has gone so far have left some believing the worst is yet to come.
Nowell says: 鈥淲e will have new implementing technical standards, probably next year, which are set to add unwanted additional complexity to reporting and will make 18 June seem like a minor blip in comparison.鈥�
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