EMIR: An Unpleasant and Imminent Surprise
On 23 February this year, as part of the new European Market Infrastructure Regulation (EMIR) legislation, the European Parliament published technical standards for the central clearing and reporting of over-the-counter (OTC) derivative contracts. This implies that these technical standards have been endorsed as legislation and represent the next step in creating transparency in the derivative markets, thus reducing credit risk and mitigating system risk for treasurers, financiers and others.
However, few people have commented on the serious consequences of this new EMIR legislation, such as the fact that it will enable financial institutions (FIs) to go bankrupt while all companies – both financial and non-financial – will have an extensive derivative reporting obligation imposed on them. While the former consequence is a promising one as it will encourage sound business practices within FIs, the latter consequence has hardly been remarked on. A small-scale survey carried out by Orchard Finance indicates that corporates are not well prepared for EMIR and don’t know what to expect, although of course they are in fact exempt from the OTC rules in the US under the Dodd Frank Act, which originated from the post-crash Pittsburgh G20 meeting in 2009, enabling non-profit seeking hedging to continue.
While a general outline of the European regulations is available there is little specific guidance on the practical implications of this legislation for corporates on this side of the Atlantic. EMIR impacts on all organisations, from a small high street retailer to a Euronext-listed company. The legislation mitigates financial system risk, ensuring that the familiar phrase ‘too big to fail’ can be ignored going forward. From a society viewpoint the change of attitude is healthy, but for individual FIs, and potentially bank lending and treasury hedging practices, it has far-reaching consequences.
The ‘New Normal’
Banks have become a source of credit and operational risk; worse still a source of concentrated risk in the ‘new normal’ post-crash environment. Most companies have several clients, thus limiting the amount of credit risk represented by each individual client. However, most treasuries only deal with a few banks in the single figures – implying a large concentration of credit risk if diversification is not enforced. Some treasurers who were caught out by putting too much faith in a single bank before the 2008 crash have learnt this lesson the hard way. From an operational point of view, banks are now often viewed as a source of risk. Transferring a company’s financial processes from one bank to another is never an easy job, particularly when it needs to be done unexpectedly, in the event of a failure.
Although information and guidance on these issues has not yet been provided in enough detail to be truly useful, it is already evident that EMIR will lead to bank relationship management becoming an integrated part of a company’s business process and this could benefit treasurers. Those in management will ask themselves questions, such as whether liquidity risk is preferred over credit risk and what does the bank relationship mean in terms of risk and reward?
The other side of the same legislative coin is the additional administrative burden that EMIR will impose on all companies. Assuming that the effective proposed date is not postponed again until Q1 2014, which is eminently possible, from 23 September all organisations should be reporting their derivative transactions to a trade repository in compliance with the technical standards published by the European Commission (EC). Furthermore these technical standards are relatively extensive, over 50 data fields with pre-defined formats which need to be completed and reported to the trade repository within strict, defined timelines. For registration and tracking purposes these elements of the stipulations are likely to apply to corporate treasurers too. It is an accomplishment in itself to devise more than 50 data fields for a single trade, but the rules will lead to adjustments in the data requirements of all companies as much of the data needed is currently not captured in a company’s dealing or administrative systems.
Orchard Finance’s own experience from talking to clients shows that most companies were in fact aware of the central counterparty (CCP) clearinghouse requirement under EMIR, and their end-user exemption for treasury hedging and so forth, but corporates remain unaware of the extensive reporting and transparency requirements that do apply to them. Inter-company derivative transactions will also need to be lodged with a central repository. Indeed, clients of ours fear that they are currently unable to capture all the required information in their systems and report to the trade repository in an efficient manner.
Lack of Preparation
To date, relatively few companies have started to prepare themselves for EMIR. The reasons given for this inactivity include that the information available is not yet sufficient, the company does not want to be the frontrunner and that it is allowed to outsource the reporting requirement – for example towards a bank. This overlooks the internal derivative deals or the fact that this reporting service may come at a direct and/or indirect cost. Outsourcing all the reporting requirements will also have a legal and operational impact.
From a regulatory and commercial point of view, it is remarkable that both governments and trade repositories have remained silent on EMIR. From a commercial point of view, one would expect the trade repositories to pro-actively contact large corporates to offer them assistance in their regulatory administrative burden. However there is little evidence of this happening. A logical explanation could be that they remain quiet unless and until they are formally approved as a trade repository by the European Securities and Markets Authority (ESMA). The repository does not want to jeopardise its approval and is keen to avoid legal contracting implications.
From a regulatory point of view, the silence is even more puzzling – why is the regulator not actively promoting this new regulation? Corporates are unaccustomed to this kind of regulatory reporting and are currently either not aware of the legislation or regard it as a useless administrative burden. If the regulator wants companies to comply with EMIR one would expect it to be more involved, actively promoting this legislation and explaining why it is important, what the regulator does with the information received and the consequences for companies which choose not to comply. The silence is inexplicable and raises the question of whether the government is actually ready to process all the information that EMIR will produce or will simply be sitting on a pile of data.
It is good to aim for transparency in the derivatives market, enforcing central clearing and mitigating the risk of a financial meltdown but it would be better if stakeholders were sufficiently informed on all direct and indirect consequences of this upcoming legislation.