Banking and the implementation of the European Market Infrastructure Regulation (EMIR)

On the 2^nd September 2013 the Basil Committee on Banking Supervision (BCBS), the financial supervisor for Europe, laid out the final framework a European Market Infrastructure Regulation (EMIR) for standardising derivative contracts along with a phase in period, as of then the world’s response moved into implementation from theoretical regulations.

As the world slowly drags itself out of the financial crisis, another period of financial instability falls into history, but not without leaving us with a fundamentally different market and new games ready to be played.

The 2008 collapse of the investment banks Bear Sterns and Lehman Brothers, as well as the insurance company AIG, exposed fundamental weaknesses in the “over the counter” (OTC) derivatives market – contracts that are tailored between two parties without infrastructure, standardisation or regulation governing their creation.

The OTC market had rapidly burst through from the decade before due to a new found trust in financial institutions and financial lobbying pushing deregulation of rules governing their behaviour. As a consequence, an unsupervised shadow market was created, which festered into confusion and irrational risk without any oversight from the larger ingrained economy leading to the transmission and amplification of financial losses in 2008.

That market today stands at a current value of $650 trillion and is chugging out interest rate swaps, options contracts and forward rate agreements at the same pace pre crisis. Yet today as those individuals sit at their desks and negotiate these contracts upon future market trends continue, there must now be a new found presence with a far longer list of demands.

By 2009 the G20 in Europe had seen enough of financial institutions assumed “rationality” and were bent on gaining transparency and standardisation within the OTC derivatives markets that had rapidly become central to the world.

An agreement was made through mass policy creation and reform to make it necessary that stated: “OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counter parties by end-2012 at the latest. OTC derivate contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.“

Legislation No 648/2012 otherwise known as EMIR – the equivalent of title VII, part II of the Dodd-Frank Act in the US with parallels in Hong Kong, Japan and Singapore – would become that presence at the OTC traders desk. Through the European Securities and Markets Authority (ESMA) those dealing in OTC derivatives contracts would feel their wings cut and their market heavily trimmed. Financial institutions: banks, insurers, investment firms, fund managers and spread betting firms have a completely different territory to operate within. 

The regulations that EMIR subsumes are sizeable, capital intensive and data driven. The new EMIR frameworks create the standardisation of derivatives contracts allowing contracts to be catalogued, uniform and accessibly transparent. Contracts will be traded on standard exchanges or electronic platforms instead of tailored bets between two parties, cleared through an approved Central Counter Parties (CCP) in charge of the authorisation and the storing of contract collateral of which 15% is now held for 50 year contracts up from the 2.5% pre-crisis.  CCPs will also account for common legal documentation, volume, liquidity and the acceptance of reliable pricing information.

The CCPs’ place in the new regulations is interesting and unique. Essentially it is to label which positions in the market are for measurable hedging purposes against those positions that are purely speculative and are borderline gambling in their creation of risk and high yields.

Those positions made for strictly commercial activity will be exempt from supervisory thresholds which will measure the concentration of speculative risk contracts within a company’s balance sheet. Those thresholds are being held at one billion euros for equity and credit derivatives and 3 billion euros for interest and commodity derivatives. The International Swaps and Derivatives Association (ISDA) reports that worldwide 51% of equity and credit derivatives are now cleared, which itself makes up 80% of all OTC derivatives.

All data concerning these contracts will be complied into a detailed report to a trade repository (TRs) allowing the monitoring of systematic risk within such a large market. TR’s will provide a new reporting service offered by the likes of BNP Paribus, Citi, Credit Suisse and Lloyds Banking Group and UBS. 

EMIR heavily increases the burden of IT systems and risk management processes to bring systematic risk into clear view to be regulated by third party authorities.

“It is all about transparency, stability and international co-ordination,” Steven Maijoor, Chair of the ESMA has said – something that was direly missing in the run-up to the financial crisis disallowing governmental supervisors to oversee the markets efficiently.  The new regulations also allow regulators to oversee multiple markets across boarders allowing the “avoidance of gaps across regimes” that marketeers could still take advantage of.

Currently the dispute/resolution requirements that compel those that enter into derivative contract to outline the terms for any disagreements and how to go ahead with them have entered into force as of September.

The reporting of credit and interest rate derivatives has been recently announced delayed until January 2014 as companies clamber to align themselves with the new regulations and seek to understand the demands being made of them. The complete phase in of the legislation will continue through 2015 in stages and leave the financial institutions in a much smaller box finalised in 2019.

A decade after the financial crisis those that became confused and left the world in recession are now being led by a hand so as not to fall over once again.

Patrick Corby