PRIMER: Emir Refit

Author: Jimmie Franklin | Published: 28 Feb 2020
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Emir, or the European Market Infrastructure Regulation, is aimed at creating a safe market for over-the-counter (OTC) derivatives.

Emir’s technical standards were signed off by the European Commission in 2012, and a year later were rolled out by member states of the European Economic Area – with a scope that extends far further. For a primer on Emir 2.2, which concerns central clearing counterparties, click here.

The goal of the regulation is to reduce systemic risk with Europe’s financial market and, as with many pieces of regulation since 2008, to help prevent a future financial crash.

A few years after Emir was first implemented, the Commission carried out a review of the regulation to assess where it could reduce the burden put on counterparties costs and reporting obligations. Hence, amendments were undertaken and the Refit (otherwise known as Emir 2.1) was rolled out.

While Emir is a piece of EU regulation, the FCA has made clear that rules will continue to apply for UK firms following the withdrawal from the trading bloc.

What has changed?

As the refit indicates, Emir "should cover all financial counterparties that might pose an important systemic risk for the financial system," therefore amending the definition of what a financial counterparty is and bringing investment managers into scope, regardless of where they are based – so within the EU or elsewhere.

According to Macfarlanes partner William Sykes, this has been biggest change for funds.

"Previously we had a whole section of the private funds industry where both the fund and manager would be in the Cayman Islands or Guernsey," he says.

These parties would still be considered non-financial counterparties (NFCs), as would a European fund whose manager has remained elsewhere – but since the refit, they are now in-scope as financial counterparties.

Another significant change is the introduction of a small financial counterparty category. The review has pointed out that certain financial counterparties’ activity is minimal enough that it will not pose an "important systemic risk" to the financial system.

These firms are exempted from the clearing obligation but are still required to exchange collateral to mitigate any potential systemic risk.

"In theory, this has been a good idea," Sykes says. Previously, a small Ucits fund managing a billion or so would be in the same category as a much larger organisation such as HSBC – which many would agree is far from proportionate rulemaking.

New reporting obligations

Buyside firms have new reporting obligations. As indicated by the regulation, "the reporting of historic contracts has proven to be difficult because certain details which are now required to be reported were not required to be reported before the entry into force".

In article nine of Emir, reporting obligations are indicated as applying to derivative contracts that were entered into before August 16 2012 and remained outstanding on that date.

As the review indicates, this requirement in the original regulation resulted in a high reporting failure rate, with poor quality data being submitted and a massive burden on firms.

"The fact that non-financial counterparties will no longer have to report when trading with financial counterparties later this year is very helpful for private equity funds and corporates because it lowers their reporting burden," says Sykes, adding that this move is welcomed, as the industry has long felt it does not pose a systemic risk.

How has the market reacted?

With legislation as vast and ambitious as Emir, it makes sense that it is reviewed, with appropriate proposals added, to ensure it is proportionate and does not create unnecessary obstacles for market participants. However, as often with regulation, it is another story as to whether the clarifications are helpful.

"From a reporting standpoint, the Emir Refit has been a damp squib," says David Nowell, senior regulatory reporting specialist at Kaizen Reporting. "While the whole idea was to make it more proportionate and less burdensome for market participants I think the industry has been quite disappointed with the outcome, as not a lot has actually changed."

In short, firms were expecting far more from the refit, with some believing that certain elements of the regulation would be removed altogether. One in particular is article two: the requirement to report exchange-traded derivatives (ETDs). Article two amendments were notably missing from the refit.

"I’m not sure it makes sense to report exchange traded derivatives (ETDs) at trade level," says Nowell. "What Esma [European Securities and Markets Authority] has done is mandate that they need to be reporting at a position level, and here we are talking about what could be thousands of trades conducted by banks every day. Is it really necessary that all these trades are reported? Report the position, sure, but why still report the trades? Unfortunately, nothing has changed here."

Allen & Overy partner Emma Dywer says that it is still too early to tell if this refit will lead to a reduced workload for smaller financial counterparties, though some encouraging mechanisms have been put in place. "These changes have represented such an uplift in what life was like before and after Emir was implemented. If the overall ambition to increase market stability and increase transparency is ultimately recognised, then I think that this will be welcomed by market participants."

Considering the size of the regulation, the refit is, objectively, not particularly far-reaching.

"An improvement has been the simplification and reduction in reporting, notably removing backloading, which has come with the refit," adds Dentons partner Michael Huertas. "I don’t think firms were that surprised by the changes as, in practice, many financial counterparties were reporting on behalf of non-financial counterparties, as well as many other types of clients already."

He continues that beforehand, there was too much on firms’ desks to be able to focus on getting bilateral reporting agreements in place, let alone updating them to reflect the refit’s changes.

Sykes says that the refit has been "irritating" for some funds who have been deliberately avoiding Emir by using an offshore manager. "Now that advantage has now gone away – but I wouldn’t say it’s annoying enough to do anything about."

What are the problems with it?

According to Sykes, the idea that both parties have to report remains a weakness for firms who come into the refit’s scope.

"In theory I can see why it exists, as you get tested information," he says. "However, parties reporting differently presents a process issue. There are so many mismatches in reporting due to the fact that it is detailed, and double reporting simply produces mismatched trades."

Nowell adds that financial counterparties need to ascertain whether the non-financial counterparties will continue to report or not – as they cannot simply assume they won’t exercise their rights to continue reporting.

In addition, there is nothing in the refit that says that financial counterparties must report the ETDs they conclude with non-financial counterparties on behalf of the non-financial counterparty.

"I think it all revolves around the mandatory reporting element, and the biggest part of that will be the liaison between trade repositories that are used by the financial counterparties," says Nowell. "This will all come with additional nuances as formats are supposed to be the same, but this isn’t quite the case."

As part of their reporting, financial counterparties must report to trade repositories that are recognised by Esma. This includes New York-based DTCC, as well as London repositories such as CME and Unavista.

Not to mention the issue of how clear the regulation and technical standards (RTS) actually are. According to Nowell, Esma’s RTS are causing concerns.

"What I think is really missing is a guidelines document," he says, acknowledging that the Q&A is helpful, but the answers supplied aren’t quite as beneficial for the industry as the Mifir transaction reporting guidelines, whereby Esma put together a document to analyse different scenarios.

In comparison, there isn’t really an equivalent for Emir.

"This makes it really quite difficult for firms – lots are baffled by the RTS," he says, adding that the majority of reports he sees – that have been previously validated – are still incorrect in some way.

"We could of course blame this on the firms, but considering so many are struggling, perhaps the requirements are overly complex and lack clarity," he says.

"It’s not that people do not want to comply, rather that they are struggling to clarify the meaning of the rules they’re required to follow," says Dwyer, who evidenced article 31 of the margin RTS. This section covers the treatment of derivatives with counterparties in third countries where legal enforceability of netting agreements or collateral protection cannot be ensured.

"These can be extremely challenging when interpreting what it means and what regulators expect of market participants," she says.

As time goes on, the full extent of the Emir refit’s strengths and weaknesses will be realised by market participants and regulators.

What else do we need to know?

Soon market participants will have to get to grips with another piece of similar regulation, the Securities Financing Transaction Regulation (SFTR). This is intended to increase the transparency of the securities financing markets by requiring those who enter into SFTs to report it to a trade repository.

Read Practice Insight's latest analysis of SFTR guidelines here

"While queries remain about Emir, my clients are more concerned about SFTR’s requirements and how these affect reporting," says Huertas, pointing out that while there are some common concepts between Emir and the latter, there are also fundamental differences, particularly in the type of data and how it is presented.

"With most firms having centralised regulatory reporting processes, accounting for Emir’s 129 data fields, capturing counterparty, collateral and common information is one process, and SFTR’s 153 data fields of margin, transaction, reuse and counterparty data has further fields and action types," he says, adding that this drives operational and compliance costs. "That’s even before you get to the Mifid II/Mifir review changes in the pipeline."