Swaps Clearing in Uncertain Times: EMIR, Brexit, and the Future
Intuition Learning Insights Issue 2 2019
European banks and firms that use or trade derivatives are facing an unusual degree of uncertainty. The revision to the European Market Infrastructure Regulation (EMIR) – the so-called “EMIR Refit” – is scheduled for implementation soon, but the process has dragged on longer than expected and ambiguities remain about certain provisions. At the same time, in the face of continuing Brexit-related uncertainties, the future of London as the preeminent clearing location for euro financial transactions is in question.
Initially enacted in 2012, EMIR focuses on the “plumbing” of the OTC derivatives market. It imposes reporting requirements for derivatives contracts and lays out rules for counterparties and trade repositories (TRs). It also outlines various risk mitigation techniques, the most notable being the clearing obligation that requires that certain types of derivatives to be centrally cleared.
In 2015, after its initial implementation, EMIR was subject to an assessment of its “real-time effects.” Regulators concluded that EMIR imposed overly burdensome and complex requirements on some of the players in the OTC market – specifically, nonfinancial counterparties (NFCs) and small financial counterparties (SFCs). As a result, in 2017 the European Commission decided to reform EMIR.
The three-way negotiation between the European Commission, European Council, and European Parliament over the EMIR Refit has taken longer than anticipated. However, on February 5, authorities announced they had achieved political agreement on the final shape of the revised rules. Market participants are hopeful that the revised rules will come into force over the summer.
Although the final text hasn’t yet been published, some of the key provisions will include:
- The introduction of the category of “small financial counterparty” and the provision that designated SFCs will not be subject to the clearing obligation – although they will still have to follow risk mitigation rules for noncleared transactions.
- The requirement for clearing brokers to provide their services on fair, reasonable, non-discriminatory, and transparent (FRANDT) terms.
- The removal of market participants’ obligation to “backload” reporting of certain trades that were entered into on or after August 16, 2012, and terminated before February 12, 2014.
However, the delay has raised some important concerns. Many industry players are concerned that the new rules will only come into force after June 21, which is the date on which some of the existing rules will kick in. If the new rules aren’t in place before then, firms will technically have to abide by the existing rules on June 21.
There are two main areas of concern.
First, many smaller firms – designated as “Category 3” firms under current EMIR rules – will technically have to start clearing their OTC derivatives on June 21. Under the Refit, they are likely to be designated SFCs and exempted from the clearing obligation. But due to the delay, they would theoretically have to develop infrastructure and processes to start clearing on June 21, even though they will not have to clear their transactions after the new rules come into force.
Second, under current rules firms had to backload reporting for their older trades from February, although the obligation to do so will disappear under the new rules.
The European Securities and Markets Authority (ESMA) has addressed these issues by encouraging national competent authorities not to prioritize enforcing provisions which are scheduled to be changed. However, uncertainties will remain until the rules are formally in place.
The Future of London
Compounding these issues is the position of Europe’s biggest clearing and settlement destination, London. Although the exact outcome of the Brexit process remains unknown at the time of writing, should Britain leave the European Union, London’s role will necessarily evolve.
There are various short-term agreements in place. If Britain leaves with no deal, the EU has agreed to give European derivatives traders one year’s grace to continue using UK market infrastructure (and two years to use central securities depositories). This should give markets time to adapt and, if necessary, European firms time to move their clearing business from London to other financial centers. If the UK leaves with a deal in place, there are provisions for handling regulation and oversight going forward.
However, there are still uncertainties. The Bank of England wants to have regulatory primacy over euro clearing once Britain leaves the EU, but European regulators want clearinghouses to abide by European rules, including EMIR. The final regulatory structure will only become clear once the terms of Britain’s exit are agreed, and that process has, so far, been unsuccessful. In short, all swap counterparties currently face an uncertain future.
Intuition Know-How has a number of tutorials that are relevant to EMIR and swaps clearing:
- European Market Infrastructure Regulation (EMIR)
- Derivatives – An Introduction
- Derivatives – Markets
- Swaps – An Introduction
- Swaps – Clearing
- Swaps – Documentation
- Life of a Trade – Clearing & Settlement