Introduction
The financial crisis of 2008 – 2009 and the subsequent collapse of Lehman Brothers and AIG in the United States, followed by the bailing out of HBoS and RBS in the UK has brought about changes to the regulation of the financial system to minimise the risk of the same thing happening again. In September 2009, the G20 made a commitment to transparency and safety in the financial market place (see note 1). “All standard OTC derivatives should be traded on exchanges…cleared through central counterparties…OTC derivative contracts should be reported to trade repositories.”
Authorities in the United States and the European Union (EU) both responded to this commitment through the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank) and the European Markets Infrastructure Regulation (EMIR) respectively. Both the Dodd-Frank Act and EMIR include clearing, transaction reporting and risk mitigation provisions that apply, to varying degrees, to both financial and non-financial organisations that use derivative transactions.
Under the Dodd-Frank Act and the accompanying Commodity Futures Trading Commission (CFTC) regulations, parties to swap transactions (including historical transactions in existence prior to 21 July 2010 when the Act became effective), must report the details to a swap data repository/trade repository (see note 2).
Similarly, under EMIR, which became effective on 16 August 2012, parties to swap transactions in Europe have also had to report details to a trade repository from 12 February 2014. However, there are some notable differences between the US and European regulations.
This document provides a high level summary of the key differences between the US and European responses to the G20 commitment.
Reporting Party Responsibility and Timing of Reporting
Under Dodd-Frank, only one of the parties to each swap (designated as the “reporting counterparty”) can assume responsibility for reporting at the time of the transaction and throughout its life. This has significant benefits for fund managers as under the rules it is the responsibility of the swap dealer to perform the reporting. As a consequence, the implications of trade repository reporting for US buy-side clients is minimal.
However, under EMIR, both counterparties are required to report trades. It places the responsibility on fund managers as well as their counterparty to report trades. It also creates a challenge, namely to match the data submitted by two separate counterparties, which may not even have reported to the same repository. Initially, the difficulty of such matching was exacerbated by the fact that it had to be done in the absence of a Unique Transaction Identifier. EMIR does allow buy-side swap users to delegate the reporting duty to a third party (which might be a clearing broker, a technology vendor, or middleware provider). However, they are still held as being responsible for the accuracy of the reporting and as consequence fund managers still have to do some work to at least check the data before submission, even if they have delegated the actual reporting of the data itself.
The consequences of inaccurate reporting can include corporate and personal fines, and even prosecution, quite apart from any reputational damage. The European authorities have given parties longer than the CFTC to make sure the reported data is accurate. Whilst reporting under Dodd-Franks is real-time (or as real time as practical), EMIR has set a T+1 deadline for the reporting of trade data (see note 3).
Scope – Product and Data
A further difference between the two regulatory regimes is that under EMIR, counterparties must report exchange-traded derivatives (ETDs) as well as over-the-counter (OTC) transactions, whilst the Dodd-Frank Act requires only OTC transactions to be reported.
Each Regulator requires a minimum set of data fields to be reported and whilst there is significant overlap, more details are required under EMIR than under Dodd-Frank. In addition to Counterparty and trading activity data, the 85 fields with the EMIR requirements include data relating to collateral and how it is posted (and not just an indication of whether a trade is collateralised). Under EMIR, data on the mark-to-market or mark-to-model valuations of each contract is also required (see note 4).
Clearing
Whilst Dodd-Frank and EMIR impact on many of the same types of entities, the approach they have adopted is different. The EMIR obligations are determined by Counterparty classication; being either financial counterparties (FCs) or non-financial counterparties (NFCs). The FC definition includes EU regulated investment firms, banks, insurance/re-insurance firms and pension providers. The NFC classification is a broad catch-all, which includes any entity trading a derivative established in the EU which is not an FC.
Under EMIR, FCs and NFCs who exceed certain prescribed thresholds (referred to under EMIR as NFC+ counterparties) are required to centrally clear all clearable OTC trades with an EMIR approved Central Counterparty (CCP). EMIR allows intra group transactions for both FCs and NFCs to be exempted from clearing, although both parties must include such exempt trades in their transaction reporting.
Dodd-Frank however, defines certain entities that must register because of their trading activity. Entities that hold themselves out as swap dealers or who make a market in swaps must register as “Swap Dealers” unless their dealing activities in “in-scope” swaps are below de minimis thresholds. The de minimis threshold was initially set at USD 8 Billion in aggregate gross notional amount of swaps entered into over the previous 12 months. Unless amended by the CFTC, this threshold will reduce to USD 3 Billion when the 5-year phase period ends in December 2017. Entities with substantial positions in swaps must register as major swap participants (MSPs). In the context of Dodd-Frank, “substantial position” is defined by a series of tests laid down by the CFTC with reference to the mark-to market exposure of swap positions in each of the four major swap categories (rate, credit, equity and commodity swaps) (see note 5).
The majority of the regulation applies to these two types of regulated entities. The entities not required to register under Dodd-Frank have reduced regulatory requirements but are still required to clear clearable swaps. Under Dodd-Frank, the SEC and the CFTC are responsible for determining which swaps must be cleared but unlike EMIR, there is no concept of volume thresholds being triggers for mandatory clearing.
Conclusion
EMIR and Dodd-Frank are regulations in Europe and the US to improve transparency and reduce the risks associated with the derivatives market. They demonstrate, that attempts to address particular concerns and risks by different jurisdictions can have different nuanced requirements, which create additional challenges for global banks who are required to meet the superset of requirements.
Whilst this summary covers the key differences between the European and US regulations (EMIR and Dodd-Frank), if you require more detail on either regulation please contact us for more detail on our services around Compliance and Regulatory Delivery. We translate output from regulatory advisors into change programmes to deliver technology and organisational change to meet regulatory demands.
The MHC regulatory delivery team work in partnership with client management and their compliance counterparts to deliver regulatory capability through the implementation of an effective governance model, key operating procedures, risk based MI, training and quality assurance. This can be supported through the implementation of a unified technology solution and the introduction of a robust client ownership model.
Notes
Note 1: G20 Commitments (OTC derivatives): A group of finance ministers and central bank governors from 20 countries, representing the world’s major advanced and emerging economies. During the Pittsburgh Summit in 2009, the group made the commitment to improve the OTC derivatives markets by implementing compulsory trading on exchange or electronic platforms, clearing, reporting to a trade repository and changes to capital requirements.
Note 2: Trade Repository: A Trade Repository or Swap Data Repository is an entity that centrally collects and maintains the records of over-the-counter (OTC) derivatives. These electronic platforms, acting as authoritative registries of key information regarding open OTC derivatives trades, provide an effective tool for mitigating the inherent opacity of OTC derivatives markets.
Note 3: T+1: Whenever financial instruments (bonds, equities, swaps etc.) are traded, T refers to the trade date i.e. the date the trade was executed/agreed. T+1 refers to the day following the trade date.
Note 4: Mark-to-market (MTM) is an accounting method that records the value of an asset according to its current market price Mark-to-model: the pricing of a specific investment position or portfolio based on internal assumptions or often bespoke financial models. Assets that must be marked-to-model either do not have a regular market that provides accurate pricing, or valuations rely on a complex set of reference variables and time frames. These assets are typically derivative contracts or securitized cash flow instruments, and most do not have liquid trading markets.
Note 5: Swaps: A swap is a derivative instrument in which two parties agree to exchange one stream of cashflows for another stream. An example is an Interest rate swap; A financial instrument in which the parties agree to swap different interest rates on an agreed notional amount. The market for standard IRSs is among the largest and most liquid of the swap markets. Many standard IRSs are subject to mandatory clearing.
About the Author
David Mills is a highly experienced Project Manager at Mansion House Consulting, with extensive Change and Process Management experience. He possesses a proven track record in leading major change initiatives across a variety of complex financial products and processes including OTC Derivatives, Syndicated and Traded Loans and KYC processes across a range of high profile financial corporations.
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