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Media Briefing Note: Implementation of European Market Infrastructure Regulation

24 July 2012

LONDON, 24 July 2012 - On Thursday 12 July 2012, firms had the opportunity to air their views at a public meeting in Paris on the latest proposals from the European regulators for measures to implement the European Market Infrastructure Regulation (EMIR), which is scheduled to come into effect at the end of this year.

This is in advance of the end of July consultation deadline on the European Banking Authority's Draft Regulatory Technical Standards on capital requirements for central counterparties; and in the wake of the publication of the European Securities and Markets Authority consultation paper on Technical Standards for the regulation of OTC Derivatives, CCPs and Trade Repositories, published on 25 June 2012.

Commenting on the impact of the EMIR regulations for derivatives traders, clearing houses and trade repositories Rachel Kent, partner in Hogan Lovells' financial institutions group, said:

"EMIR will introduce significant changes for the OTC Derivatives markets and the operation of clearing houses. The aim is to reduce systemic risk. However, this benefit needs to be balanced against the potential for increased regulatory burden and operating costs for both the trading and clearing sectors."

What is EMIR?

The financial crisis put the trading of OTC derivatives firmly into the regulatory spotlight. The G20 subsequently committed to implement measures in relation to OTC derivatives, stating that:

“All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

European derivatives traders and clearing houses are currently considering the European regulators' response to this commitment, the European Market Infrastructure Regulation (EMIR). On 12 July, firms were able to air their views at a public meeting in Paris on the latest proposals from the European regulators for measures to implement EMIR.

Despite EMIR having as its genesis a perceived need to address risks in trading of OTC derivatives, EMIR has a wider impact on market infrastructure. EMIR will introduce significant new regulatory requirements in three main areas:

  • Requirements for certain OTC derivative contracts to be cleared through a central counterparty
  • Pan-European requirements for the authorisation, supervision and operation of clearing houses
  • Requirements for derivatives contracts to be reported to trade repositories, together with requirements for the operation of trade repositories.

EMIR is due to come into force at the end of this year.

What are the latest EMIR publications?

The European regulatory bodies are currently consulting on two sets of "level 2" measures to implement the high level principles and requirements in EMIR:

  • The European Banking Authority's Draft Regulatory Technical Standards on capital requirements for central counterparties, the consultation for which is due to close at the end of July. The EBA is proposing the imposition of capital requirements for central counterparties that are more in-line with requirements applicable to banks.
  • The European Securities and Markets Authority consultation paper on Technical Standards for the regulation of OTC Derivatives, CCPs and Trade Repositories. This doorstop of a consultation paper sets out the detailed rules that derivatives traders, clearing houses and trade repositories will need to comply with when EMIR comes into force next year.

The potential impact of EMIR

  • Although the requirement for centralised clearing of OTC derivatives may reduce the risks to counterparties of a default by one or more individual counterparties, it also concentrates default risks in the CCPs. If the CCP fails, the impact on the markets will be more profound than the failure of a single trading firm.
  • The centralised clearing obligation will result in increased costs to the OTC derivatives trading markets. CCPs manage default risk through the levy of margin requirements. One study has suggested that an additional $2 trillion of high quality assets will be required for use as margin. In addition to the cost to market participants, one potential side-effect of the clearing obligation may be an increase in demand for high quality assets for use as margin. This could reduce the availability of such assets for other purposes, as more capital will be tied up as, essentially non-productive, margin at clearing houses.
  • There is some uncertainty as to how the obligation to clear OTC derivatives centrally and to post margin will work in the context of derivatives which are part of a structured transaction, such as a securitisation, where the legal documentation is not standardised and where the cashflows do not support the posting of collateral. Further clarity is needed from the European Securities and Markets Authority to avoid any dislocation in these markets. 
  • EMIR does not confine its requirements for the operation of clearing houses to those specialising in clearing derivatives. The requirements apply to all clearing houses. European clearing houses should therefore currently be in the process of analysing the extent to which they need to modify their rules, operations and governance arrangements to meet the new, detailed requirements of EMIR. They will need to submit applications to their regulators to demonstrate compliance with EMIR. In itself, this process of validation, process upgrades and submission-preparation constitutes a material cost for the CCPs. However, many will also need to raise additional funds in order to meet the new capital requirements. For those CCPs that do not have owners with deep pockets, the alternative may be to impose increased clearing fees on their participants.
  • The burden of work is not just felt by the CCPs. Regulators face the task of analysing the submissions that their CCPs will be making from the end of this year. For the UK regulators, this will coincide with a transfer of responsibility for clearing houses from the FSA to the Bank of England.
  • EMIR will also create a new "passporting" right for EEA clearing houses, which will help to remove national barriers to the entry of new clearing houses to compete to provide clearing services for domestic exchanges and trading venues. Differing national regulatory treatments of clearing houses have posed significant hurdles to the ability of the new breed of pan-European clearing house to access certain markets (such as France, where a clearer for a local exchange must be a French-based bank).
  • EMIR also raises some interesting points in relation to the future of financial regulation. In particular, EMIR reinforces a general move in European legislation towards ESMA becoming a pan-European supervisory authority and standards-setting body. Whilst this may have the benefit of facilitating a more consistent application of common European rules, this will be of concern to those who believe that financial services regulation and supervision is best dealt with at a national level.

To discuss any aspect of EMIR please contact:

For Clearing House Regulatory Issues:

  • Rachel Kent, Partner
  • Michael Thomas, Of Counsel

For Derivatives/ Markets Issues:

  • David Hudd, Partner
  • James Doyle, Partner

For Clearing House Collateral and Security Issues:

  • Geoffrey Yeowart, Partner

 
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