OTC derivatives reform still lacks coherence
La Lettre du Trésorier By Jean-Eric Bousser
June 2014
Corporates, which have generally been exempt from the European Market Infrastructure Regulation
(EMIR), are subject to a reporting obligation which is not easy to implement. Data collection relating
to their derivatives activity should improve the ability to monitor systemic risk - the question is by
when?
Five years after the historic decision of the G20 in Pittsburgh to exercise stronger control over the
world’s derivatives markets, progress appears to be very patchy.
Although still beset by uncertainty, the Dodd-Frank Wall Street and Consumer Protection Act in the
United States and EMIR in Europe constitute an essential milestone which we hope will lead to the
effective monitoring of systemic risk and greater harmonisation of the rules governing derivatives
markets.
In Europe, the regulation exempts a vast majority of non-financial companies (Non-Financial
Counterparties or NFC) whose OTC derivatives contracts fall below the regulatory thresholds
prescribed by EMIR. However, NFCs do have many other obligations including risk mitigation
programs, reporting and confirmation of transactions, portfolio reconciliation, and dispute resolution.
These measures require a certain amount of work but, in theory, this should not be too complex if
reporting were not required. As one specialist said, “for risk monitoring purposes and for the
consolidation of accounting data, the information already exists, and most corporates have a global
view of their exposures, due to the fact that they centralise provision.”
Notwithstanding all of the above, “the regulatory requirements are relatively simple to implement for
the majority of corporates, even though – we must stress – it requires effort and resources. This
arrangement has even contributed to the promotion of best practice in internal controls, such as the
rapid confirmation of trades between counterparties and the monitoring of their market value”, says
Edouard Cazaugade, Director of Financial Management at Sanofi and a member of the Regulation of
Derivatives Products Commission of the AFTE.
Applicability of the dual reporting requirements
On the other hand, Cazaugade adds, “dual reporting’s added value in respect of its coverage of nonfinancial companies may already be open to question. It is even more difficult when these transactions
are between subsidiary companies because the rules on reporting are incomplete, and the trade
counterparties are not the only stakeholders.” There is, in effect, a third or even a fourth stakeholder:
one or two trade repositories to which the counterparties to the transaction must report, as each
counterparty is able to choose its own trade repository.
Moreover, companies which have managed to submit their reports from 12 February usually do not
have any information on whether their reports match the reports submitted by their counterparties,
something which is the responsibility of the trade repositories. One may also wonder whether, in the
first months of the reporting obligations being in force, pairing of the different reports has always
been correctly carried out.
“At the beginning of the year the topic of EMIR compliance, while still on the radar of our clients, was
not a major preoccupation. Therefore, in February it may have been a little difficult to get started but
now our clients are generally up to date with their obligations” explains Guillaume Devaux, partner in
charge of the Corporate Treasury and Financing Hub at Mazars.
In addition, not every bank had reached the same level of preparation with some being more proactive
than others and ready to offer delegated reporting.
According to Frédéric Jeanperrin, in charge of EMIR & Mifid (European Markets in Financial
Instruments Directive) at Société Générale, “at a European level, the number of legal entities needing
an LEI (Legal Entity Identifier, or unique identifier for stakeholders in the financial markets) on 12
February to fulfil the obligation to report to trade repositories has been estimated at around one
million. Also at that date, according to our estimates, a maximum of 200,000 LEIs had been allocated
in Europe. In other words, some 80% of the market was not ready.”
These delays were essentially due to the fact that there were some problems in understanding the
regulation. Responses to queries by corporates were sometimes formulaic and bore little resemblance
to their questions on how to deal with specific cases. The notion of derivatives had not been fully
defined either. This, of course, did not encourage rapid compliance, as corporates feared having to
subsequently alter any arrangements they might adopt.
The French Financial Markets Authority had also said that it would be lenient to begin with, bearing
in mind the workload created by these obligations and the congestion observed within trade
repositories.
“Both the European Securities Markets Authority and national regulators were aware of the scale of
the task and have shown tolerance, for the time being at least. However, the time will come when
authorities will become much stricter and begin to impose sanctions for those who do not comply”,
states Jeanperrin.
Most of the major banks are offering delegated reporting, for free, over the first months or years at
least. This offer is made in “a simple contract that defines the roles and responsibilities of each party”,
explains Jeanperrin, adding: “We were rather expecting demand to come mainly from non-financial
companies, especially SMEs, but many financial counterparties, some of them very large, have also
shown interest in our services, which came as rather a surprise to us.”
To delegate or not to delegate
The volume of internal derivatives transactions they conduct has generally determined whether a
corporate chose to delegate the reporting to a banking counterparty. Mathieu Vincent, senior manager
of the Corporate Treasury and Financing Hub at Mazars says that, “major corporates generally choose
to report to trade repositories themselves, for the simple reason that they centralise the provision and
have to report derivatives exposures for their internal transactions. In these conditions, they might as
well declare both their internal and external derivatives transactions.”
Noting that finance directors are still facing many questions, François Masquelier, President of the
Association of Corporate Treasurers in Luxembourg and Vice President of the Board of Directors of
the European Association of Corporate Treasurers (EACT), claims that “adequate communication (by
the regulators) would allow companies to realise that beyond good practice, in terms of confirmation,
reconciliation and risk reduction promoted by EMIR, their efforts to comply with the regulation
effectively serve to reinforce prudential controls and reduce systemic risk.”
Bearing in mind the persistence of operational and regulatory uncertainty, the basic question being
asked by corporates is how will they know if the G20 objectives will be met and if the data they report
is sufficient to meet these objectives? In addition, it would be helpful to reduce as soon as possible the
regulatory uncertainties still surrounding the implementation of EMIR, for example, on questions
related to forex.
The outstanding matter of FX
As we know, the definition of derivatives covered by EMIR refers to the list of financial
instruments drawn up for the requirements of the Mifid. However, in response to the question about
how to know if FX forwards fall under the remit of this latest directive, the European Commission had
stated in 2007 that “FX instruments which are not tied into an investment service, in other words FX
forwards with a commercial purpose, are not covered by Mifid”. It was, however, still up to national
legislators to choose whether or not to apply this interpretation. This has caused disparities between
countries and compromised consistent implementation of the trade reporting requirements under
EMIR. So, in the United Kingdom, transactions with a payment date of up to seven days are
considered to be spot transactions, compared to two days in most other countries, and the FX
forwards for commercial purpose are exempt from reporting.
On 14 February 2014 this situation led to the European Securities and Markets Authority (ESMA)
requesting that the European Commission (see the editorial of March 2014) urgently clarify the
definition of FX derivatives. In particular, to state the precise boundary between spot and forward, the
status of forwards concluded for commercial aims, as well as that of forwards of commodities which
are physically deliverable. While waiting for these clarifications, ESMA announced that it was
suspending EMIR reporting for this type of transaction “wherever the regulation permits it”.
In its response to ESMA on 26 February 2014, the European Commission recognised that it was
necessary to clarify the boundaries between FX spot and forwards, prompting it to launch a formal
consultation on the matter on 10 April. This consultation, which closed on 9 May, enabled the
principal stakeholders, and the EACT in particular, to assert their point of view.
At the time of writing, we were expecting the European Commission to draw up its definition of FX
derivatives towards the end of the summer and to state that it had to rule on this question by means of
an implementing legislation. Coordination with the European Parliament was arranged in June and if
legislation is agreed upon in August as planned, it could come into force in November, no doubt before
the nomination of the new European Commission.
In this context, EACT, for its part, is already paving the way for the discussions which will doubtless
take place at the time of the review of EMIR which is planned for the summer of 2015. At that time, a
report by the European Commission should determine if there should be a revision of EMIR. If that is
the case, questions related to the exemption from reporting of transactions between subsidiaries as
well as that of dual reporting could be looked at again.
In any case, while waiting for these questions to be decided, “corporates face the paradox which is that
they must set up, or else face penalties, an arrangement for the confirmation, reconciliation and
reporting of FX instruments while at the same time the regulator is not removing major uncertainties
on the scope of the requirements in this area”, states the treasurer of a large corporate.
Delicate aggregation of data
Since 2009, regulators have made a concerted effort to set in place a global regime for reporting of
derivatives transactions. The development of EMIR is aimed at better prudential supervision of the
derivatives markets and the monitoring of build-up of systemic risk.
These efforts depend upon three main cornerstones: the LEIs the UTIs or Unique Trade Identifiers
(USI for the American Commodity Futures Trading Commission) and UPIs or Unique Product
Identifiers. Currently, there is no real international harmonisation in place as to the taxonomy of
Unique Product Identifiers (UPI), and no real standardisation exists as to the format of the files and
data fields to be provided. In the reports, data on UTIs and LEIs is still often wrong, partial, or even
missing, showing the state of unpreparedness of the stakeholders involved.
This leads to an unsatisfactory level of reconciliation of transactions that is especially low when both
counterparties report to different trade repositories. The regulators’ choice to allow several trade
repositories, often national, to offer their services instead of favouring a single reporting solution,
such as the one recommended by many stakeholders, such as DTCC – as would be expected - and the
International Swaps and Derivatives Association (ISDA) does not encourage reconciliation and
aggregation, to achieve the transparency goal. Robert Pickel, a veteran of ISDA, therefore does not
hesitate to state that the risk of data inconsistencies due to the existence of multiple repositories
could “impact the ability [of regulators] to monitor the build-up of risks in the system”.
In addition to the existing uncertainties about which data needs to be reported, in particular
concerning FX derivatives, other problems are emerging. National legislations are disparate in the
area of data protection, and reporting practices are divergent depending on the country. For example,
the requirement for dual reporting in Europe and Japan, countries where the UTI is not used, as
opposed to single reporting requirement in the United States. It is obviously essential to achieve
reconciliation and a satisfactory aggregation of data collected if the regulators indeed wish to be in a
position to identify in good time the potential sources of systemic risk.
The FSB on alert
The Financial Stability Board (FSB), a body which coordinates the work of national prudential
authorities and that of standardisation organisations at an international level, is well aware of these
deficiencies, as can be seen in its report to the G20 last April on progress in derivatives reform. It is
also evident in the analysis published in February on “the feasibility study on approaches to the
aggregate OTC derivatives data”.
For the FSB, “even when reporting requirements are in place in every jurisdiction, no authority or
organisation will have a truly global view of the derivatives market, even on an aggregated or
‘anonymised’ basis, unless an aggregation mechanism is developed”. The FSB therefore invited market
stakeholders to submit their opinion on three points: should we be looking to set up a “physically”
centralised model that would concentrate and process the data from the various trade repositories all
over the world? Should this centralisation be done “according to a virtual model”, which would draw,
at some sort of request, on the national repositories; or else should each national authority upload the
raw data from the different repositories and then process them and aggregate them locally?
The FSB also states: “Trade repositories themselves have varying interpretations of the terminology,
the specifications concerning reporting and the format of data, in line with the regulations of their
jurisdictions and their own preferences. Data from the trade repositories must therefore be
transformed into a common and coherent form, in order to be of use for analysis at an aggregated
level. This would be made easier if the same interpretations and data standards were applied by the
repositories. Where there are different standards and interpretations, data harmonisation is more
difficult and may in certain cases be impossible.”
This is a very clear message and one which EACT also highlighted in the response it made to this
consultation. The association has “the feeling that there is a risk that the issue of aggregating the
reporting data of derivatives might essentially be seen as a purely technical challenge whereas it is
more a matter of emphasising the challenge of the incoherence of the new regulatory requirements
concerning reporting”. The technical implementation of an aggregation project must therefore not
result in these incoherencies being set in stone, and “we must rather use the opportunity afforded by
the FSB consultation to first encourage greater harmonisation and coherence in the nature of the data
collected at international level”. EACT proposes, with the aim of harmonising the reporting
obligations and reducing the volume of data, the abolition of dual reporting (with the responsibility
for reporting being incumbent upon financial counterparties) and the exclusion from reporting of
intragroup transactions as well as transactions entered into by non-financial entities for hedging or
commercial purpose.
As for the DTCC, in its response to the FSB, it said that it “strongly recommends that the FSB change
the order of its review and rather than starting with technical options first begin with completing a
study that identifies the analysis required to achieve the G20 systemic risk goal together with
identification of the actual data required to complete this analysis”. Moreover, the study should focus
on the necessary steps to be taken with regard to amending local regulation and agreeing global data
standards to facilitate aggregation. “Only when consensus has been reached on these aspects is it
logical to identify any technical solution to the aggregation. Such analysis and consensus will help to
avoid the creation of any potentially unnecessary new and duplicative infrastructure”.
For the DTCC, “the FSB is ideally placed to complete this determination of the correct data set to be
aggregated and the analysis of that data, which are pre-requisites to determining the most appropriate
aggregation solution”, and “such analysis might yield a different conclusion about whether another
infrastructure needs to be established or whether solutions might be around governance of already
established global infrastructures”. The DTCC rams home the point by saying: “as the market evolves
and increasing numbers of jurisdictions require trade repository services or establish trade
repositories, expedience with respect to the implementation of a global aggregation model will be
critical .” According to Marisol Collazo, who leads on regulatory matters at DTCC Deriv/SERV LLC,
“with a global solution in place current jurisdictions can effectively revise their laws and future
jurisdictions can follow global guidelines when establishing their local legal, privacy and access
laws resulting in increased transparency and the ability to address systemic risk in the global
market.”
The debate on the most appropriate aggregation solutions to achieve the objectives of derivatives
reform is only just beginning. We were waiting with bated breath at the time of writing the report
summing up the lessons the FSB had drawn from the consultation undertaken in February. Especially
if, as expected, the G20 in Brisbane in mid-November were to address these matters.
The original article was published by the author(s) in French. This text in English has been prepared
by translators as a courtesy for your convenience and information purposes only. DTCC shall not be
held liable to anyone for any direct or indirect loss or injury caused in whole or in part by the
incomplete or inaccurate translation of this article. In the event of any translation that constitutes a
departure from the original, that translation should be disregarded and the original article in
French referred to.