After a long and arduous road to the final EMIR Interest Rate Swap (IRS) Regulatory Technical Standards (RTS), the dates are set and front-loading requirements remain.
Front-loading is a requirement that stipulates all trades executed on or after a pre-set date, that meet a defined criteria (instrument, currency and remaining maturity) on obligation date, must be cleared.
These trades can either be:
- front-loaded i.e. all trades executed on or after the effective date are immediately cleared or;
- back-loaded i.e. all trades executed on or after the effective date are bilateral until the clearing obligation date and then those trades are back-loaded into clearing– this could mean either termination or execution of a new trade with new economic terms or novation of the bilateral trade into clearing.
Background
Frontloading was included at the outset of the regulatory process, in the level one EMIR text and therefore could not be completely removed from the final implementation of the regulation. However after significant deliberation, the RTS has provided much needed compromise and clarity to the implementation.
The complications to implementing the frontloading requirements were that in its initial form, frontloading was expected to be effective once a CCP had been ESMA authorised for a particular product set. Yet at this point in time, the product RTS were not in place and therefore the market had no clarity as to which entities or underlying instrument, currencies and maturities would be subject to the frontloading requirement or what the relevant timeline would be – a classic chicken and egg scenario!
In short, entities that eventually were classified as subject to the frontloading requirement in its original form would have been faced with looking back to over a years worth of trading activity to ascertain trades that needed to comply and back-load into clearing. Additionally, at the point of executing trades in this period, brokers had no transparency as to whether the trades they were pricing were going to be subject to the clearing obligation and thus could not provide relevant accurate pricing.
Hence additional criteria has been included in the final RTS to specifically stipulate / restrict the front-loading requirement to be effective only once the eligibility of entities and trades for the clearing mandate are known.
Although some thought the frontloading requirement was inconsequential, it has in fact the ability to significantly affect the market; an example of this is when there was a lack of equivalence for the US. The market impact as the Category one front-loading date drew near was very meaningful, movements in the basis between CME and LCH were substantial. Without equivalence, the Category 1 entities were facing having to make the decision not to offer cleared pricing to clients for CME, as their internal cost increase without equivalence could not be absorbed. The agreement between US and Europe does alleviate this issue however the actual implementation of the agreed terms remains to be completed on time and there are further considerations that remain to be dealt with on a case by case basis for Category 2 entities by May.
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Final requirement
IRS
Category One – counterparties that are clearing members for at least one of the classes of OTC derivatives set out in the Annex to this Regulation, of at least one of the CCPs authorised or recognised before that date to clear at least one of those classes
Front-loading is effective for all trades entered into or novated before 21st February 2016 if the remaining maturity is greater than:
- Basis Swaps: 50 years
- Interest Rate Swaps: 50 years
- Forward Rate Agreement: 3 years
- Overnight Index Swaps: 3 years
And for all trades entered into or novated after 21st February 2016 if the remaining maturity is greater than 6 months for all mandated classes.
Category Two – counterparties not belonging to Category 1 that belong to a group whose aggregate month-end average of outstanding gross notional amount of non-centrally cleared derivatives for January, February and March 2016 is above €8bn and which are:
- financial counterparties
- alternative investment funds that are non-financial counterparties
NOTE: For the purposes of calculating the group aggregate month-end average of outstanding gross notional amount, all of the group’s non-centrally cleared derivatives, including foreign exchange forwards, swaps and currency swaps, shall be included. Where counterparties are alternative investment funds or undertakings for collective investment in transferable securities, the EUR 8 billion threshold shall apply individually at fund level
Front-loading is effective for all for trades entered into or novated before 21st May 2016 if the remaining maturity is greater than:
- Basis Swaps: 50 years
- Interest Rate Swaps: 50 years
- Forward Rate Agreement: 3 years
- Overnight Index Swaps: 3 years
And for all trades entered into or novated after 21st May 2016 if the remaining maturity is greater than 6 months for all mandated classes
What are the remaining impacts and considerations?
Exemption
Within the EMIR Clearing obligation there is an exemption for pension funds, currently until 2017, with the potential of a further 1 year extension. However dependant on the type of pension scheme, this exemption can only be utilised if evidenced that the entities OTC derivative contracts that are “objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangements”, or in some cases the exemption needs to be “granted by the relevant competent authority”.
This process will take time, in the case of requesting exemption from the relevant competent authority, the relevant authority then need to notify ESMA who in turn have 30 days to produce an opinion.
Firstly, in order to have clarity by the frontloading date, those entities looking to use the exemption need to have already or immediately start the process. Secondly, given the many flavours of pension scheme and underlying investments, there is no guarantee that an exemption will be granted and if the entity is Category 2 without an exemption, front-loading will apply from May 2016.
Even if the exemption is granted, it may not actually be that useful. The likely driver for a pension scheme into clearing is going to be cost. Long term, the cost due to the fact that pension schemes are subject to the bilateral collateral requirements but the short term cost implication are due to cleared versus bilateral pricing differences. Bilateral pricing will increasingly become more punitive.
Pricing
There are many factors to regulation that are incentivising clearing, including the bilateral collateral requirements and more so the cost Basel / CRD capital requirements through Risk Weighted Assets (RWA) and Leverage Ratio.
During the evolution of the Basel / CRD implementation, there has been an expectation from the market to see a different cleared price versus bilateral price and due to the heavier burden of capital and cost for bilateral trades, the cleared price is expected to be the lower. That pricing differential certainly exists in the market, in fact there is even a pricing differential between CCPs. More and more buy-side entities are confirming that they are increasingly seeing prices that are ‘encouraging’ them into clearing and that their expectation is that the impact of the pricing differences will only increase in the lead up to and after front-loading in May.
This is will be exacerbated by the fact that there are banks advising that they will default to a cleared price for Category 2 clients and even potentially decline to execute bilaterally for certain Category 2 entities!
Once the higher price for bilateral/lower price for cleared is prevalent in the market post front-loading, it is likely that Category 3 entities and pension funds will need to voluntarily clear ahead of their respective obligation dates in order to preserve fund performance. At this point there will be no time for implementation and on-boarding projects or negotiation of terms with clearing members. In fact clearing member capacity or appetite to take on additional clients is already minimal.
Market participants should (and in most cases are) at least consider having all the plumbing in place, meaning clearing members, documentation, technology etc., to be able to move swiftly into clearing when faced with pricing that is more beneficial to clear.
Identification
In order to provide appropriate pricing and/or apply internal policy to clients, the executing brokers will need to identify the category classification for each client account. Now for the most part banks will be reaching out to clients requesting notification of their category classification but these processes can only be completed in April, once the 3 month average notional period to trigger Category 2 has passed; however it is feasible that there will be missing account representations for some time to come.
For accounts where the category classification is not on record, the executing broker will have to make a judgement call, apply an internal conservative assumption based on known due diligence on the client account. This may not be the most favourable outcome for the client, for example: in the case of a Category 3 client being quite close to the Category 2 trigger, they could find themselves conservatively assumed as Category 2 and lose access to bilateral execution from those brokers who will only provide cleared pricing for Category 2 entities. It is important that clients are proactive with regard to notification of category classification to their executing brokers, actually all counterparties can specifically expect to have to provide disclosure as to the category of the principal to a trade at least at point of execution and/or novation of historic trades.
Execution
There are many firms that will go to market and block trade across multiple accounts and allocate to the underlying account post execution. Within EMIR, these accounts can (and are likely) to be spread across different category classifications. To state the obvious, it is not possible to execute a block trade where part is cleared and part remains bilateral.
Therefore, a firm may either:
- have chosen to voluntarily clear all accounts that could be included in a block trade (albeit if some accounts are Category 3 / 4 or have an exemption or,
- have to split the block trade into separate blocks - cleared and bilateral which, by reducing the size of the trade, could also impact the pricing received
Documentation
For those banks that will continue to execute bilateral trades for Category 2 entities post the front-loading effective date, all clearing eligible trade will have to be cleared by the Category 2 clearing obligation date (December 2016). In order to ensure regulatory compliance at the point of Category 2 clearing obligation, executing banks need assurance that in the event that the client fails to novate the trade into clearing, the bilateral trade will be terminated. This assurance comes in the form of an Additional Termination Event (ATE) included in the bilateral ISDA. The ATE is not currently included in the exiting ISDA documentation, therefore Category 2 entities need to negotiate the inclusion of this ATE to ALL of their bilateral ISDA’s by May 2016 otherwise they will face executing brokers declining to trade!
Valuation
A bilateral trade and a cleared trade have very different valuation models, again major contributors to the model differences include the bilateral collateral requirements and more so the cost Basel / CRD capital requirements through margin period of risk (MPOR), Risk Weighted Assets (RWA) and Leverage Ratio.
Post execution of a bilateral trade during the front-loading period, the trade logically should apply the bilateral valuation model however within 6 months the trade will have to be novated into clearing or be terminated. An expectation and understanding of how this will be managed has to be clear and documented at point of execution – will the trade be terminated and a new execution required to reinstate the position with updated cleared economics? Or will the execution broker apply cleared economics during the frontloading period, based on the agreement that the trade will be novated into clearing by no later than 21st December 2016 otherwise terminated?
Credit standing of available clearing members / executing brokers
With all of the considerations and complications relating to clearing in general, not only front-loading and the withdrawal of major banks from certain asset classes or the clearing business; the availability of top tier / top rated / top capitalised major banks is reducing. These ‘top’ banks in turn are being more selective with regard to the clients and accounts that they offer services to.
The large premier clients of these top banks are rightly confident that they will be able to retain the desired relationships and also negotiate favourable terms however this is less the case for medium to small buy-side market participants. This second and third tier client base are facing either punitive terms with their preferred banks or in worst case scenario, being unable to secure tier 1 relationships and therefore forced to consider counterparties that would not normally meet their preferred risk/creditworthiness criteria – tier 2 banks.
The result could be medium to small buy-side market participants being unable to compete against the larger entities for Derivative mandates and either losing underlying clients completely or outsourcing the derivative part of mandates to the larger firms.
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Peter Rippon, COO OpenGamma
Michael Boroughs, Sales and Relationship Management, Eurex Clearing
Nick Chaudhry, Head of OTC Clearing Services
Jaki Walsh, Managing Director, Derivati Consulting
Byron Baldwin, Senior Vice President, Eurex Clearing
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