This blog was co-authored by Anas Ben Chekroun, Intern, Capital Markets Policy EMEA.

The European Market Infrastructure Regulation (EMIR) has applied since August 2012 and regulates over-the-counter (OTC) derivative contracts with the aim of tackling systemic and operational risk in the OTC derivative market. By ensuring that OTC derivatives are centrally cleared, regulators hope to improve the transparency and stability of the financial system in the aftermath of the global financial crisis.

To do so, three new regulatory requirements have been imposed under EMIR: transaction reporting, clearing, and risk mitigation. First, EMIR aims to increase transparency in the market by requiring that counterparty data and other common information (e.g., notional amount, maturity) on all European derivatives be reported to trade repositories (i.e., central data centers), thus easing supervision by authorities. Second, EMIR requires that all standard derivative contracts be cleared by a Central Counterparty Clearing (CCP). Third, should an OTC contract not be cleared by a CCP, risk mitigation requirements will apply, and counterparties consequently will be required to exchange collateral in the form of initial and variation margins.EMIR allows for the recognition of CCPs based outside the EU. This recognition is based on the adoption by the European Commissionof “equivalence decisions,” which ensure that third-country CCPs (TC-CCPs) comply with legal and supervisory arrangements that are comparable and equivalent to EMIR requirements in the EU.

EMIR 2.2: A New Upgrade Is Available

A new regulation, known as EMIR 2.1, came into force on June 2019 amending EMIR. It aimed to simplify rules and administrative burdens for some derivative counterparties without compromising the core requirements under EMIR. In June 2017, a second part of the EMIR review, known as EMIR 2.2, was proposed by the Commission with further amendments to increase the effectiveness and consistency of the supervisory system for CCPs. Under EMIR 2.2, TC-CCPs seeking recognition by the European Securities and Market Authority (ESMA) will be classified according to their level of systemic importance for the stability of the EU or individual member states. A systemically important TC-CCP (or Tier 2 CCP) will be required to meet additional conditions to be recognized and authorized to provide clearing services.

On May 2019, ESMA issued a consultation paper seeking advice on the criteria for tiering and thus assessing the degree of systemic risk of TC-CCPs to determine whether they should be considered Tier 2 CCPs. The criteria proposed by ESMA evaluate various aspects of a CCP, including the nature, size, and complexity of its business; the effect of its failure or disruption in the financial system; its membership structure, including direct memberships and — conditional on data availability — the structure of its clearing member’s (CM’s) network of direct and indirect clients; the extent to which alternative clearing services (substitutes) are available to CMs; and, finally, the CCP’s interconnectedness with other participants in the financial system and the extent to which these interactions may affect the financial stability of the EU or its member states. ESMA proposes a set of quantitative and qualitative indicators to further assess each of these criteria.

CFA Institute and the Systemic Risk Council Agree on a Way Forward

CFA Institute has responded to this consultation by drawing the attention of ESMA to the work of the Systemic Risk Council (SRC). Sponsored by the CFA Institute, the SRC is a body of former government officials and financial and legal experts committed to mitigating systemic risk.

In a comment letter to ESMA, CFA Institute emphasized the fact that risk in the financial system can only be transferred or shared but never canceled. Consequently, risk undertaken by investment managers in derivative trading ends up being transferred to CMs and CCPs. This makes CCPs prone to systemic risk, which is further exacerbated by their for-profit and concentrated nature, making them too big to fail. Conscious of the danger that CCPs may turn from “risk absorbers” into “systemic risk transmitters and amplifiers,” Sir Paul Tucker, chair of the SRC, stressed in a letter sent to the Financial Stability Board (FSB) the urgent need for authorities to agree on a resolution regime should a failure in the system occur. The option to draw on taxpayer support to avoid a financial collapse should be discarded.

CFA Institute has also commented on some of the indicators proposed by ESMA in more detail. In general, CFA Institute believes that it would be useful for a CCP to estimate the proportion of cleared derivatives that are being used for hedging and speculative purposes. This has important implications for the evaluation of systemic risk and the imposition of prudential requirements on individual CCPs. CFA Institute strongly supports the standardization of contractual terms, disclosures, and operational processes for financial instruments and thus encourages ESMA to assess the proportion of derivatives covered by the International Swaps and Derivatives Association or equivalent industry standardized contractual terms. CFA Institute again directs ESMA’s attention to Tucker’s letter to the FSB, which highlights the need for a better assessment and understanding of the loss absorption capacity of a CCP from external events, including losses from investment of equity, initial margin moneys, and the default fund (on top of losses resulting from a CM’s default).

Although beyond the scope of this consultation, ESMA should consider restrictive investment and credit policies for CCPs, as suggested in Tucker’s letter. Finally, CFA Institute suggests the use of an indicator that will monitor a CCP’s exposure to market risk and will be based on traditional risk management techniques, such as value at risk.

CCPs are a critical piece of market infrastructure and CFA Institute welcomes ESMA’s ambitious effort to formalize and remove the discretion around determining the systemic nature of a given CCP.

Image Credit: ©Kiyoshi Hijiki