European Union: EMIR:"Too Big To Fail", Again?

Last Updated: March 19 2015
Article by Stephen Phillips, Gillian Smith and Alexander Janes

"...just to give you an idea of the actual impact of Lehman Brothers, we can consider the figures published by one of the Lehman's counterparties: Merrill Lynch, which in the third quarter of 2008 disclosed a US$2 billion pre-tax trading loss, which was mainly due to the unwinding of trades for which Lehman Brothers was a counterparty. Merrill Lynch was only one of the hundreds of counterparties of Lehman, so the aggregate impact on counterparties' losses of Lehman's default was much bigger than the one generally used.1 "

This telling quote is from a speech given by Steven Maijoor on 27 March 2013, the then chair of the European Securities and Markets Authority ("ESMA"), in which he is describing the violent aftermath of the Lehman collapse whose financial tremors nearly brought down the West's financial system.

This alert focuses on the European Market Infrastructure Regulation (or "EMIR" as it is better known2) which was introduced as the equivalent of the Dodd-Frank Act of 2010, to address a wide range of issues, many of which were said to be linked to the problems identified in the over the counter ("OTC") derivatives market3 following the collapse of Lehman. However, as we set out below, there are serious questions which arise as to the effectiveness of EMIR and the implications of the seismic changes in the OTC market.     

THE OPAQUE MARKET PROBLEM

When Lehman collapsed, regulators had no idea what effect this was about to have on the OTC derivatives market as a whole. There was no regulatory requirement for OTC derivatives market contracts to be disclosed. Since it is common in the OTC derivatives market to enter into an array of complex hedging arrangements to transfer risk, it was impossible for the regulators to predict or understand where the losses lay when market shocks such as Lehman's collapse occurred.

The proposed solution is to impose a blanket reporting requirement on the derivatives market. Regardless of whether the party to the contract is a small company entering into a relatively few transactions aimed at hedging foreign exchange or interest rate risk or a large multinational bank entering into large volumes of trades, all European "counterparties" (other than natural persons) are required to report to newly created bodies called "trade repositories" extensive details (there are up to 80 fields of data to be supplied) of all derivative transactions entered into. The rationale is that if all counterparties are required to report their trades, the regulators will be better able to anticipate the impact of a collapse, and potentially predict when one might occur. Basic level reporting has been in force under EMIR since 12 February 2014, with the requirement to report valuation and collateral updates also applying from August 2014.  For a number of reasons further discussed in this alert, it's moot whether the derivative markets are less opaque in 2015 and beyond.

The first is that the data is not going to just one place. When trade repositories were introduced, the regulators wanted to ensure that there was competition in the market place, and so, rather than establishing a single trade repository, they created a regulatory system for authorising trade repositories, so that anyone (within or outside the EU) who met the required criteria, could set one up. There are currently six registered trade repositories. Parties have a free choice which repository to use, can use different repositories for different trades and the two counterparties to a trade can use different repositories. The information is reconciled through the use of unique trade identifiers (so called UTIs). It is expected that it will be many years before regulators will be able to gain any meaningful information from the swathes of data now being collected.  Indeed, the silos created by having multiple trade repositories using different processes and systems appears to be a significant obstacle to meeting the transparency objective behind the regulation.  Arguably, one central repository for reporting information would have made more sense and been more effective.

In addition, we also suggest that the "net of parties/transactions" caught by the reporting obligation is far too wide. In our view, the regulation should have sieved out derivatives contracts below a specified threshold. 

The data required to be reported is extensive and complex. Expensive systems have had to be implemented to ensure that these reports can be made. The financial services industry has made strenuous efforts to comply and data is now being reported (including historic data for all transactions entered into since 16 August 2012, whether still in place on 12 February 2014 or not). Nonetheless, if a "Lehman-like" collapse were to happen again tomorrow, it is questionable whether the regulators would glean useful insights from the costly and far reaching reporting requirements imposed on the derivatives market by EMIR.

THE COUNTERPARTY RISK PROBLEM

The regulators' assumption was that if counterparties to an OTC derivatives trade were not facing each other directly, then the risk of a domino effect, whereby the collapse of one bank would trigger the collapse of others, would at least be lessened if not avoided.

The solution proposed by the G20 was that all OTC derivatives must be entered into with a central clearing counterparty ("CCP") so that in the event of "another Lehman", losses would not ripple through the markets because counterparties would be facing a CCP rather than a potentially financially challenged entity. Losses would then be absorbed by the CCP which would have robust risk management procedures (including requiring collateral to be posted in respect of all trades) in place to deal with the threat.

The specific provisions relating to which counterparties must use a CCP are complex and ill-defined.  For example, the criteria underlying such provisions can be difficult to gauge resulting in potential compliance hazards.  This is particularly the case for (i) entities not in the financial sphere but whose business activities may require entry into derivatives and (ii) for non-EU entities which are nonetheless expected to be cognisant of the requirements of EMIR.

Pension funds have a temporary exemption from the rules until August 2015, which is proposed to be extended for a further two years (and potentially for a further year thereafter), to give time for the system to bed down before being required to clear through a CPP. But even for those entities which are not exempt, due to the complexity of implementation of the regime, the timeline for mandatory clearing in Europe continues to get pushed back; it is currently targeted to come into effect in September 2015 at the earliest and this date may still get extended.

IMPACT OF FAILURE OF A CCP?

The big question remains, what happens if the CCP becomes insolvent? The answer to this "armageddon scenario" has been attracting more and more attention recently. Banks who are members of these CCPs are becoming increasingly focused on the risks they might be facing by being a member of the CCP in the first place.  In these draconian circumstances, if governments do not step in to bail out the CCP, the clearing members (generally being the major European banks) could be bearing significant losses.

In November 2014, ISDA issued a paper making recommendations on the adequacy and structure of CCP loss-absorbing resources and on CCP recovery and resolution. It noted: (i) there needs to be more transparency in particular, more disclosure relating to initial margin methodologies and the process for computing default-fund contributions (for instance, margin periods, stress scenarios used and assumptions made) and more detail on the risks faced by the CCP (for instance, the largest concentrations and exposures to clearing members); (ii) standardised, mandatory, stress tests should be introduced to allow market participants to assess their risks and also to make like-for-like comparisons between CCPs (for which regulatory action would be needed); (iii) there should be for each CCP a transparent and clearly defined recovery plan in place to address what would happen if its loss-absorbing resources proved to be insufficient (on the premise that recovery and continuity is likely to be less disruptive and less costly to the financial system than closure of a CCP); and (iv) there should be a material amount of CCP 'skin-in-the-game', on the grounds that CCP 'skin-in-the-game' plays a significant role in aligning the CCP's behaviour with that of its clearing members by encouraging the CCP to maintain robust risk management practices.

That these matters remain under discussion three years after EMIR became law is illustrative of the complexity of the issues and begs the question whether all that has been achieved is elevating the "too big to fail" risk to a new, higher level.

THE RISKY NON COLLATERALISED TRADES PROBLEM

 The use of a CCP requires some standardisation of derivatives, and so for those contracts unsuitable for central clearing or for which central clearing is not available, e.g. currently non-deliverable forwards (a futures contract in currencies), counterparties must ensure that they exchange collateral. Many counterparties, of course, already do this, but while previously the decision to post collateral was an economic one (taking into account the risks that the counterparties were willing to take in respect of the trades), this will become a mandatory regulatory requirement (the earliest estimate being 1 December 2015 for variation margin and a phased in obligation as regards initial margin). This, in turn, prompts new concerns around the availability and cost of obtaining eligible collateral when demand for it will be much higher than previously. In a recent ISDA survey of derivatives users, the introduction of margin requirements for non-cleared derivatives was highlighted as a key area of concern, with nearly two thirds of respondents prospectively subject to the rules saying they were worried about their ability to meet the requirements.

THE OPERATIONAL AND CONTRACTUAL RISK PROBLEMS

Alongside the requirements described above, EMIR also imposes other requirements known together as the "risk mitigation requirements". These require that contracts must be confirmed within a short time period, they must include dispute resolution provisions and portfolios must be compressed and reconciled. While these provisions have been introduced to the market to ensure best practice in legal and operational processes, the effect is to impose stringent requirements on parties making a commercially agreed bargain. It is interesting to note a warning recently issued by Timothy Massad, chairman of the CFTC, to the effect that the leverage rules under the Dodd-Frank Act may add costs which deter banks from processing trades through a CCP, yet, in relation to trades which are uncleared, mandatory collateral requirements also under the Dodd-Frank Act will be treated as assets on the balance sheet which will trigger a requirement for increased capital.

COST/BENEFIT ANALYSIS?

More than five years on from Lehman, the resulting EMIR reforms have had a huge cost, but it remains to be seen whether the widespread reform measures imposed on the OTC derivatives market to deal with the perceived risks will achieve the objectives underpinning the legislation. It is fair to ask whether the costs of EMIR outweigh the benefits. With the introduction of treaty through CCPs, it is not surprising that commentators are focused on the possible failure of a CCP. The regulators, through bank resolution legislation and other measures, have made strenuous efforts to mitigate the "too big to fail" problem. For a new structure to have been introduced, the failure of which may lead to systemic failure, is very disconcerting. This regulatory change brings to mind the well-known line from the Leopard by Giuseppe Tomasi di Lampedusa,  "For things to remain the same, everything must change".

Footnotes

1.EMIR: A Fair Price for Safety and Transparency, speech given by Steven Maijoor on 27 March 2013

2.The full name being the Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.

3.An "OTC derivative" is any derivative which is not executed on an EU regulated market (as defined in MiFID) or equivalent non-EU market.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
Stephen Phillips
Events from this Firm
21 Sep 2018, Conference, Florida, United States

Employment partner, Michael Weil will be participating in The Intellectual Property Law Institute’s 2018 Conference.

26 Sep 2018, Conference, New York, United States

Employment Partner, Mandy Perry and Chair of Orrick's Global Employment Law Practice, Mike Delikat will be participating in the Global Business Protections 2018: International Restrictive Covenants and Confidential Information Conference.

26 Sep 2018, Seminar, Tokyo, Japan

Orrick’s Global Japan Practice is hosting a series of “Orrick Library” seminars to explore legal issues in various fields in Japan as well as the United States, Asia and Europe

Similar Articles
Relevancy Powered by MondaqAI
 
In association with
Related Topics
 
Similar Articles
Relevancy Powered by MondaqAI
Related Articles
 
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Registration (you must scroll down to set your data preferences)

Mondaq Ltd requires you to register and provide information that personally identifies you, including your content preferences, for three primary purposes (full details of Mondaq’s use of your personal data can be found in our Privacy and Cookies Notice):

  • To allow you to personalize the Mondaq websites you are visiting to show content ("Content") relevant to your interests.
  • To enable features such as password reminder, news alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our content providers ("Contributors") who contribute Content for free for your use.

Mondaq hopes that our registered users will support us in maintaining our free to view business model by consenting to our use of your personal data as described below.

Mondaq has a "free to view" business model. Our services are paid for by Contributors in exchange for Mondaq providing them with access to information about who accesses their content. Once personal data is transferred to our Contributors they become a data controller of this personal data. They use it to measure the response that their articles are receiving, as a form of market research. They may also use it to provide Mondaq users with information about their products and services.

Details of each Contributor to which your personal data will be transferred is clearly stated within the Content that you access. For full details of how this Contributor will use your personal data, you should review the Contributor’s own Privacy Notice.

Please indicate your preference below:

Yes, I am happy to support Mondaq in maintaining its free to view business model by agreeing to allow Mondaq to share my personal data with Contributors whose Content I access
No, I do not want Mondaq to share my personal data with Contributors

Also please let us know whether you are happy to receive communications promoting products and services offered by Mondaq:

Yes, I am happy to received promotional communications from Mondaq
No, please do not send me promotional communications from Mondaq
Terms & Conditions

Mondaq.com (the Website) is owned and managed by Mondaq Ltd (Mondaq). Mondaq grants you a non-exclusive, revocable licence to access the Website and associated services, such as the Mondaq News Alerts (Services), subject to and in consideration of your compliance with the following terms and conditions of use (Terms). Your use of the Website and/or Services constitutes your agreement to the Terms. Mondaq may terminate your use of the Website and Services if you are in breach of these Terms or if Mondaq decides to terminate the licence granted hereunder for any reason whatsoever.

Use of www.mondaq.com

To Use Mondaq.com you must be: eighteen (18) years old or over; legally capable of entering into binding contracts; and not in any way prohibited by the applicable law to enter into these Terms in the jurisdiction which you are currently located.

You may use the Website as an unregistered user, however, you are required to register as a user if you wish to read the full text of the Content or to receive the Services.

You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these Terms or with the prior written consent of Mondaq. You may not use electronic or other means to extract details or information from the Content. Nor shall you extract information about users or Contributors in order to offer them any services or products.

In your use of the Website and/or Services you shall: comply with all applicable laws, regulations, directives and legislations which apply to your Use of the Website and/or Services in whatever country you are physically located including without limitation any and all consumer law, export control laws and regulations; provide to us true, correct and accurate information and promptly inform us in the event that any information that you have provided to us changes or becomes inaccurate; notify Mondaq immediately of any circumstances where you have reason to believe that any Intellectual Property Rights or any other rights of any third party may have been infringed; co-operate with reasonable security or other checks or requests for information made by Mondaq from time to time; and at all times be fully liable for the breach of any of these Terms by a third party using your login details to access the Website and/or Services

however, you shall not: do anything likely to impair, interfere with or damage or cause harm or distress to any persons, or the network; do anything that will infringe any Intellectual Property Rights or other rights of Mondaq or any third party; or use the Website, Services and/or Content otherwise than in accordance with these Terms; use any trade marks or service marks of Mondaq or the Contributors, or do anything which may be seen to take unfair advantage of the reputation and goodwill of Mondaq or the Contributors, or the Website, Services and/or Content.

Mondaq reserves the right, in its sole discretion, to take any action that it deems necessary and appropriate in the event it considers that there is a breach or threatened breach of the Terms.

Mondaq’s Rights and Obligations

Unless otherwise expressly set out to the contrary, nothing in these Terms shall serve to transfer from Mondaq to you, any Intellectual Property Rights owned by and/or licensed to Mondaq and all rights, title and interest in and to such Intellectual Property Rights will remain exclusively with Mondaq and/or its licensors.

Mondaq shall use its reasonable endeavours to make the Website and Services available to you at all times, but we cannot guarantee an uninterrupted and fault free service.

Mondaq reserves the right to make changes to the services and/or the Website or part thereof, from time to time, and we may add, remove, modify and/or vary any elements of features and functionalities of the Website or the services.

Mondaq also reserves the right from time to time to monitor your Use of the Website and/or services.

Disclaimer

The Content is general information only. It is not intended to constitute legal advice or seek to be the complete and comprehensive statement of the law, nor is it intended to address your specific requirements or provide advice on which reliance should be placed. Mondaq and/or its Contributors and other suppliers make no representations about the suitability of the information contained in the Content for any purpose. All Content provided "as is" without warranty of any kind. Mondaq and/or its Contributors and other suppliers hereby exclude and disclaim all representations, warranties or guarantees with regard to the Content, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. To the maximum extent permitted by law, Mondaq expressly excludes all representations, warranties, obligations, and liabilities arising out of or in connection with all Content. In no event shall Mondaq and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use of the Content or performance of Mondaq’s Services.

General

Mondaq may alter or amend these Terms by amending them on the Website. By continuing to Use the Services and/or the Website after such amendment, you will be deemed to have accepted any amendment to these Terms.

These Terms shall be governed by and construed in accordance with the laws of England and Wales and you irrevocably submit to the exclusive jurisdiction of the courts of England and Wales to settle any dispute which may arise out of or in connection with these Terms. If you live outside the United Kingdom, English law shall apply only to the extent that English law shall not deprive you of any legal protection accorded in accordance with the law of the place where you are habitually resident ("Local Law"). In the event English law deprives you of any legal protection which is accorded to you under Local Law, then these terms shall be governed by Local Law and any dispute or claim arising out of or in connection with these Terms shall be subject to the non-exclusive jurisdiction of the courts where you are habitually resident.

You may print and keep a copy of these Terms, which form the entire agreement between you and Mondaq and supersede any other communications or advertising in respect of the Service and/or the Website.

No delay in exercising or non-exercise by you and/or Mondaq of any of its rights under or in connection with these Terms shall operate as a waiver or release of each of your or Mondaq’s right. Rather, any such waiver or release must be specifically granted in writing signed by the party granting it.

If any part of these Terms is held unenforceable, that part shall be enforced to the maximum extent permissible so as to give effect to the intent of the parties, and the Terms shall continue in full force and effect.

Mondaq shall not incur any liability to you on account of any loss or damage resulting from any delay or failure to perform all or any part of these Terms if such delay or failure is caused, in whole or in part, by events, occurrences, or causes beyond the control of Mondaq. Such events, occurrences or causes will include, without limitation, acts of God, strikes, lockouts, server and network failure, riots, acts of war, earthquakes, fire and explosions.

By clicking Register you state you have read and agree to our Terms and Conditions