EMIR - Which Stakes For Which Actors?
European banks active in the U.S. will be able to capitalize on their Dodd-Franck experience to comply to EMIR, while U.S. banks involved in derivative trading in Europe should not underestimate the impact of the reglementation on their activities. Energy traders also face big challenges related to EMIR and the energy trading industry is likely to face a higher cost of hedging in the near future.
The Financial Sector: Leveraging Dodd-Frank Experience To Respond To EMIR Requirements
EMIR compliance is a central focal point for all European banks in 2013. In order to control costs and meet EMIR's deadlines, European banks need to leverage their Dodd-Frank compliance experience.
Since 2011, a sizeable number of European institutions, those with significant operations in the Unites States, have registered their Head Office as a swap dealer with the CFTC, and rolled out a global compliance program in order to satisfy their obligations under Dodd-Frank. These banks have been able to mobilize numerous stakeholders across all business lines and geographical areas. They have set up project teams combining important business representatives, key legal and compliance resources, project managers, subject-matter experts, and consultants. After nearly two years, these project teams are now able to effectively analyze regulatory requirements and efficiently implement compliance programs. As noted earlier, since many EMIR and Dodd-Frank requirements are very similar, the European banks should be capable of capturing even greater efficiencies by leveraging their experience with Dodd-Frank and applying that knowledge to the implementation of their EMIR compliance programs. To this end, the European banks will likely have to involve their U.S. branches in EMIR projects as it was the U.S. branches leading the way on Dodd-Frank compliance.
U.S. banks that underestimate the importance of EMIR do so at their own risk. Even if the question of territoriality remains unclear, U.S. banks will have to comply with many EMIR requirements (clearing, reporting, etc.) each time they trade with a European client or a European bank. For U.S. banks, the upside created by this exposure to EMIR is the potential for new business opportunities. For example, pursuant to EMIR's trade reporting requirement, one counterparty is permitted to delegate its reporting burden to the other counterparty (in this case, the trade reporting is performed twice by one partyonce for itself, and once as a proxy for the non-reporting party.). Banks that will be able to offer a complete reporting service to their clients will be well positioned to retain and / or capture new business.
The impact of EMIR on the buy-side will be considerable. For one, the buy-side has little familiarity with the process of clearing transactions through CCPs. EMIR will specifically impact asset managers, in the areas of clearing house access (directly or through clearing brokers), reconciliation of deals and positions with clearing brokers (assuming responsibility or delegating to executing brokers), and margin calls.
Valuation is going to be another very important issue in 2013. The majority of asset managers today have less sophisticated valuation mechanisms for OTC derivatives. They are based on simpler models and market data from traditional providers (Bloomberg, etc.). As it stands, these mechanisms are not sufficient to comply with new regulatory constraints primarily because the frequency of the calculations (and the frequency of the market data) will have to be increased to achieve an almost real-time valuation. More sophisticated models will be required in order to value positions on complex derivatives. For both centrally cleared and other types of derivatives, valuation processes will have to be improved as well in order to validate and anticipate the valuations delivered by the CCP and the associated margin calls, and to calculate margin calls and optimize the collateral, respectively. Asset managers will have to decide between in-house implementation of these processes and out-sourcing to clearing brokers or custodians.
A common concern shared between the sell-side and buy-side is the margin requirement for non-centrally cleared derivatives. Currently, EMIR requirements and Dodd-Frank rules are expected within this space. Particularly worrisome to the major players in this space are the Basel Committee and IOSCO's recommendations regarding an initial margin. The Industry seems to believe that it would not be able to afford the monumental amount of collateral needed if the current recommendations were implemented, and is providing appropriate and coordinated analysis on this topic through ISDA, SIFMA, and other business groups.
Energy Traders Are Also Impacted
EMIR regulation will also impact the functioning of the current Energy Market. Like Financial Institutions, all Energy Trading firms must review their existing processes for trade valuation, collateral management, confirmations and margining. Additional investments in process improvement and upgrading or renewal of existing IT systems will put pressure on their project calendars for 2013 and 2014.
For Non-Financial Institutions, mandatory clearing is excluded for transactions that reduce the risk of commercial and treasury activities (for example, Energy Trading firms that hedge their Power Generation). Nevertheless, if non-hedging activities exceed the €3 billion threshold, all standard derivatives must be cleared. Exceeding the threshold would mean losing the "non-financial" status and would consequently result in the clearing of all standard derivatives for all group entities (including affiliates and subsidiaries). This will have a significant impact on the way Energy Trading firms manage their day-to-day business.
Not only the amount of the threshold was subject to debate, but also the question as to how an Energy Trading firm would know if the counterparty it is trading with has or has not exceeded the clearing threshold. As such, it is also important to determine how related information should be shared between market parties. This issue was addressed by the Energy industry in its response to the ESMA regulatory guidelines, as Energy Traders requested that ESMA disclose such information through a central and official publication process. Currently, in order to obtain this information, the Industry relies on the EMIR status provided by the counterparty itself, unless it has information which demonstrates that information provided by the counterparty is incorrect.
Given the investment required to meet regulatory demands and the additional parties involved in each trade, costs of hedging and trading will increase. This will reduce the number of transactions an Energy Trading firm will be able to perform. As such, smaller companies will probably re-prioritize certain trading activities affecting liquidity levels in the Energy Market.
The expected increase in clearing costs and the substantial requirements in terms of collateral (bank guarantees that are not "fully backed" are ineligible for example) will have to be funded and could further lead to an increased market concentration (e.g. bankruptcies or take-overs of Energy Trading companies). In addition, increased dependency on the financial sector will increase as CCPs begin to play a more significant role in the Energy Trading business. As such, the increase in financial regulations will provide numerous opportunities for the more experienced Corporate and Investment Banks to expand their activities in the Energy market.
Despite the fact that ESMA has postponed derivatives reporting until November at the very earliest, observers say reporting under EMIR will most likely begin in 2014. A delay in the commencement of EMIR reporting is likely to be more than welcome by Energy Traders, given their current involvement in ongoing efforts to prepare for EMIR regulation. Still, some questions remain: What will be the long run impact EMIR regulation on market liquidity? How will the end customer be affected?