How Can European Managers Navigate the Extensive EMIR Regulations for OTC Derivatives?

The European Union (EU) enacted the European Market Infrastructure Regulation (EMIR) in 2012 to govern over-the-counter (OTC) derivatives markets and reduce systemic risk. This reform aims to increase stability and transparency in OTC derivatives through central clearing, reporting, risk mitigation standards, and other requirements.

As major participants in derivative markets, asset managers in the EU face extensive obligations under EMIR that mandates central clearing, reporting, margining, and other requirements.

This short guide examines the key requirements applicable to asset managers, clarifying areas of ambiguity, and providing practical guidance on interpretation, implementation, and monitoring. By comprehensively addressing their key obligations under EMIR, managers can strategically strengthen their operational resilience.

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Clearing Obligation

Articles 4 and 5 mandate central clearing through authorized central counterparties (CCPs) for standardized OTC derivatives exceeding specified thresholds. This requirement intends to increase transparency and reduce counterparty risk.

Financial counterparties like banks and institutional investors above certain position limits in an asset class, and large non-financial counterparties, must clear eligible OTC derivative transactions through CCPs. Intragroup transactions and pension funds are currently exempt under certain conditions.

Clearing obligation thresholds are calculated based on the 12-month average notional value of outstanding OTC derivatives, with positions converted into Euros. For non-financial counterparties, intragroup transactions not qualifying as hedging must be counted separately on both sides.

Breaching the limits in an asset class triggers a requirement to start clearing new OTC derivative transactions in that asset class through CCPs within 4 months.

Managers must track regulatory technical standards to continually identify financial instruments, counterparties, and transaction types falling under the clearing mandate as it evolves across asset classes. When considering new OTC derivative contracts, their eligibility for mandatory clearing must be analysed in advance to ensure clearing arrangements are in place.

Extensive due diligence is needed when transacting with new counterparties to verify their status and exemptions related to the clearing obligation. This requires analysing counterparty exposures to determine if criteria under Article 4 are met.

Robust connectivity and legal agreements must be established with multiple CCPs in relevant asset classes to facilitate seamless clearing when mandated. Sufficient collateral must also be secured, with effective collateral management processes, to meet margin requirements and capital impacts.

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Reporting Obligation

Article 9 imposes extensive reporting requirements for both OTC and exchange-traded derivative contracts, covering transaction details, valuations, modifications, corrections, and terminations.

Given the severe penalties under Articles 65 and 66 for failing to comply, managers must establish robust processes to ensure timely, accurate and comprehensive reporting as mandated.

This requires mechanisms to capture all necessary data fields within required timeframes, including specialized systems to extract data from multiple platforms. Arrangements must also be made with authorized trade repositories for submission of reports directly or via third parties.

Extensive record-keeping is crucial to facilitate reporting of historical contracts within expected lookback periods. While banks typically handle reporting for centrally cleared OTC trades, managers have direct responsibility for reporting uncleared bilateral OTC and exchange-traded derivatives.

Intragroup transactions meeting specific criteria under Article 3 are exempted from reporting, so managers must carefully assess any presumption of exemption before not reporting a transaction. They must distinguish duties related to banks, clients, and counterparties to avoid reporting gaps or duplications.

The updated reporting technical standards enumerate over 100 mandatory and conditional data fields across common, counterparty, product and valuation categories that must be accurately populated in submissions. Timely reporting requires streamlined data flows between systems and reporting infrastructure, with reconciliation procedures to validate contents.

To ensure compliance, managers should perform assessments to identify data gaps, implement validation checks, assign accountability for data integrity, establish controls to monitor submission status, and conduct periodic audits. Reference data management is imperative for accuracy.

While banks and service providers can facilitate submission logistics, responsibility for reporting remains with managers under EMIR. Investing in reporting architecture, data management and monitoring capabilities is essential to mitigate compliance risks and potential penalties.

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Risk Mitigation

For OTC derivatives not cleared through a central counterparty, Article 11 mandates a robust set of risk mitigation requirements between counterparties to limit counterparty and systemic risks. These include timely confirmation of contract terms, portfolio reconciliation, compression of outstanding contracts, dispute resolution, daily mark-to-market, and exchange of collateral.

Managers face extensive obligations in implementing integrated systems and operational procedures to satisfy these risk mitigation requirements when trading OTC derivatives falling outside the central clearing mandate. Specific implications include:

• Maintaining high standards of valuation accuracy through daily mark-to-market of every open OTC derivative position based on current market conditions using independent, validated pricing sources.
• Managing collateral flows efficiently on a close to real-time basis, adapting to changing margin requirements as market volatility shifts. This necessitates investment in specialised collateral management technology.
• Closely monitoring for frequent updates to EMIR technical standards which often modify specific risk mitigation requirements related to valuation, reconciliation frequency, margin processes, collateral eligibility and other aspects.
• Conducting diligence on intragroup transactions to ascertain and maximise eligibility for exemptions from risk mitigation requirements based on defined criteria.

For portfolio reconciliation, managers must have institutionalised processes to regularly identify and match key economic terms, transaction valuations and collateral details for each outstanding OTC derivative contract through robust data sharing with counterparties. Reconciliation frequency varies based on counterparty type and volume of trading activity.

Formal compression exercises must be undertaken at least twice yearly to identify opportunities to terminate or create offsetting OTC derivative contracts to reduce gross notional exposures outstanding. Compliance also requires implementing agreements and procedures for identification, logging and timely resolution of any disputes arising from reconciliation discrepancies.

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Organisational Standards

Under Articles 26-29, EMIR establishes far-reaching standards spanning governance, risk management, outsourcing, conflicts of interest and record-keeping that apply to managers. Key requirements include:

• Implementing adequate risk monitoring and control mechanisms with timely reporting and escalation procedures, supported by appropriate technology infrastructure and analytics capabilities.
• Maintaining proper segregation of the risk management function from business lines to ensure its independence and authority in enforcing EMIR compliance.
• Comprehensive record-keeping through integrated systems to retain required activity and transaction data for minimum periods of 5 years under Articles 28 and 29.
• Formulating detailed policies and procedures governing all aspects of EMIR compliance with assigned accountability for adherence.
• Implementing robust controls to promptly identify, disclose, and appropriately manage conflicts of interest throughout the value chain.

Significant investment is likely required to review existing governance frameworks and enhance risk, data and reporting systems to shore up any gaps relative to EMIR's complex organisational standards. Compliance necessitates clearly defining and documenting internal governance structures, roles, risk limits and controls.

Data retention infrastructure must be sized sufficiently to retain granular records across trading, clearing and risk monitoring systems over extended time horizons. Detailed policies and procedures governing registration, reconciliation, management of default procedures and other critical functions are imperative, along with training on these procedures. Rigorous audits should validate adherence to conduct standards for conflicts management.

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Record-keeping

Under Articles 28 and 29, EMIR mandates extensive record retention requirements applicable to managers for all activities related to OTC derivatives. Records must be maintained in accessible format spanning a minimum period of 5 years to facilitate regulatory investigations and audits.

This presents substantial data archival requirements necessitating investment in specialised systems like trade repositories to accurately capture granular derivative contract details over lengthy timeframes. Sufficient data warehousing capacity must be built to retain activity logs across front, middle and back-office systems involved in trade execution, processing, risk management and reporting.

With records obligated to encapsulate entire lifecycles of transactions from origination through maturity, managers may need to enhance existing architecture to ingest and structure relevant data from myriad sources into a centralised, queryable repository. Content must include order and trade details, legal terms, margin flows, confirmations, valuations and modifications.

Retrieval functionality is critical to promptly provide required information during random or targeted regulatory inquiries, examinations or proceedings. Appropriate data access controls must be implemented to secure confidential records, while also providing visibility to regulators upon request. Detailed policies must govern authorised data usage across trade processing, risk analysis, audits, and legal obligations.

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Transparency

Various Articles under EMIR mandate transparency through reporting obligations to clients, regulators and trade repositories applicable to managers. These include:

• Communicating extensive contract and pricing details to counterparties for every derivative transaction under Article 38.
• Publicly disclosing relevant governance documents, rulebooks and compliance policies under Articles 26 and 63.
• Establishing robust procedures to ensure timely reporting of all transactions to registered trade repositories under Article 9.
• Providing any derivative data requested by regulators like ESMA in a timely, accurate and comprehensive manner under Article 63.

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Interoperability Arrangements

Under Articles 51-54, any direct or indirect interoperability agreements between CCPs can impact trading venues and associated managers. This compels firms trading derivatives affected by interoperating CCPs to identify all relevant arrangements across CCPs and platforms, evaluate potential impacts on clearing workflows and ensure seamless interaction across CCPs, and assess risks including reduced liquidity arising from interoperability.

With numerous CCP linkages emerging, managers must take a strategic approach in determining how these intersections of clearing ecosystems may affect current trading, clearing, margin and settlement activities. Adapting operational processes proactively is advisable to avoid disruptions.

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Recognition of Non-EU CCPs

Under Article 25, ESMA recognises non-EU CCPs meeting EMIR standards for providing clearing services in the EU. Managers may need to clear trades through such approved foreign CCPs. This necessitates confirming the recognition status and approved asset classes of any non-EU CCP associated with a particular financial instrument or venue and evaluating potential impacts from any suspension or withdrawal of a third-country CCP's recognition.

Managers should monitor proposed CCP linkages to identify any critical foreign clearing houses falling in their transaction scope and maintain updated compliance information on associated recognition status, eligible instruments, risk management standards and regulatory compliance.

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Registration of Trade Repositories

Articles 55 to 77 of EMIR govern the registration, regulation and recognition of trade repositories authorised to centrally collect and maintain records related to derivative contracts.

Trade repositories must satisfy stringent criteria related to governance, capital, systems resilience, security, accessibility, and transparency to obtain EMIR registration enabling them to offer reporting services to counterparties.

Managers face minimal direct compliance obligations associated with trade repository registration, but an indirect need to confirm the authorised status of any repository used to meet reporting requirements under Article 9.

Specific implications include:

• Ensuring connectivity and submission processes are established only with appropriately EMIR-registered trade repositories.
• Continuously monitoring the regulatory compliance of chosen trade repositories, reacting promptly to any breach or lapse notifications.
• Maintaining contingency plans to shift transaction reporting to alternate trade repositories seamlessly if a chosen provider has its EMIR registration suspended or withdrawn.
• Participating in industry testing initiatives coordinated by regulators or trade repositories to validate readiness.
• Considering the merits of reporting via authorised service providers who manage repository connectivity, formatting, and submission complexities on an outsourced basis.

While the use of trade repositories represents little explicit compliance burden for managers under EMIR, ensuring the continued authorised regulatory status of reporting infrastructure is crucial to satisfy broader obligations related to transparency, risk monitoring and record retention.

Best-in class governance measures include periodic due diligence on trade repository compliance, monitoring of regulatory publications, inclusion of trade repository clauses in outsourcing agreements, and testing switchover processes. Proper oversight of reporting channels reduces continuity risks.

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Penalties

Under Articles 12, 65 and 66, EMIR empowers EU regulators to levy substantial penalties against financial counterparties like managers for violations of provisions including reporting, clearing, risk mitigation, conduct standards and overall compliance.

Penalties can range from formal warnings and public censures to fines of up to 10% of annual turnover in certain jurisdictions or suspension of activities, based on factors such as infringement severity, self-reporting, remediation undertaken, track record of previous breaches, level of cooperation with authorities and potential systemic consequences.

To avoid severe penalties, managers must:

• Interpret EMIR regulations comprehensively with advice from legal counsel and regulators.
• Implement robust compliance systems proactively with adequate resourcing.
• Monitor adherence across the business (Front-Office, Middle-Office, Back-Office).
• Remediate identified deficiencies promptly and notify authorities.

Maintaining current awareness of enforcement precedents and participating in industry testing programs is also advisable. Whilst specialised infrastructure such as trade reporting systems and collateral management tools can provide technological support, robust governance, accountability, and risk culture remain essential. Transaction monitoring with periodic compliance audits and staff training focused on priority risk areas is essential.

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Implementation Guidelines

Whilst specialised infrastructure such as trade reporting systems and collateral management tools can provide technological support, robust governance, accountability, and a risk culture is paramount. Transaction monitoring with periodic compliance audits and staff training focused on priority risk areas is also essential. Managers should consider:

·???????? Maintaining comprehensive records of all trades for at least 10 years.

·???????? Utilising only approved TRs for transaction reporting.

·???????? Analysing OTC trades to determine clearing eligibility.

·???????? Establishing collateral management procedures for non-centrally cleared derivatives.

·???????? Carefully evaluating any outsourcing plans for compliance impacts.

·???????? Implementing controls around data security and conflict identification.

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Monitoring and Controls

Managers should:

·???????? Conduct periodic reconciliations to verify trade repository reporting contents.

·???????? Perform assessments to identify and remediate any data gaps relative to EMIR requirements.

·???????? Implement automated validation checks for reporting data prior to submission.

·???????? Establish controls to monitor status of report submissions.

·???????? Undertake periodic audits focused on priority risk areas like reporting quality, trade eligibility assessments, and collateral management.

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Conclusion

EMIR aims to improve financial stability through enhanced reporting standards. But this requires substantial commitment from asset managers to strengthen risk management, transparency, and stability in OTC derivatives markets.

While ESMA’s EMIR refit offered clarifications, ambiguities remain around determining reportable derivatives, allocation of responsibility, reconciliation breaks, harmonization, data quality, timelines, specifications and more. Stakeholders continue to emphasise the need for greater clarity, harmonisation, and proportionality within EMIR’s evolving regulatory landscape.

Close collaboration across trading, operations, collateral, and the risk teams are imperative as is robust monitoring, training and audits focused on priority risk areas to fulfil EMIR’s extensive reporting requirements given the severe penalties for non-compliance.

While investing in technological solutions can aid compliance, ultimately meticulous data management, accountability, and risk-focused culture are essential to fulfil EMIR’s extensive transparency and risk reduction mandates. Ultimately, effective compliance can help recalibrate the derivatives market for greater sustainability.