May 2014

Non-financial firms are struggling to get to grips with financial market regulation

EMIR signals a new paradigm in market regulation. Usually reserved for financial institutions, this derivatives-focused regulation extends beyond banks and trading houses, investment and financial services firms to include non-financial firms and other end users of such instruments.

Despite the fact that EMIR was designed to have a less intrusive impact on non-financial firms, many are struggling to calibrate their compliance responses due to a lack of industry benchmarks and guidance from regulatory authorities. Doing nothing, however, may prove to be more expensive than the cost of effective compliance.

By now, most non-financial firms are aware of the European Markets Infrastructure Regulation (EMIR), but many have not devoted the resources necessary to ensure proper compliance. In most instances, non-financial firms have consciously adopted a wait-and-see approach. Others have made attempts at compliance but have been left frustrated at the lack of clarity on what precisely is required from them as end users. This has proven especially frustrating for those non-financial firms that have not previously been subject to financial regulation, and certainly not at the level of complexity brought about by EMIR. At the frontline in many of these organizations is the treasury function. The remit of treasury can vary broadly. In addition to the more common focus of foreign exchange and interest rate hedging, many treasury functions are also tasked with commodity hedging and procurement activities. This typically means greater complexity in terms of traded instruments and markets, often leaving the treasury function without the necessary systems, processes or resources to effectively comply with EMIR.

Here we focus on some of the challenges faced by non-financial firms, as well as the key success factors that they should consider when trying to meet their EMIR obligations.

Unchartered territory between non-financial firms and financial market regulationNon-financial firms have relatively little precedent to draw upon when it comes to compliance with financial market regulation. EMIR requires any organization that deals in derivatives and, to a greater extent, over-the-counter (OTC) derivatives to establish a compliance framework involving systems, policies and processes. For non-financial firms, the extent of existing capability to meet these obligations often varies widely, depending on the level and sophistication of derivative activity.

EMIR: I’m a corporate, get me out of here!

2 | EMIR: I’m a corporate, get me out of here! April 2014

For non-financial firms, there is a clear distinction between those who rely on treasury for “traditional” financing activities and those who perform a broader role, including risk management (and possibly even trading). The latter often adopt sophisticated trading and risk management systems and processes to manage their physical requirements and risk exposures, and the challenge is to leverage these systems and processes to ensure compliance with EMIR. Typically, these organizations have coped more easily with the implementation of EMIR, given their existing capabilities. However, this is a broad generalization.

There is evidence of a wide and divergent range of experiences across the non-financial sector in relation to the implementation of EMIR. The required response to EMIR is directly related to the complexity of the organization’s derivative trading activity.

EMIR 101: recap of requirements typically applicable to non-financial firmsIt is anticipated that a significant majority of EU non-financial firms will be “non-financial counterparties” (NFCs) under EMIR, and many are likely to fall beneath the “clearing threshold” by virtue of the aggregate size and nature of their OTC derivative activities.

While EMIR provides certain exemptions for NFCs, non-financial firms that engage in any form of OTC derivative activity should not take it for granted that such exemptions automatically apply to them. An overview of the potential obligations can be seen below.

Requirement Description

Clearing threshold calculation* (effective from 12 March 2013)

NFCs are required to calculate the gross notional position of all open “non-hedging”** OTC derivatives across their worldwide group of entities. The gross notional position should be calculated as a 30-working-day rolling average. This implies that, in the strictest sense, the position should be understood on a daily basis. If the total position exceeds any one of the clearing thresholds (five are specified), the organization will become an “NFC+” (i.e., an NFC that exceeds the clearing threshold) and be subject to a higher level of compliance obligation than for an, “NFC-“ (those below the threshold). An NFC+ will be required to clear all eligible OTC derivatives through an approved Central Counterparties (CCPs) and, where a particular contract is not accepted for clearing by a CCPs, the Counterparties will be required to exchange appropriate collateral. Non-hedging OTC transactions conducted with other entities within the group count toward the threshold.

Risk mitigation for non-cleared OTC derivative contracts* (effective from 12 March 2013)

Firms in scope of EMIR are required to introduce or enhance risk management measures to reduce the operational risk around OTC derivatives that are not centrally cleared. The requirements are as follows:

► Timely confirmation: non-cleared OTC trades must be confirmed electronically (where possible) within specified time limits.

► Portfolio reconciliation: NFC- firms must reconcile their portfolios exceeding 100 transactions (with any other single counterparty) at least once per quarter, otherwise once per year if it’s less than 100 transactions.

► Dispute resolution: all counterparties to a trade must agree upon the processes and procedures to identify, record and monitor valuation and collateral disputes. A specific process must exist for disputes not resolved within five days.

Transaction reporting (effective from 12 February 2014)

All firms in scope of EMIR must report all derivative transactions (not only OTC derivatives) to an authorized Trade Repository (TR). Reporting may be delegated to a third party, but the responsibility to report accurately and in a timely manner remains with the firm. All trades must be reported on a T+1 basis and trades open at, or executed since, 16 August 2012 must also be reported, albeit with extended deadlines between 90 days and three years from 12 February 2014.

* Applies to NFC– only; more rigorous requirements apply for NFC+.

** Note that the term “hedging” is not actually used in EMIR; rather, it defines activity that is “objectively measurably as reducing risk directly relating to the commercial activity or treasury financing activity of the NFC or of the group.” This is a broad definition and covers most of the derivatives activity typical to a treasury function, as well as any transactions that qualify as hedges in accounting terms, including proxy and macro hedging, where no “exact” hedging instruments exist.

Factors potentially impacting the complexity of your EMIR compliance response:

► The nature of derivative activity, i.e., hedging or some other purpose

► The type of derivative instruments held

► The organizational structure and the number of legal entities that have derivatives

► The regulatory jurisdictions in which these entities operate

► The degree of centralization of derivatives activity

3EMIR: I’m a corporate, get me out of here! April 2014 |

Non-financial firms and EMIR: are you living on safe ground?“EMIR will go away if we ignore it”Perhaps surprisingly, there are still incidences of non-financial firms adopting a “head-in-the-sand” attitude toward EMIR. Besides the obvious regulatory and governance risk, it conflicts directly with the view expressed by a number of EU national regulators that “doing nothing is not an option.” There is an apparent mindset in some cases that, provided the overall cost of complying with EMIR exceeds the likely penalty for non-compliance, there is little impetus to “invest” in compliance. This is a naturally risky strategy that, besides leading to corporate governance exposure, disregards possible harm from reputational risk and the potentially sizeable financial penalties that are yet to be “tested” across European regulatory jurisdictions.

“We’re only covering our UK entities for EMIR: the rest of the group are on their own”Many non-financial firms have approached EMIR in isolated silos or in an internally “fragmented” way (for example, either a divisional or country focus) and, in the process, have not paid the required level of attention to one of the main precepts of the regulation, i.e., the varying rigor of EMIR’s compliance requirements are driven by the aggregate OTC derivative activity across the entire organization, including non-EU jurisdictions. There is also a question of efficiency and the reduction of the overall cost of compliance, which may be far better achieved by deploying a standardized process across the organization that reduces duplication and redundancy.

“The regulation only applies to EU entities: we’re not based in the EU so we can ignore EMIR”Although EMIR does not apply directly to organizations outside the EU, uncertainty still exists around the exact compliance requirements involving entities based in, “third countries,” including Switzerland, where many multinational non-financial firms have a presence, often including their treasury and commodity procurement functions. Understanding the nature of transaction activity and the role of each party within every transaction is absolutely necessary to ensure the required compliance measures are adopted.

“We’ve made our own assumptions about EMIR and its applicability to our type of organization.”A number of non-financial firms have actively considered their compliance obligations under EMIR but have reached erroneous conclusions due to incorrect assumptions about how the regulation applies to them. Typical examples include “I thought transactions executed for commercial hedging purposes were excluded from the reporting obligation” or “everything we do is for hedging purposes — no further action required.” The same may apply to the more technical aspects of EMIR, for instance, the difference in the interpretation by national regulators of which derivative instruments are in or out of scope of EMIR. While such misconceptions have become less common as EMIR implementation has progressed, it is likely that a number of corporates may be in a non-compliant position without even realizing it.

“Do we really need to do a threshold calculation every day?”In the context of a lack of clear guidance and potential differences in the interpretation of the regulation by national regulators, a varying range of responses in respect to calculation of the clearing threshold have been observed in practice. While some non-financial firms have opted to perform a regular threshold calculation (i.e., daily or weekly), others have decided to do them on an ad hoc basis or at fixed intervals (i.e., quarterly or biannually), and when any significant changes in derivative activity occur. While the regulation is unambiguous regarding the need for a 30-day rolling average to be calculated, combined with the requirement for the immediate notification to the regulator when a breach occurs, many corporates are reluctant to commit people and system resources to meet the letter of the regulation. Furthermore, the justification of the threshold calculation will undoubtedly rely on a comprehensive hedge policy with specific references to EMIR – the likes of which many non-financial firms are yet to develop. It still remains to be seen how regulators will respond, but until a precedent is set or clear guidance is provided, many non-financial firms may remain on uncertain and potentially risky ground.

“The board isn’t that concerned about EMIR, why should we be?”It is the ultimate responsibility of the board to ensure that the organization complies with regulations such as EMIR. Management of some non-financial firms have engaged in an intense exercise of “managing upward” to ensure that their boards are aware of the organization’s obligations under EMIR and appreciate the resourcing required to ensure effective compliance. Many non-financial firms have struggled to effectively deliver this message, as derivative trading is not seen as a core activity. This has often resulted in either a limited or a fragmented response due to lack of resources or focus. With enforcement powers now in place across most EU jurisdictions, it is only a matter of time before the consequences of unpreparedness are known.

What does this mean for you?

For non-financial firms that have not engaged effectively in a robust compliance response, it is not too late. Although an unsanctioned “grace period” may be coming to an end, the obligation to demonstrate ongoing compliance is not going to go away. A rapidly deployed work program should be mobilized with the necessary resource and assistance. Becoming an “enforcement test case” is something that all organizations should avoid.

EY | Assurance | Tax | Transactions | Advisory

About EYEY is a global leader in assurance, tax, transaction and advisory services. The insights and quality services we deliver help build trust and confidence in the capital markets and in economies the world over. We develop outstanding leaders who team to deliver on our promises to all of our stakeholders. In so doing, we play a critical role in building a better working world for our people, for our clients and for our communities.

EY refers to the global organization, and may refer to one or more, of the member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. For more information about our organization, please visit ey.com.

© 2014 EYGM Limited. All Rights Reserved.

EYG No. CQ0136

1483236.indd (UK) 05/14. Artwork by CSG Design.

ED None

In line with EY’s commitment to minimize its impact on the environment, this document has been printed on paper with a high recycled content.

This material has been prepared for general informational purposes only and is not intended to be relied upon as accounting, tax, or other professional advice. Please refer to your advisors for specific advice.

ey.com

How we can helpEY has a team of experienced professionals who understand traded markets in the context of treasury, commodity procurement and commodity trading functions. We will work with you to understand your compliance requirements under EMIR and formulate an appropriate response in an effective, cost-efficient manner. We also firmly believe that regulatory compliance need not necessarily be a sunk-cost proposition, but that explicit benefits can often be gleaned as a result. We will work with you to understand these benefits.

ContactsAndrew Woosey Partner

T: + 44 20 7951 8117 M: + 44 7766 498 328 E: awoosey@uk.ey.com

Shane Henley Director

T: + 44 20 7951 9501 M: + 44 7739 127 457 E: shenley@uk.ey.com

Craig Kennedy Partner

T: + 44 20 7951 9026 M: + 44 7768 164 068 E: ckennedy1@uk.ey.com

Our services include: ► Conducting rapid gap assessment to identify required

enhancements for regulatory compliance

► Assisting with the interpretation of key elements of EMIR

► Assisting with the implementation of all aspects of the EMIR compliance requirements

► Facilitating cross-divisional or cross-functional regulation workshops to compile regulatory requirements and help prioritize your response

► Helping you coordinate your response, considering overlaps with other regulations to ensure these are incorporated effectively into your work program in order to avoid duplication of effort and unnecessary costs

► Conducting project and program management for regulatory compliance initiatives

► Reviewing your compliance with key elements of the regulation

Who we areEY has a integrated team dedicated to servicing treasury, commodity procurement and commodity trading functions for organizations within the Europe, Middle East, India and Africa (EMEIA) region, as well as globally. The team provides a broad range of advisory and assurance services to a large number of leading European organizations, including non-financial firms (including end users), and energy and commodity trading organizations across multiple asset classes and markets (including oil, gas, electricity, metals, softs and renewables).