November, 2011

©2003-2011 International Swaps and Derivatives Association, Inc.ISDA® is a registered trademark of the International Swaps and Derivatives Association, Inc.

The Impact of EMIR on Risk Management of OTC Derivatives

Roger Cogan, Senior Policy Director, International Swaps and Derivatives Association, and Head of ISDA Brussels office

1. G20 commitments1. G20 commitments

Deadline end-2012

• Clearing ‘standardized’ contracts • Trading standardized contracts on exchanges and

electronic platforms (‘where appropriate’)

• Reporting to trade repositories• Higher capital requirements for non-cleared contracts

Committed to…”implement global standards consistently… ensures…level playing field…avoids fragmentation of markets, protectionism, and regulatory arbitrage”

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2. Dodd2. Dodd--Frank and rulemakingFrank and rulemaking

US response to crisis – DFA – adopted July 2010

- Mandatory clearing- Mandatory trading on ‘SEFs’- Mandatory trade reporting- Rules on margining bilateral transactions- Transparency rules- Volcker rule - End user exemptions- Extra-territoriality (indemnification, registration…)

Rulemaking (CFTC and SEC filling in the detail of above) ‘bogged down’

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3. Our view of the world3. Our view of the world

Support for • Central clearing

• Of the right contracts, of the right mkt participants• as long as CCPs are robust

• Trade Repositories• We’ve built 5! (CDS, IRS, EQD, FX, Commods)

Concerns• Trading on public venues• Public transpar. (esp. pre-trade) - (support reg

transpar.) • Capital

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4. EMIR summary4. EMIR summary

EMIR (EU Market Infrastructure Regulation)• No CCP location restriction;• CCPs authorized at national level;• New EU regulator to decide contracts for clearing;• Reporting to trade repositories;• Bilateral risk mitigation rules for non-cleared;• Exemptions for ‘low-risk’ end users;

Legislation now in final negotiations:• Retrospectivity of clearing req? Phase-in?• Intra-group transactions?• Indirect Clearing• Extra-territoriality?

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5. EMIR points of contention5. EMIR points of contention

1. Backloading/Frontloading• (Dodd-Frank clearing requirement not retroactive);• EC proposal silent; legality?• MS initially interpreted G20 as applying retroactively;• Council refers to (equivalent term) ‘front-loading’:

• Contracts initiated after EMIR in force and before that class is deemed eligible will have to be cleared (once eligible);

• …provided residual maturity >x ('x' determined by ESMA) • European Parliament opposed to front/back-loading

Phase-in: by type of counterparty; (for front-loaded contracts only)?

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5. EMIR points of contention5. EMIR points of contention

2. Intra-group transactions – exempt?

Exemptions from clearing and collateralization but conditional:• Geographically neutral? (‘consolidated’/’group’)• Equivalence• ‘Practical or legal impediments to prompt transfer of

own funds or repayment of liabilities…’ • Bilateral approval by regulators?

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5. EMIR points of contention5. EMIR points of contention

3. Indirect Clearing

• Comply via a client of a client of a clearing member? (EP agrees)

• Not all banks want to be clearing members (or should be)

• Not all clients want to deal directly with a clearing member (e.g. in another jurisdiction)

• Allows client-bank relationships to be maintained• Allows local regulatory ‘hold’.

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5. EMIR points of contention5. EMIR points of contention

4. Extra-territoriality

• DFA didn’t help…• Insufficient attention to date• Branches?• When may EMIR-regulated entities access 3rd country

service providers? • Uncertainty – when is a 3rd country client in- and out- of

scope of clearing requirement? (‘at least one CP outside EU?’

Most challenging issue. 9

45.8%

23.8%

16.2%

7.6%

6.6%

UK

USA

EU

Asia

RoW

Share of daily turnover (April 2010; rates derivatives)

(incl Switzerland)

6. Impact of EMIR for clearing6. Impact of EMIR for clearing--eligible contractseligible contracts

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Source: Bank for International Settlements, Triennial Survey, September 2010

6. Impact of EMIR for clearing6. Impact of EMIR for clearing--eligible contractseligible contractsWe support clearing but….• Regionalisation of clearing will undermine netting

benefits – so even more costly;• Need to post margin at CCPs – sell illiquid assets and

buy cash;• You are creating one (or a small number of) huge

point(s) of failure (actually CCPs have failed before) –and we don’t yet have a plan for this.

Large Complex Financial Institutions will need to find between $70 and 140 billion in margin for clearing (IMF).

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6. Impact of EMIR for clearing6. Impact of EMIR for clearing--eligibleeligible contractscontracts (the (the processprocess))

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CCP applies to national competent authority for

authorization, including authorization in relations to contracts it wishes to

clear

National competent authority authorizes CCP to clear class of

derivatives andnotifies European Securities Market Authority (ESMA).

(within 6 months) ESMA decides

whether relevant class of derivatives

is eligible and required to be cleared

ESMA will decide from when the clearing obligation will apply (though EC will officially take the decision).*

ESMA Eligibility considerations (tbc) – with ‘overarching aim’ of reducing systemic risk:

§ Degree of standardization of contractual terms and operational processes of contracts;

§ Volume and liquidity of contracts;§ Availability of fair, reliable and generally

accepted pricing information.* EP/Council disagreement on phasing-in.

European Commission (EC) adopts decision

specifying whether contract is eligible for

clearing

6. Impact of EMIR for clearing6. Impact of EMIR for clearing--eligible contractseligible contracts• CCP governance – EU focus more on access.

• Risk committee: clearing members +… (independent experts/clients/competent authorities)?

• Collateral – EMIR proposes range that is (too?) wide (not just cash…bonds, gold; even bank guarantees? (non-financials))

• Unfettered right of re-use of collateral/capital treatment?

• Full segregation – opt-in or opt-out?

• Location (€-contracts)• ‘emergency access to (€-zone) central bank liquidity’.• EC supports sympathetic language; ECB uncomfortable.

Deferred till [2014] review;

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7. Impact of EMIR for non7. Impact of EMIR for non--cleared cleared contractscontracts

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Bilateral risk management requirements • Exchange of collateral and/or capital;• CPs must have the option of seg before entering into contract;• Electronic confirmations• Portfolio Reconciliation• Dispute Resolution Mechanisms;• Daily M2M or reliable and prudent mark-2-model where mkt

conditions prevent M2M.

ESMA to decide on detail of much of this.

Some intra-group transactions may not have to be cleared or bilaterally margined.

7. Impact of EMIR for non7. Impact of EMIR for non--cleared cleared contractscontracts

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Bilateral risk management reqs: outstanding issues• Segregation – IA only?• Segregation offer – mandatory at outset of

contract only?• Collateralization facing exempted non-

financials?• Segregation option at 3rd party custodians?

8. Reporting to TRs8. Reporting to TRsTR Registration or Recognition• Registration requirement for Trade Repositories – with ESMA; • Trade Repositories must be ‘legal persons’ within EU or be

recognized as ‘3rd country trade repository’ by ESMA (for purpose of firms complying with reporting requirement). Conditions therein:Ø TR authorized and subject to effective supervision;Ø 3rd country jurisdiction is ‘equivalent’;Ø Existence of international agreement re access to (and

exchange of) information with that 3rd county;Ø Existence of cooperation arrangements ensuring continuous

access.

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8. Reporting to TRs8. Reporting to TRsGeneral Requirements for TRs• Robust Governance• Written organisational and administrative procedures for

managing conflicts of interest• Compliance policies• Price and Fee disclosure• Operational Reliability• Transparency and (aggregated) data availability

Professional Secrecy RequirementsØ Obligation of professional secrecy on TRs other than

sharing information with ‘relevant authorities’ for use in ‘performance of duties’.

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8. Reporting to TRs8. Reporting to TRsExtraterritoriality Issues• Indemnification requirement under Dodd-Frank• Access to information (problems during crisis)

Proliferation vs coherence?

Trade Repository or Risk Repository?

Outstanding concern (trilogue): reporting/banking secrecy rules conflict

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9. Regulation: changes to ISDA docs9. Regulation: changes to ISDA docsStandardization & the CSA• The inherent flexibility of the CSA is a positive: vast majority of the wide

universe of derivatives executed with the entire spectrum of credit quality counterparties can be collateralized under a CSA.

• However, regulatory perception is that not all variations under the CSA are warranted; or put another way, standardizing some terms to reduce the number of variations would not harm the market.

• Focus on eligible collateral, Thresholds, MTAs and IA.

• Operational procedures and market standards are in fact very consistent across market participants

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9. Regulation: changes to ISDA docs9. Regulation: changes to ISDA docsDownsides of standardization of CSA• There is an active market in derivative novation and assignment. In

addition, regulators and market participants are encouraging the transfer of bilateral risk to CCPs where possible.

• LIBOR-OIS discounting issues makes these risk transfers more difficult, because of the differences in choice of underlying curve.

• The collateral-related effects render these risk transfers even more difficult, since CSA terms are not consistent across the market, and the two parties to a given CSA may factor the collateral terms into pricing differently (if at all).

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What is the SCSA?• Work in progress.

• Superficially it looks similar to the 1994/1995 ISDA CSA - preserves current legal enforceability analysis wherever possible.

• But major changes beneath the surface:

§ Exposure and collateral computed by currency “silo”.

§ Eligible collateral is G5 cash only.

§ No thresholds, de minimis standardized MTA (possibly zero).

• No change to IA - still negotiated by counterparties and may be covered by securities collateral (at least until legislated otherwise!) . This is possible because IA is collateral in excess of any mark-to-market exposure and therefore is not funding the underlying derivative cashflows.

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9. Regulation: changes to ISDA docs9. Regulation: changes to ISDA docs

Advantages of the SCSA• Removes collateral “switch options”

• Restricts variation margin to cash only, so that collateral interest accruals will approximate the funding cost of underlying cashflows.

§ Further limits this to cash for which a liquid OIS market exists.

§ Will be extensible as other OIS markets develop liquidity, promoting the growth of liquid OIS markets.

• Simplifies calculations by standardizing terms.

• Eliminates structural CSA diffs & related pricing differentials, thus

§ Making market pricing more consistent and transparent

§ Making novation, assignment and risk transfer to CCPs easier

§ Reducing one cause of margin disputes22

9. Regulation: changes to ISDA 9. Regulation: changes to ISDA docsdocs

Status of SCSA• As of October 11, the SCSA project was approved by the ISDA

Board to move into active implementation.

• This follows a year-long program to:

• Study the technical feasibility of the SCSA.

• Develop prototype documentation.

• Devise methods to manage the risk inherent in the SCSA.

• Understand the logistical challenges and develop and implementation plan.

• Document findings and efforts to educate the market and supervisors on the SCSA.

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9. Regulation: changes to ISDA 9. Regulation: changes to ISDA docsdocs

Clearing

§ New documentation§ legal issues§ New risks§ New solution - “Master master” set-off and

portfolio margining

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9. Regulation: changes to ISDA 9. Regulation: changes to ISDA docsdocs

Clearing§ Trades between clearing members and clearing house

governed by clearing house rules and procedures (including procedure to clear a trade, margining, default rules etc.)

§ Clearing houses use different models to offer client clearing services - there are differences within the same model

§ Multiple clearing houses offer client clearing for the same / similar products

§ Documentation is not standard between the various clearing houses or per product

§ This means different rules and a separate set of documents when facing each clearing house

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9. Regulation: changes to ISDA 9. Regulation: changes to ISDA docsdocs

Rules / Procedures / Conditions

Rules / Procedures / Conditions

Cleared Transactions

Cleared Transactions

Clearing House

Clearing MemberClearing Member

Standard ISDA Documentation

Inter-dealer – Relationship and Documents

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GiveGive--Up AgreementUp Agreement

ISDA & CSA ISDA & CSA (Cleared & (Cleared & NonNon--cleared)cleared)

Security Security DeedDeed

Clearing House

Client

CB

EB

Principal ModelsPrincipal Models

Clearing House RulesClearing House Rules

Statutory Statutory segregation segregation rulesrules

Futures Futures Agreement Agreement CCP CCP AddendumAddendum

Agency ModelsAgency Models

Customer Customer DocumentDocument??

Client Clearing – Different Models

GiveGive--Up AgreementUp Agreement

Clearing House

Client

CB

EB

Clearing House RulesClearing House Rules

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Basic documentation required under principal model for client clearing

1. New ISDA Master Agreement and CSA with amendments (e.g. “LCH Clearing Agreement”)

• Creates ISDA Master and CSA between CM and Client for transactions to be subject to client clearing.

• Cleared ISDA and CSA specifically designed for client clearing, so amendments are made.

• Original ISDA Master and CSA remain for uncleared trades.• New set of documentation for each CCP.

2. Security created in favour of client in respect of CM’s rights against CCP (e.g. LCH’s Deed of Assignment)

• Agreement by which the CM grants to its Client a security interest in respect of the relevant Client account at LCH.

• New security arrangement for each CCP.

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Basic documentation required under principal model for client clearing

3. Give-Up Agreement

• Agreement between CM and EB whereby CM agrees to accept give-up transactions in relation to underlying clients.

4. Compensation Agreement if transaction not cleared

• Fall-back to the Give-Up Agreement, which covers compensation arrangements between an EB and the Client in the event that a transaction is not accepted by the CM for clearing.

5. FIA-ISDA Cleared Derivatives Execution Agreement

• Sets out agreement between two parties relating to clearing of transactions entered into between them.

• Optional “trilateral” Annexes permit addition of clearing members as parties.

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1. A Futures Agreement in place with FCM/ Addendum for OTC Cleared Transactions

2. Give Up Agreement between FCM, Client and EBs

3. Other (e.g. licenses for use of electronic systems like clearport)

Basic documentation required under agency model for client clearing

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