Don’t panic! Here's the Emir checklist

June 2016 should see the European Markets InfrastructureRegulation (Emir) come into effect. For buy-side firms the rules have long beenanticipated and discussed but there are still very significant decisions to bemade. The rules represent Europe’s take on obligations to clear and reportover-the-counter (OTC) derivatives trades, decided in 2009 by the G20countries.

With Japan and the US having started clearing in 2012 and2013, Europe is playing catch-up. Its highly democratic process of creatingdirectives and regulations is not geared towards efficiency. In this instancethe challenge has extended to international negotiation with overseasregulators. For investment managers, there are several issues which willrequire immediate action in order to ensure their migration into the newclearing regime is as smooth as possible, while any additional costs that theprocess incurs are controlled within reason.

Transaction reporting has been a requirement since August2014 with mark-to-market valuations of positions and on collateral valueprovided daily to trade repositories, however there is no commonality in thelevel of preparedness for other requirements, although larger firms are commonlysaid to be far ahead of the curve.

“They are all ready to varying degrees, ranging fromcompletion to fairly early stages of engagement in preparing for mandatoryclearing,” says Angus Canvin, senior advisor for regulatory affairs at buy-sidetrade body the Investment Association.

Get in a relationship…

The first matter of concern is the selection of a clearing brokerto allow connectivity to the relevant central counterparty. Many brokers arestill evaluating their own cost base and the viability of this businesses. Severalhave been hard pressed to provide transparent guidance around their Emirdisclosure of fees, and all emphasise that the costs are worked out with eachclient individually.  That can make theprocess trickier, however the longer it is delayed the more problems can arise.

“Clients that havenot selected clearing brokers and are not live are definitely playing catch-up,”says Eugene Stanfield, head of head of derivatives execution and clearingservices at Commerzbank. “They run the risk of a situation where the clearingbrokers have limited or no resource availability such as balance sheet or evenfrom a man-power perspective to on-board those clients.” 

…with a local?

Another serious issue that requires consideration is thelack of equivalence between the US and European regimes.

Miles Courage, chiefoperating officer at JPS Alternatives Group, a credit-focussed hedge fundsays: "You can form a view on a regulation in isolation but the criticaldetail is often how it interacts internationally, especially for managers withEU and US operations and offshore funds.”

Despite the European authorities having approved themajority of regimes in major Asia-Pacific financial centres – bar China andIndia – along with Canada, Mexico, South Africa and Switzerland, the US has notpassed muster. With disagreement over margin requirements ongoing, there is noobvious reason for optimism. Consequently investment firms are seeking to avoidexposure to non-equivalent regimes.

“Where clients are falling under Emir, they arediscontinuing relationships with brokers who are subject to Dodd-Frank and viceversa,” says Jörn Tobias, head of AgentFund Trading and Collateral Services at custodian State Street.

Although the interpretation of the G20 2009 mandate has beennuanced in every jurisdiction, there are reasons to think the global marketwill not be fractured, as long as equivalence can be achieved, says RadiKhasawneh, Analyst, FixedIncome Research at Tabb Group.

“We are seeing a proliferation of clearing entities inregions and what the clearing entities and the trade repositories do functionsas a canary in the coalmine for likely activity of the wider market,” he said,speaking at the Fixed Income Leaders Forum on 14 October 2015. “So aftertrading venue and clearing house fragmentation into regional silos, we expectto see them then reverse flow as they get comfortable with equivalence where itexists, and then we will see this huge dispersion start to reverse itself.”

Getting andprotecting collateral

Moving to a cleared model, requiring both initial margin tocover the value of a contract and variation margin to cover changes in valuewill require a mechanism to source the instruments needed for margin.

A major cost and/or risk for asset managers will be the acquisitionand protection of collateral. For larger firms or those with funds thattypically have the assets required, either cash or high quality bonds, collateralmanagement may be viable in-house. However other firms will need to weigh up ifthe value of outsourcing collateral management to a broker or custodian canreduce the operational costs or at least create a buffer to any future changingcosts by mutualising cost via a single supplier.

The challenge ofdeveloping and managing a system also includes considerable risk and cost,where a tried and tested platform provided by a third party can be deliveredmore rapidly than an in-house system. A decision must also be made aboutthe account selected to protect those assets.

“There are a rangeof options available, and not every clearing house has the same range,” saysCanvin.

The two main categories of account come in a variety of flavours,often with similar names. Typically the options offered are for a fully orindividually segregated account in which the collateral held will be marked outand in the event of a default by the clearing broker, the exact assets can be returnedas deposited. There is little or no co-mingling of assets and they are held tosupport the initial margin for only that client.

The second type is an omnibus account, in which the accountis shared by many firms whose net or gross (both are offered) initial margin hasto be covered by the value of the assets held. This holds far less security inthe event of a default, but is decidedly cheaper.

“Clearing housesare offering the buy-side, through the clearing brokers, omnibus accountstructures which provide for the pooling of groups of clients,” says Stanfield.“This can be preferential to clients who can define their tolerance to fellowcustomer risk and select an appropriate omnibus account pool or for end userssuch as fund managers to aggregate all the funds under their management into aclosed omnibus account. These clients are effectively saying they are happy forfellow customer risk but only to a known set of end users.”

Market participants report the two extremes of the account rangeare typically the only choices taken, offering the ability to choose betweenrisk and cost.

“It would be the end-investors who quite rightly should bedictating according to the combination of their risk appetite and then the costthey are willing to bear,” Canvin adds.