10 myths around emir dodd franck ccp and central clearing of otcs

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Whitepaper 10 myths around EMIR, Dodd-Frank Act, CCP and central clearing of OTC derivatives

Authors:

Thomas Bodenski [Senior Partner] Martin Schuhmayer [Chief Knowledge Officer] Youssouf Atifi [Senior Consultant]

Content

1. Introduction 2. 10 myths around CCP

1. "Achieving compliance just means selecting a clearing broker" 2. "When we are compliant with EMIR, we are also compliant with DFA" 3. “Let's not do back-loading, it has an impact on P&L” 4. “I only need one clearing broker, that's easy!” 5. "Only centrally cleared deals have to be reported to transaction repositories" 6. "Only new deals affect capital charges" 7. "Why should I clear now, nobody clears" 8. "EMIR is a standalone regulation and done by ESMA" 9. "EMIR is about clearing, so let's just not do any IRS and CDS and we are fine" 10. “CCP has no impact on my business model, it is a pure back office topic”

3. Conclusion 4. Discuss this paper with us online @ FOXNET 5. About FOXEYE and our offering

Disclaimer: The opinions expressed are as of January 2013 and may change as subsequent conditions vary.

Whitepaper

10 myths around EMIR, DFA, CCP and

central clearing of OTC derivatives

Copyright © 2013 FOXEYE AG – The Frontoffice Xperts www.foxeye.net of 14

1. Introduction Now, at the beginning of 2013, central clearing of OTC derivatives is not a new topic anymore. At the sell-side central clearing has already been a common practice since more than 10 years. EMIR and the Dodd-Frank Act entered into force in 2012 already and will ultimately impose mandatory central clearing for all financial institutions and some non-financial institutions as well. Institutions established new clearing broker divisions to benefit from the new business of client clearing while buy-side institutions launched projects for selecting and onboarding clearing brokers. Clearing houses have been busy clearing contracts with trillions of USD notional. So everything should be clear by now and everybody should be ready to go.

Looking closer however still reveals a big lack of clarity, leading to some strange myths which we came across during our activities in this space.

The origination of those myths is not caused by a lack of data, as the world wide web offers lots of information about EMIR, the Dodd Frank Act, central clearing of OTC derivatives, the reporting requirement and leading transaction repositories. Most of that information is however very high level, outdated or incomplete, thus sometimes wrong and is therefore causing confusion and contributes to the spreading of myths.

At this point we felt that it is important to disprove these myths, as some of them could really be troublesome for financial institutions around the world.

This whitepaper discusses the 10 most common myths we came across and disproves them with a proper explanation. Its objective is to contribute to more clarity.

Please feel free to join us and experts from other firms at FOXNET, an online community on LinkedIn and Xing, to discuss the content of this.

"Is everything clear? Are you ready to go?"

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2. 10 myths around CCP

1 "Achieving compliance just means selecting a clearing broker"

Granted - selecting a clearing broker is definitely an important step towards achieving compliance if an institution chooses to act as a so called client instead of becoming a direct member at a clearing house. However, the selection is not as easy and straight forward as one might think. With all these clearing brokers still busy shaping their service offering, it is very tough to compare them from a feature perspective as well as from a financial perspective.

Moreover, a bank should onboard with at least 2 clearing brokers. And as none of the clearing brokers really wants to act as a backup clearing broker, banks face an additional challenge in handling the minimum clearing volumes and fees.

Any institution should make sure to keep its options open until the full clearing service contract is signed and executed. There is a lot to negotiate like fees, credit lines, etc. and based on experience such negotiation takes quite some time and effort from both sides, the client and the clearing broker.

The other big issue to deal with is the operational onboarding. As many clearing broker service offerings are rather new and flexible there is the need for a detailed planning and customization phase for areas like reporting, collateral management, etc. Central clearing also requires the adoption of affirmation platforms like MarkitWire or ICELink which as well have their separate legal documentation and customization needs.

Besides adapting the system and process landscape, an institution will also have to review its business model, as capital charges or liquidity hits forces banks to rethink the way they do business and also require a review of the bank wide risk management methodology.

Overall, selecting a clearing broker is very important, but just a small portion of the entire project.

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2 "When we are compliant with EMIR, we are also compliant with DFA. As a European bank, we will never have to comply with DFA"

The European markets infrastructure regulation (EMIR) is a regulation specific to Europe on OTC derivatives, central counterparties and trade repositories. And it is the result of an agreement between the European Parliament and the Council aimed to establish more stability, transparency and efficiency in the European derivatives markets. The Dodd-Frank Act on the other hand is a law specific to the United States of America which in its title VII also aims to regulate OTC derivatives, central clearing and trade reporting.

Although both of the two regulations are a result of the same G20 commitments, they have significant differences, and compliance with EMIR does not imply compliance with DFA. As an example, according to EMIR reporting of new deals has to be done within the next business day, whereas DFA requires it to be done within 15 minutes.

Any foreign bank, or in general any non-US institution, may be required to comply with the Dodd-Frank Act and register as a swap dealer (SD) or major swap participant (MSP) if their OTC business with US or even just US-guaranteed institutions exceeds certain thresholds. This can be a very big business constraint, and some financial institutions started assessing their counterparties and established processes to monitor and limit their US business in order to avoid having to implement DFA compliance.

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3 “Let's not do back-loading, it has an impact on P&L”

First of all, back-loading is a term which is often wrongly used to describe the whole process of transforming old bilateral OTC deals into centrally cleared deals. This process is however two-fold and consists out of back-loading and late clearing.

Back-loading just refers to the process of replacing the existing paper based confirmation of a bilateral OTC deal with an electronic confirmation through middleware technologies like MarkitWire or ICELink. A back-loaded deal stays exactly the same and is still bilateral. Note however that the back-loading process may reveal disputes over terms & conditions between both counterparties.

Back-loading is a prerequisite for late clearing, as processes around central clearing rely on electronic middleware platforms. Late clearing now means the process of submitting an old, already booked bilateral deal for clearing - thereby transforming it into a centrally cleared deal with the clearing house or clearing broker.

Although late clearing will not be an obligation it may still be beneficial, as its main advantage is to lower the capital equity charges. This is because centrally cleared deals will not require a CVA charge and will allow to apply a very small risk weight in RWA calculations.

One wrong perception about late clearing is that it impacts P&L, assuming that the trades to be late cleared would need to be canceled and reissued. Late clearing however is just a novation which in general will only impact P&L because of changes in the collateral agreement (e.g. currency of collateral).

A solid analysis of an institutions current positions and a strategy development is required to figure out the best scenarios, such as full late-clearing, partial late-clearing or no late-clearing.

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4 “I only need one clearing broker, that's easy!”

Selecting and onboarding one clearing broker is cumbersome enough, so there is reluctance to onboard two or more. While EMIR compliance with regards to the clearing obligation can be achieved by choosing a single clearing broker, there are lots of implications and disadvantages in doing so.

First of all the CRR incentive of applying a low 2% risk weight for centrally cleared transactions will only be applicable if the client has properly setup segregated accounts at the CCP, and made sure that positions and collateral can be moved to another clearing member in case of the default of a clearing broker.

Now this can of course only be assured if there is an active agreement with another clearing broker in place. In theory, one could imagine a pure backup arrangement with another clearing broker is sufficient, but in practice, most of the clearing brokers are not willing to accept the role of a pure backup by e.g. imposing minimum volumes.

In addition, having more than one clearing broker can be very beneficial. Many clearing brokers waive their clearing fees for deals executed with them. Total initial margin requirements may be reduced by intelligently distributing new deals across different clearing brokers, as IM is calculated based on a VaR on the portfolio level. Furthermore local laws may require distributing the exposure instead of concentrating it to one clearing broker.

It is best to select two primary clearing brokers and distribute the business across them according to the institutions strategic decisions. In some instances it might even be required to use two, three, four or more clearing brokers according to the institutions capital and credit lines.

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5 "Only centrally cleared deals have to be reported to transaction repositories"

The reporting obligation actually applies to all derivatives contracts, including exchange traded derivatives. OTC derivative transactions need to be reported regardless whether they are centrally or bilaterally cleared.

With the technical standards around the reporting to trade repositories being adopted by the European Commission in late December 2012 some facts are known already.

The reporting obligation will start on July 1st 2013 for IRS & CDS and on January 1st 2014 for all

other derivatives. The information to be reported is specified in detail and includes information about all involved parties and the main economic characteristics of the contracts, including their market value.

Mark-to-market or mark-to-model valuations of all contracts will have to be reported on a daily basis while other characteristics need to be reported no later than the working day following the conclusion, modification or termination of the contract.

It is explicitly allowed to delegate the reporting of a contract to the other counterparty or a third party - thus centrally cleared deals will in many cases be centrally reported by the CCPs.

6 "Only new deals affect capital charges"

A common misunderstanding is that those higher capital charges which are to be introduced via Basel III / CRD IV / CRR will just affect new deals. This is however not true as CRR will of course affect all active deals!

CRR however offers an incentive for centrally cleared deals by allowing a client to apply a risk weight as low as 2%, provided that the collateral is held in segregated accounts at the CCP and that there is a backup clearing broker ready to take over the positions in case one clearing broker defaults.

CRR also introduces CVA as an additional component to the capital charges and it will have a huge impact, especially if the current bilateral business lacks netting- and collateral agreements and there are no CDS hedges in place. CRR offers another incentive by exempting centrally cleared transactions from the CVA requirement. Thus late clearing of existing deals may indeed be a very important tool to help banks achieve the strict capital ratios set out by Basel III.

"There is no need to late clear my existing portfolio."

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7 "Why should we clear now, nobody clears?"

According to latest estimates of ESMA it will not be before summer 2014 that the first clearing obligations will have to be obeyed across EU member states. So some consider central clearing as something new, which is just starting to evolve. This is not true. Although it was not mandatory, a majority of big financial institutions have been centrally clearing their OTC derivatives since more than 10 years already. For instance LCH.Clearnet, a leading clearing house, launched the clearing of interest rate swaps in 19991. Since then, LCH cleared 2.3 million OTC interest rate swaps with USD 356 trillion notional2.

The decision to enforce mandatory central clearing "by end-2012 at the latest" has been taken at the G20 Pittsburgh summit in 2009, resulting in regulatory initiatives around the globe. It was due to the upcoming clearing obligation that the number of institutions requiring access to clearing houses increased dramatically. This is why the concept of client clearing has been introduced, allowing those institutions who

are already member at a clearing house to offer clearing services to their clients, thereby acting as so called clearing brokers.

So central clearing of OTC derivatives is really nothing new, it is just the concept of client clearing which is rather new. Getting ready for central clearing can be a huge project for an institution. Several institutions have already successfully finished their projects in 2012; others have at least started them. Even without any clearing obligation in place, finding a counterparty that is willing to accept a bilateral deal will get harder and harder. So waiting any longer could lead to huge trouble - especially as capacity at clearing brokers and infrastructure providers is limited.

Also bear in mind, that central clearing has an impact on the business model as well and requires banks to adapt to a new market environment and manage their balance sheet according to these new market conditions.

1 http://www.lchclearnet.com/swaps/swapclear_for_clearing_members/ - information extracted on 11-12-2012. 2 http://www.swapclear.com/why/index.html - data as of Dec 2012 – web site visited on 11-12-2012.

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8 "EMIR is a standalone regulation and done by ESMA"

First of all one has to differentiate between the regulation EMIR and its implementing rules, the so-called "technical standards". EMIR has already entered into force on August 16th 2012. The technical standards are developed by the ESAs as laid out by the European Commission within the EMIR text. While EMIR just defines the "framework legislation", the law is only enforceable through the technical standards. The Commission delegated most of the work around the technical standards for EMIR to ESMA, but certain parts were also delegated to the EBA3. On many aspects ESMA also has to work closely with the EBA, ERSB and ESCB. Some EMIR articles even delegate power to the ESAs as a whole (e.g. for the risk mitigation techniques for non-centrally cleared deals).

There are also important cross references and cross dependencies to other European legislation such as MiFID II/MiFIR and CRD IV/CRR. So for instance MiFIR will define the conditions under which OTC derivatives will have to be traded on electronic venues, and CRR will define the conditions under which a client may apply reduced risk weights for centrally cleared deals. Note that those cross references may have an important impact on any project introducing central clearing within a bank.

9 "EMIR is about clearing, so let's just not do any IRS and CDS and we are fine"

EMIR is not just about central clearing of IRS and CDS. First of all, the obligation to centrally clear is in general for all OTC derivatives. It will be the job of the ESMA to, over time, impose clearing obligations for more and more product types, depending on their degree of standardization, liquidity and the availability of reliable pricing.

And although there have been some attempts to position replacement products for IRS like exchange traded swap futures, their acceptance by the market is very low.

Now while the clearing obligation is surely the most prominent part of EMIR, there are many more obligations which cannot be circumvented simply by avoiding IRS and CDS. EMIR requires extensive reporting of OTC as well as exchange traded derivatives to registered trade repositories. EMIR also imposes a significant set of risk mitigation rules for un-cleared OTC derivatives with regards to the confirmation process, dispute resolution, portfolio reconciliation/compression, mark-to-market model and collateral management.

3 e.g. around capital requirements for CCPs.

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10 “CCP has no impact on my business model, it is a pure back office topic”

Actually this is one of the most underestimated topics around CCP. It is nowhere near a simple back office topic; instead it has a huge impact on nearly all departments across the bank, especially on the front office area. And more importantly institutions will have to rethink and adapt their business model.

Many business decisions will need to be taken around the selection of clearing brokers, around understanding the impact on the current and future business model and around late-clearing needs including an analysis on a deal by deal basis. Especially the topic of collateral management is so huge that banks may need to launch separate projects just for that, as many are simply not prepared from an organizational, system and procedural point of view. Many responsibilities within collateral management may also shift from the back office into the front office as collateral and CVA management is more and more evolving into a front office function.

The front office will also have to carry out some additional pre-trade tasks for new OTC deals. E.g. each deal requires choosing the right clearing broker / CCP combination that minimizes costs and collateral requirements. There will also be extended limit checks. On execution, institutions will need to check their bilateral exposure against the executing broker as well as their clearing exposure against the clearing broker and potentially also their overall exposure against the CCP. The front office will also have to understand the implications towards a Dodd-Frank-Act relevance when dealing with US or US-guaranteed counterparties and rethink processes around market operations as those are not possible for centrally cleared deals (only possibility are offsetting trades).

In general, this can be summarized as the following: Traders need to understand the impact on P&L, liquidity and capital prior to execution and base their decisions on fees, capital charges and collateral requirements.

Central clearing will also have an impact on the institutions liquidity management as collateral requirements are very strict. In general banks will need to manage their balance sheet more actively based on factors like capital charges, liquidity hits and P&L impacts. In some instances big portions of the balance sheet will need to be restructured and adapted.

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3. Conclusion Achieving compliance with EMIR and the Dodd-Frank Act is a highly complex task requiring the launch of projects with dedicated and experienced staff. The topic's complexity and the vast amount of contradicting information has contributed to the spreading of many myths resulting in a lack of clarity.

Given the huge impact on the business model and processes across almost all areas within financial institutions, any project failure may have devastating results. Therefore initiatives to comply with EMIR and the Dodd-Frank Act are generally marked as high-risk projects.

While this paper focuses on the 10 most common myths, the devil really lies in the details and each financial institutions situation is rather unique. It will require expertise, experience and a dedicated team spanned across all business functions within an institution to not just enable compliance, but to establish a sustainable business model and viable operations.

By sharing our experience from advising and assisting clients in this area for years and by disproving those 10 most common myths, we hope that we were able to contribute to the success of your initiatives.

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4. Discuss this paper with us online @ FOXNET Engage with experts online @FOXNET, the community for front office experts, to discuss the content of this paper or collaborate with financial experts around the world on topics within capital markets and financial regulation.

FOXEYE is a dedicated contributor to FOXNET.

Join FOXNET now! on LinkedIn or Xing to collaborate with experts from FOXEYE and other firms.

FOXNET is a unique online community, with 100% focus on topics within capital markets: trading, asset management, treasury, asset management and risk management, also covering financial regulation that impacts capital markets such as EMIR, the Dodd-Frank Act, FATCA and more.

FOXNET is moderated by a group of selected people that will monitor and quality assure the content at any point in time.

Thomas Bodenski Senior Partner LinkedIn - Xing

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Youssouf Atifi Senior Consultant LinkedIn

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10 myths around emir dodd franck ccp and central clearing of otcs

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