The OTC (over-the-counter) Derivative Trade Reporting requirement kicked-in the past month of February as part of the new EUÔÇÖs regulation for off-exchange derivative transactions (EMIR). Even though the new requirement does not involve excessive complexity, it has posed substantial problems as it affects the totality of entities, which have at least an OTC derivative in their books.
The new EMIR regulation differentiates between three types of entities for which the application of the new requirements affects in a different way:
- FC (Financial Counterparties).
- NFC (Non Financial Counterparties). Those counterparties are not financial in nature but still trade OTC derivatives. In this category there is a new subdivision:
- NFC-, when the derivative is hedge-effective and is aimed at mitigating certain financial risks; or, if it has been traded for speculative purposes, certain volume levels have not been surpassed. The thresholds are defined depending on the derivative transactionÔÇÖs underlying (interest rates, FX, etc.).
- NFC+, when the derivative has been traded for speculative purposes and the volume thresholds have been surpassed.
The EMIR defines a series of Risk Mitigation Techniques to counterparties. The type of counterparty, as per the definitions above, is crucial as it determines the number of techniques applicable. There are a number of requirements no entity trading an OTC derivative can escape from. Basically, the requirements can be summarized in the following three:
- The Derivative Trade Reporting requirement, mentioned above.
- The Derivative Trade Confirmation requirement.
- The Derivative Trade Valuation and Reconciliation requirement.
None of these techniques entail excessive difficulties to financial counterparties. However, they pose an enormous problem to NFC- entities, which are less accustomed to deal with financial regulations.
Firstly, the Derivative Trade Reporting mitigation technique requires counterparties to report the terms of their OTC derivative transactions to a centralized Trade Repository (TR), so that regulators can keep track of all outstanding transactions in the market and spot sources of potential systemic risk.
Secondly, the Derivative Trade Confirmation mitigation technique requires counterparties to confirm their transactions in a relatively short period of time. The usual practice when dealing OTC derivatives has been to close the transaction over the phone and later issue a written confirmation with the exact terms. However, it has been frequent to see how transactions have been left unconfirmed for relatively long periods of time (sometimes months). The new regulation in place will require parties to confirm trades within a few business days to avoid issues like potential discrepancies in the precise terms of the transaction long after the execution date.
Lastly, the Derivative Trade Valuation and Reconciliation mitigation technique requires parties to periodically perform independent valuation on all outstanding OTC derivative transactions and reconcile the results with their counterparties. Moreover, the requirement establishes a period of five business days to solve any discrepancies and agree on the same valuation. This requirement is aimed at solving the discrepancies in the accounting of OTC derivatives. For instance, while a party was posting a gain of +1.1 million Euros, its counterparty could be posting a slightly different figure, say, -1.0 million Euros). The requirement forces parties to agree on a number.
This last requirement is probably the one that poses greater problem to entities of type NFC-. The reason is that the new accounting standards require valuation of derivatives to include adjustments for counterparty credit risk (CCR adjustment, also called CVA or Credit Value Adjustment). The new standard requires taking into account the chances of a counterparty defaulting on its financial obligations under an OTC derivative transaction, and adjusting the mark-to-market valuation accordingly. Due to these new requirements and standards, NFC- entities face important challenges and investments. They have to either equip themselves with the technological means or outsource to providers to comply with a requirement that could entail huge complexity from an analytical standpoint, and to which financial entities a better adapted.