“…just to give you an idea of the actual impact of Lehman Brothers, we can consider the figures published by one of the Lehman’s counterparties: Merrill Lynch, which in the third quarter of 2008 disclosed a US$2 billion pre-tax trading loss, which was mainly due to the unwinding of trades for which Lehman Brothers was a counterparty. Merrill Lynch was only one of the hundreds of counterparties of Lehman, so the aggregate impact on counterparties’ losses of Lehman’s default was much bigger than the one generally used.[1]”
This telling quote is from a speech given by Steven Maijoor on March 27, 2013, the then chair of the European Securities and Markets Authority (“ESMA”), in which he is describing the violent aftermath of the Lehman collapse whose financial tremors nearly brought down the West’s financial system.
This alert focuses on the European Market Infrastructure Regulation (or “EMIR” as it is better known[2]) which was introduced as the equivalent of the Dodd-Frank Act of 2010, to address a wide range of issues, many of which were said to be linked to the problems identified in the over the counter (“OTC”) derivatives market[3] following the collapse of Lehman. However, as we set out below, there are serious questions which arise as to the effectiveness of EMIR and the implications of the seismic changes in the OTC market.
THE OPAQUE MARKET PROBLEM
When Lehman collapsed, regulators had no idea what effect this was about to have on the OTC derivatives market as a whole. There was no regulatory requirement for OTC derivatives market contracts to be disclosed. Since it is common in the OTC derivatives market to enter into an array of complex hedging arrangements to transfer risk, it was impossible for the regulators to predict or understand where the losses lay when market shocks such as Lehman’s collapse occurred.
The proposed solution is to impose a blanket reporting requirement on the derivatives market. Regardless of whether the party to the contract is a small company entering into a relatively few transactions aimed at hedging foreign exchange or interest rate risk or a large multinational bank entering into large volumes of trades, all European “counterparties” (other than natural persons) are required to report to newly created bodies called “trade repositories” extensive details (there are up to 80 fields of data to be supplied) of all derivative transactions entered into. The rationale is that if all counterparties are required to report their trades, the regulators will be better able to anticipate the impact of a collapse, and potentially predict when one might occur. Basic level reporting has been in force under EMIR since February 12, 2014, with the requirement to report valuation and collateral updates also applying from August 2014. For a number of reasons further discussed in this alert, it’s moot whether the derivative markets are less opaque in 2015 and beyond.
The first is that the data is not going to just one place. When trade repositories were introduced, the regulators wanted to ensure that there was competition in the market place, and so, rather than establishing a single trade repository, they created a regulatory system for authorizing trade repositories, so that anyone (within or outside the EU) who met the required criteria, could set one up. There are currently six registered trade repositories. Parties have a free choice which repository to use, can use different repositories for different trades and the two counterparties to a trade can use different repositories. The information is reconciled through the use of unique trade identifiers (so called UTIs). It is expected that it will be many years before regulators will be able to gain any meaningful information from the swathes of data now being collected. Indeed, the silos created by having multiple trade repositories using different processes and systems appears to be a significant obstacle to meeting the transparency objective behind the regulation. Arguably, one central repository for reporting information would have made more sense and been more effective.
In addition, we also suggest that the “net of parties/transactions” caught by the reporting obligation is far too wide. In our view, the regulation should have sieved out derivatives contracts below a specified threshold.
The data required to be reported is extensive and complex. Expensive systems have had to be implemented to ensure that these reports can be made. The financial services industry has made strenuous efforts to comply and data is now being reported (including historic data for all transactions entered into since August 16, 2012, whether still in place on February 12, 2014 or not). Nonetheless, if a “Lehman-like” collapse were to happen again tomorrow, it is questionable whether the regulators would glean useful insights from the costly and far reaching reporting requirements imposed on the derivatives market by EMIR.
THE COUNTERPARTY RISK PROBLEM
The regulators’ assumption was that if counterparties to an OTC derivatives trade were not facing each other directly, then the risk of a domino effect, whereby the collapse of one bank would trigger the collapse of others, would at least be lessened if not avoided.
The solution proposed by the G20 was that all OTC derivatives must be entered into with a central clearing counterparty (“CCP”) so that in the event of “another Lehman”, losses would not ripple through the markets because counterparties would be facing a CCP rather than a potentially financially challenged entity. Losses would then be absorbed by the CCP which would have robust risk management procedures (including requiring collateral to be posted in respect of all trades) in place to deal with the threat.
The specific provisions relating to which counterparties must use a CCP are complex and ill-defined. For example, the criteria underlying such provisions can be difficult to gauge resulting in potential compliance hazards. This is particularly the case for (i) entities not in the financial sphere but whose business activities may require entry into derivatives and (ii) for non-EU entities which are nonetheless expected to be cognizant of the requirements of EMIR.
Pension funds have a temporary exemption from the rules until August 2015, which is proposed to be extended for a further two years (and potentially for a further year thereafter), to give time for the system to bed down before being required to clear through a CPP. But even for those entities which are not exempt, due to the complexity of implementation of the regime, the timeline for mandatory clearing in Europe continues to get pushed back; it is currently targeted to come into effect in September 2015 at the earliest and this date may still get extended.
IMPACT OF FAILURE OF A CCP?
The big question remains, what happens if the CCP becomes insolvent? The answer to this “armageddon scenario” has been attracting more and more attention recently. Banks who are members of these CCPs are becoming increasingly focused on the risks they might be facing by being a member of the CCP in the first place. In these draconian circumstances, if governments do not step in to bail out the CCP, the clearing members (generally being the major European banks) could be bearing significant losses.
In November 2014, ISDA issued a paper making recommendations on the adequacy and structure of CCP loss-absorbing resources and on CCP recovery and resolution. It noted: (i) there needs to be more transparency in particular, more disclosure relating to initial margin methodologies and the process for computing default-fund contributions (for instance, margin periods, stress scenarios used and assumptions made) and more detail on the risks faced by the CCP (for instance, the largest concentrations and exposures to clearing members); (ii) standardized, mandatory, stress tests should be introduced to allow market participants to assess their risks and also to make like-for-like comparisons between CCPs (for which regulatory action would be needed); (iii) there should be for each CCP a transparent and clearly defined recovery plan in place to address what would happen if its loss-absorbing resources proved to be insufficient (on the premise that recovery and continuity is likely to be less disruptive and less costly to the financial system than closure of a CCP); and (iv) there should be a material amount of CCP ‘skin-in-the-game’, on the grounds that CCP ‘skin-in-the-game’ plays a significant role in aligning the CCP’s behavior with that of its clearing members by encouraging the CCP to maintain robust risk management practices.
That these matters remain under discussion three years after EMIR became law is illustrative of the complexity of the issues and begs the question whether all that has been achieved is elevating the “too big to fail” risk to a new, higher level.
THE RISKY NON COLLATERALISED TRADES PROBLEM
The use of a CCP requires some standardization of derivatives, and so for those contracts unsuitable for central clearing or for which central clearing is not available, e.g. currently non-deliverable forwards (a futures contract in currencies), counterparties must ensure that they exchange collateral. Many counterparties, of course, already do this, but while previously the decision to post collateral was an economic one (taking into account the risks that the counterparties were willing to take in respect of the trades), this will become a mandatory regulatory requirement (the earliest estimate being December 1, 2015 for variation margin and a phased in obligation as regards initial margin). This, in turn, prompts new concerns around the availability and cost of obtaining eligible collateral when demand for it will be much higher than previously. In a recent ISDA survey of derivatives users, the introduction of margin requirements for non-cleared derivatives was highlighted as a key area of concern, with nearly two thirds of respondents prospectively subject to the rules saying they were worried about their ability to meet the requirements.
THE OPERATIONAL AND CONTRACTUAL RISK PROBLEMS
Alongside the requirements described above, EMIR also imposes other requirements known together as the “risk mitigation requirements”. These require that contracts must be confirmed within a short time period, they must include dispute resolution provisions and portfolios must be compressed and reconciled. While these provisions have been introduced to the market to ensure best practice in legal and operational processes, the effect is to impose stringent requirements on parties making a commercially agreed bargain. It is interesting to note a warning recently issued by Timothy Massad, chairman of the CFTC, to the effect that the leverage rules under the Dodd-Frank Act may add costs which deter banks from processing trades through a CCP, yet, in relation to trades which are uncleared, mandatory collateral requirements also under the Dodd-Frank Act will be treated as assets on the balance sheet which will trigger a requirement for increased capital.
COST/BENEFIT ANALYSIS?
More than five years on from Lehman, the resulting EMIR reforms have had a huge cost, but it remains to be seen whether the widespread reform measures imposed on the OTC derivatives market to deal with the perceived risks will achieve the objectives underpinning the legislation. It is fair to ask whether the costs of EMIR outweigh the benefits. With the introduction of treaty through CCPs, it is not surprising that commentators are focused on the possible failure of a CCP. The regulators, through bank resolution legislation and other measures, have made strenuous efforts to mitigate the “too big to fail” problem. For a new structure to have been introduced, the failure of which may lead to systemic failure, is very disconcerting. This regulatory change brings to mind the well-known line from the Leopard by Giuseppe Tomasi di Lampedusa, “For things to remain the same, everything must change”.
[1] EMIR: A Fair Price for Safety and Transparency, speech given by Steven Maijoor on March 27, 2013
[2] The full name being the Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.
[3] An “OTC derivative” is any derivative which is not executed on an EU regulated market (as defined in MiFID) or equivalent non-EU market.