Risk Mitigation

What is risk mitigation technique?

The risk mitigation rules require brokers and market makers to measure, monitor and mitigate operational risk and counterparty credit risk in relation to OTC derivative transactions not cleared through a dedicated clearing house. EMIR’s risk mitigation obligations also call for adequate capital to cover exposures arising from OTC derivatives not cleared through a dedicated clearing house and for segregated exchange of collateral, though until such time as the European Supervisory Authorities develop technical standards on the treatment of collateral, parties may apply their own rules.

On 15 Dec 2016 the Commission Delegated Regulation (EU) 2016/2251 with regard to regulatory technical standards for risk-mitigation techniques was published in the Official Journal.

FCs that enter into an OTC derivative contract which is not cleared by a CCP, are required to ensure, exercising due diligence, that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least:

  • The timely confirmation (as from 15 March 2013), where available, by electronic means, of the terms of the relevant OTC derivative contract. Article 12 of RTS 149/2013 specifies exactly the time frame. In addition, FC must have procedures in place for unconfirmed OTC derivative contracts outstanding for more than five business days [Article 12(4), RTS 149/2013].
  • Formalized processes (as from 15 September 2013) which are robust, resilient and auditable in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them, and to monitor the value of outstanding contracts.
  • Portfolio reconciliation – FCs to an OTC derivative contract must agree in writing or other equivalent electronic means with each of their counterparties on the arrangements under which the portfolios must be reconciled. Such agreement must be reached before entering into the OTC derivative contract. Article 13 of RTS 149/2013 specifies the frequency where the portfolio reconciliation must be performed.
  • Portfolio compression – Involves parties netting trades to maintain the same risk profile but reducing the number of contracts and therefore the gross notional value. FCs with 500 or more OTC derivative contracts outstanding with another counterparty must have in place procedures to regularly, and at least twice a year, analyse the possibility to conduct a portfolio compression exercise in order to reduce their counterparty credit risk and engage in such a portfolio compression exercise. FCs must be able to explain if they have concluded this is not appropriate.
  • Dispute resolution – FCs must have agreed detailed procedures and processes to a) identify, record and monitor disputes relating to the recognition or valuation of the contract and to the exchange of collateral counterparties, and b) resolve disputes in a timely manner with a specific process for those disputes that are not resolved within five business days.
  • Monitoring the value – FCs must mark-to-market on a daily basis the value of outstanding contracts. Where market conditions prevent marking-to-market, reliable and prudent marking-to-model must be used. Articles 16 and 17 of RTS 149/2013, clarifies the above.

Operational risk management requirements (Risk mitigation techniques) for OTC derivative contracts not cleared by a CCP, do not apply in the cases where the ‘counterparty’ of the FC is an individual provided that the individual is not carrying out an economic activity and is consequently not considered as undertaking.

When to apply risk mitigation techniques?

Your company needs to apply risk mitigation techniques for OTC derivative contracts that are not centrally cleared, unless you benefit from an exemption.

The risks mitigation techniques apply to non-financial companies even if they do not exceed the clearing threshold. However, the applicable rules may differ depending on whether the non-financial company exceeds the clearing threshold or depending on the size of its portfolio.

On 8 March 2016 the Joint Committee of the European Supervisory Authorities (EBA, EIOPA, ESMA – ESAs) published the final draft Regulatory Technical Standards (RTS) outlining the framework of the European Market Infrastructure Regulation (EMIR) regarding risk mitigation.

The draft RTS contain the following provisions:

  1. For OTC derivatives not cleared by a Central Counterparty (CCP), the draft RTS prescribe that counterparties have to exchange both initial and variation margins. This will reduce counterparty credit risk, mitigate any potential systemic risk and ensure alignment with international standards.
  2. List of eligible collateral for the exchange of margins, the criteria to ensure the collateral is sufficiently diversified and not subject to wrong-way risk, as well as the methods to determine appropriate collateral haircuts.
  3. Operational procedures related to documentation, legal assessments of the enforceability of the agreements and the timing of the collateral exchange.
  4. Procedures for counterparties and competent authorities related to the treatment of intragroup derivative contracts.

On 8 March 2016, the ESAs submitted the final draft RTS to the European Commission for endorsement. On 9 June 2016, the European Commission notified the ESAs of a delay in the endorsement process providing an endorsement with amendments of the draft RTS on 28 July 2016.

On 8 Sept 2016 the three European Supervisory Authorities (EBA, EIOPA, ESMA – ESAs) published their Opinion addressed to the European Commission expressing disagreement with its proposed amendments to the final draft Regulatory Technical Standards (RTS) on risk mitigation techniques for OTC derivatives not cleared by a central counterparty (which were originally submitted for endorsement on 8 March 2016).

Following the European Commission’s communication on 28 July 2016, of its intention to endorse the ESAs’ final draft RTS with amendments, the ESAs issued an Opinion rejecting some of the proposed changes.

In particular, the ESAs disagree with the European Commission’s proposal to remove concentration limits on initial margins for pension schemes and emphasise that these are crucial for mitigating potential risks pension funds and their counterparties might be exposed to.

In addition, in the Opinion the ESAs observed the following:

  • As with other thresholds in the RTS submitted to the European Commission, the calculation of the threshold against non-netting jurisdictions should consider both legacy and new contracts.
  • With reference to covered bonds, the additional condition included in the European Commission’s proposed amendments would have the effect of ranking derivatives counterparties after bond holders, which is contrary to the reasoning established in European Market Infrastructure Regulation (EMIR) to grant a preferred treatment to cover bonds.
  • The ESAs recommend providing clarity that non-centrally cleared derivatives concluded by central counterparties (CCPs) are not covered by this regulation. This has been a source of concern for stakeholders.
  • More clarity should also be brought to the application of the RTS to transactions concluded with third country counterparties, in particular non-financial counterparties.
  • The delayed application to intragroup transactions should be maintained to allow national competent authorities to complete the relevant approval process before the obligation will start applying.

The ESAs believe that the introduction of a number of wording changes proposed by the European Commission may lead to a different application of the provisions compared to their original text of the RTS and, therefore, advise amending them accordingly.

A version of the draft RTS containing all the aforementioned corrections in detail is included as an Annex to the Opi​nion.

On 4 October 2016 the European Commission adopted a delegated regulation that specifies how margin should be exchanged for OTC derivatives contracts that are not cleared by a CCP. The Commission adopted the draft regulatory standards submitted by the European Supervisory Authorities with amendments.

For those derivatives not centrally cleared EMIR requires bilateral exchange of collateral to mitigate risks. Should one counterparty to the transaction default, the margin collected will protect the non-defaulting counterparty against resulting losses. The draft regulatory technical standards (RTS) under EMIR were submitted jointly by the three European Supervisory Agencies (ESAs). The Commission decided to endorse these standards with certain amendments, in particular concerning the concentration limits for pension scheme arrangements and the timeline for implementation. The decision takes the form of a Delegated Regulation and is now subject to an objection period by the European Parliament and the Council after which it will be published in the Official Journal. The full text of the press release is available here.

The text of the delegated Regulation is available here.

What is the exemption from the application of risk mitigation techniques?

If NFC enters into intragroup OTC derivative contracts that are not centrally cleared NFCs may benefit from an exemption from the obligation to exchange collateral when the conditions set in Articles 11 (5), (7), (9) and (10) of EMIR are met.