Reporting of both over the counter (OTC) and exchange-traded derivatives to one of the six authorised trade repositories started on 12 February 2014. The Financial Conduct Authority (FCA) is responsible for implementation of the Regulation in the United Kingdom. Dominic Hobson spoke with John Tanner, head of OTC clearing and post-trade policy at the FCA, about the challenges of implementing EMIR at the national level in line with the policies set by the European Securities and Markets Authority’s (ESMA) most important international centre for fund management in Europe.
Hobson: Were you satisfied with the preparations fund managers, pension funds and corporates made to be ready to report from 12 February?
Tanner: All the fund managers and corporates that we met with asserted that they were reasonably confident they would be reporting successfully from 12 February, but obviously there were a lot of people that we had not spoken to. We were reasonably confident that people were making good endeavours to be compliant. There was an expectation that the reporting would not be 100 per cent perfect on 12 February. We were not expecting perfection but we were expecting firms to be working very hard to be ready and to address any failures to comply with the reporting requirement after 12 February as a matter of priority.
Hobson: Were you pleasantly surprised by what happened after 12 February?
Tanner: Overall, firms responded to the requirement to report and there is a steady flow of information into the trade repositories. We are now engaged in reviewing the data and there are clearly a number of issues over things like product identification and the use of Legal Entity Identifiers (LEIs). We will be picking these up with the firms concerned over the coming weeks.
Hobson: In retrospect, do you think you could have done any more to ensure regulated firms were better prepared for the 12 February 2014 deadline?
Tanner: We talked to a wide range of people, by reaching out to them. We also ran a series of presentations on EMIR, which were open to people to come, and a wide range of people came to those and listened to us and asked us questions. We also had an email address to which people could send questions, and they came from a wide range of people too. What we found from all that contact is that people were preparing for the reporting obligation, and clearly they faced some difficulties. There were some unknowns, and we accept that guidance on some of these points was not available as early as we would have liked, but we believe that the guidance now available answers most of the key questions.
We published on our own web site what we called our FCA Supervisory Priorities Arising from EMIR, which gave our approach to all the EMIR deadlines, not just the reporting ones. It set out our expectations of regulated firms. We were careful to make sure that we followed the guidance from ESMA, so people got a consistent, pan-European answer, and we did not create any scope for regulatory arbitrage. It would have been desirable to have got some of the Q&As out earlier than we managed, but this wasn’t feasible in practice.
Hobson: That said, there were differences between national regulators. The FCA took the view that FX transactions settling no more than seven days hence were not a derivative, while regulators in most other member-states thought they were. Now ESMA has asked the European Commission for clarification, do you feel vindicated?
Tanner: An area which got a lot of attention was the exact scope of EMIR. There was a technical issue about whether certain FX forwards were covered by EMIR or not. We published some information about this on our web site, so it is an area where the FCA consciously set out to help the market based on the questions that we had received. The reason for this is that, in our view, whether FX forwards were in scope or not depended on the definition of a derivative contract in the Markets in Financial Instruments Directive (MiFID) of 2007. There is no definition of a derivative contract in EMIR. It relies upon MIFID. That is sensible, because you get a consistent definition across the two pieces of legislation, but MIFID was a directive, and therefore subject to national implementation.There are therefore some differences between member-states as to what is classified as a derivative for the purposes of EMIR. The debate about the impact of that on EMIR continues.In an ideal world, we would not have that discrepancy, but it is there, and there is nothing that we can do about it in the short term. It is not a question of feeling “vindicated” – what is needed is certainty for the market, which we hope the Commission will be able to provide.
Hobson: National differences span the Atlantic as well as Europe. How material are the differences between the reporting requirements of EMIR and those of Dodd-Frank?
Tanner: There are differences in scope. In EMIR, both exchange-traded and OTC derivatives have to be reported, whereas Dodd-Frank covers OTC only. There are some differences as to who reports. In EMIR, both sides have to report whereas in Dodd-Frank, only one side has to. There is also a practical difference, which impacts different people in different ways. This is what Dodd-Frank requires reporting relatively quickly after the event, whereas EMIR is content to allow people to report the day after the event. So EMIR is more relaxed on the time-frames of reporting, but that makes no real difference to what is reported.
Hobson: Where and how do regulators work together to minimise these differences?
Tanner: CPSS-IOSCO discusses derivative reporting. There is a Financial Stability Board study into whether there can be global aggregation of this data. Some of the issues get discussed there, because any differences make it harder to aggregate data. It is not a forum for resolving differences, but it is a forum for identifying issues that need to be resolved.
Hobson: Is it a good idea to have so many bodies issuing LEIs?
Tanner: That is the way it has been set up. A decision was taken by the Regulatory Oversight Committee, set up by the FSB to create the LEI, that there should be a number of entities issuing LEIs, and it seems to be working. A large number of Local Operating Units (LOUs) are authorised to issue so-called pre-LEIs, and an LEI issued by any of them is acceptable. People have a free choice of which one to use.The LOUs reconcile between each other, and there are strong protocols and systems in place to make sure an organisation cannot, for example, get two LEIs from different pre-LOUs. The system is robust.
Hobson: There was surprise among fund managers that ESMA had not issued definitive guidance on Unique Trade Identifiers (UTIs) and Unique Product Identifiers (UPIs) before the 12 February deadline. Were you surprised as well?
Tanner: On UTIs, the legislation said that the two parties should agree a unique identifier, and both should use it in their reports. What the legislation did not say is how that was to be achieved. Clarification on that point had to await guidance from ESMA. Inevitably, that meant that on 12 February different people were doing it in different ways. It was not possible to appoint issuing bodies for UTIs, like the LOUs for LEIs, because it would have required too many UTIs, much too quickly. An LEI is relatively static. An organisation gets an LEI, and hopefully that remains unchanged forever. But there are millions of trades a day, and so you need millions of UTIs to be issued every day. Although in theory you could conceive of just one place that you go to get them but in practice it is not feasible. So other approaches had to be considered.
Hobson: How do you predict UTIs will be generated in practice?
Tanner: The likeliest outcome is a two stage process. In the first stage, one of the two parties to a trade is given responsibility for generating a UTI. In the second stage, that party is given a methodology to generate it. Dodd-Frank had a process of that sort in place already, mandated by the Commodity Futures Trading Commission (CFTC). ESMA, as the body responsible for Europe, might or might not develop a process with some similarities.
Hobson: Do UPIs pose a different problem?
Tanner: In terms of identifying what product was traded, the legislation says there are three ways of doing it, but you do not necessarily get a free choice as to which one you use. There is a hierarchy. What it says is that, if there is a UPI system endorsed by ESMA for creating UPIs, then you must use that. Since there is no such system, the legislation says – and I am paraphrasing here – that you must identify the product in the same way that you would on a MiFID transaction report, i.e. by using an ISIN or Aii code. If the MiFID method is not available – and it may not for OTC derivatives without ISINs – there is a descriptive option embedded in the EMIR secondary legislation in which you can use various codes to describe what sort of product you have traded.
Hobson: ISDA is working on a solution for UPIs. What status does it have?
Tanner: There is an ISDA taxonomy which provides a hierarchy for identifying the distinguishing components of a contract down to a certain level of detail. It is possible that ESMA will endorse the taxonomy, or something like it, but that has not happened yet. I cannot predict whether ESMA will do that. There is no requirement in the legislation that ESMA should come up with its own UPI methodology, and the legislation is not restrictive either, so it could endorse an industry methodology such as the one ISDA has devised, or produce its own, or endorse that of somebody else.
Hobson: Can we expect whatever ESMA endorses to become the industry standard?
Tanner: Possibly. You have to recognise that there are bound to be other commercial codes out there that might also work, but which are not yet envisaged by EMIR. If some other major jurisdiction went down a different path, that could also become an industry standard. It is hard to say what might become the industry standard.
Hobson: Back-loading is a potentially large burden. How far do firms have to go back, and do you think it will prove to be problematic?
Tanner: When it comes to back-loading, there are two elements to consider. The important one is to recognise that, if one of the main purposes of EMIR is to help regulators understand people’s exposures, it is not sufficient to just get reports of new trades. You need to know what positions they have open already. The main purpose of back-loading is to enable the regulators to use the data in the way that was intended, which they could not do otherwise. The second, and more technical component, is that EMIR came into force on 16 August 2012 and, even though the reporting obligation did not start until 12 February 2014, everything executed since 16 August 2012 or open at that point is reportable. In fact, trades executed since 16 August 2012 have to be reported even if they are no longer an open transaction. For the various types of trade, depending on what their status is and when they were traded, the deadline for back-loading varies. For some, it is instantaneous. For others, it is up to three years into the future.It is therefore possible that we will still be getting back-loaded reports up to 12 February 2017. Exactly how long depends on how long ago it was traded, but it is tightly defined in the legislation. Some of those back-loaded reports had to be made by 13 February 2014. To help with that, some of the trade repositories allowed people to do their back-loading early. A lot of people took advantage of that, because it reduced the operational risk of reporting.
Hobson: You have to report collateral posted as well. Is that effective immediately?
Tanner: That does not start until six months after 12 February 2014. From that point onwards certain people – not everybody, it depends on your status – also have to report an up to date valuation of the contract, and how much collateral they have posted against their exposure. So that will start in August this year.
Hobson: What is the logic of including collateral in the reports?
Tanner: It is to understand the actual exposure. If all you know is the original trade, that does not tell you the exposure now. The value of the components changes over time. Getting the collateral information enables you to understand the net exposure. In principle, people might have to update their collateral reports every day, because the valuations are likely to change every day. The valuation may happen to be static for a particular contract but for most contracts it will change day by day. Therefore, you might expect that those people affected by this part of the legislation - essentially, financial counterparties and the largest non-financial counterparties, not the large number of corporates that have a relatively small derivatives portfolio - will be updating their reports every day.
Hobson: Regulators are going to receive a great deal of information. How confident are you that they will be able to make sense of it?
Tanner: Work to enable us to understand the information is well in hand, though I cannot speak for every regulator.Different regulators have different mandates, as defined in the legislation. The FCA is charged with checking that people are actually meeting the reporting obligation but will also use the data for other purposes as well. Anybody who is a prudential regulator – which we still are for lots of firms – will look at individual exposures. Regulators concerned with systemic risk will be looking at the inter-relationships between individual exposures. But that is just a sample of the various uses to which the data will be put.
Hobson: Will this data be made available publicly?
Tanner: In general no, for reasons of commercial confidentiality. However, the trade repositories are obliged to publish some high level summary data. That data will not allow anybody to identify anybody else, but it will provide high level summaries of the amount of business being written. When regulators use the data, for whatever purpose, anonymised summaries of that work may also find their way into the public domain.
Hobson: Would you regard it as helpful if the private sector had full access to the data and was able to analyse it as well?
Tanner: There is a question of confidentiality, obviously. The data is potentially quite sensitive. It is possible that some academic research could be done that makes use of the data, suitably anonymised, but that is outside our scope. I am not sure what rules would be set for that, but in general it would be quite hard to give the private sector access. EMIR lays down who can see the data, and for what purposes, and it does not include private sector access to non-anonymised data. On the whole, it is for regulators, and not for others.
Hobson: Were you surprised that the reconciliation processes between competing entities were insufficiently robust to avoid breaks? There have certainly been plenty of them since 12 February 2014.
Tanner: EMIR mandates a reconciliation process between the six trade repositories, precisely because people have a free choice as to which trade repository they use. Since there is two-sided reporting, the two parties to a trade could choose different repositories. Nevertheless, the repositories have to reconcile across each other to match the two sides up. Clearly, there will be breaks. But there are only two reasons why there can be breaks. The first, which is perfectly legitimate, is that although EMIR mandates two-sided reporting, there will be circumstances where only one side has to report. For example, if one side of the trade is a so-called “natural person” they do not have a reporting obligation. Or, if one of the parties to a trade is a non-European Union (EU) counterparty, they do not generally have an EMIR reporting obligation either. So one sided reporting is one reason why we will get reconciliation breaks. The second reason is that both sides reported, but each side reported something different. Clearly, we do not want too many of those. In those cases, the regulators will be looking to the counterparties concerned to work out why they disagree, and sort it out. So far, the rate of successful reconciliation appears to be lower than we would like. All of the parties involved (reporting firms, trade repositories and regulators) are analysing the data to try to understand the causes of this. Once they are identified, we can start to take action to address them and improve the reconciliation rate.
Hobson: How long are you giving regulated firms to reconcile breaks?
Tanner: EMIR does not lay down a timescale for the resolution of reconciliation breaks in the EMIR reports, though it does include guidance on dispute resolution, and lays down a timetable for confirmation of trades, so you could read across from those that reconciliation should follow a set timetable. We will certainly have a view, as a regulator, on the speed with which breaks are reconciled.
Hobson: Do you detect an appetite among regulated firms for greater harmonisation, or do they prefer the fragmentation of regulation?
Tanner: You would have to ask the firms that. Firms say different things in different contexts.