European Market Infrastructure Regulation | EMIR
What is the European Market Infrastructure Regulation?
European Market Infrastructure Regulation (EMIR) is a European Union regulation for over-the-counter (OTC) derivatives, central counterparties as well as trade repositories first introduced by the EU in 2012 in fulfilment of their commitment at the G20 summit, an international forum for the governments and central bank governors of the European Union and 19 other countries promoting international financial stability.
EMIR’s aim is to clear systemic, counterparty and operational risk whilst increasing transparency in the OTC derivatives market, having been designed to serve as a preventative measure to avoid fallout during future financial crises. In response to the 2008 global financial crisis, where the negligence, exploitation, and excessive risk-taking of banks led to a global financial collapse, resulting in extreme financial hardship for people around the world.
Eventually, this caused the US housing bubble to burst, resulting in the values of securities tied to US real estate plummeting, significantly damaging the global economy. This downward spiral was epitomised by the Lehman Brothers (the fourth-largest US investment bank at the time) filing for bankruptcy – showing that no company is too big to fail. This series of events sparked the Great Recession – the most severe global recession since the Great Depression of the 1930s.
How to fulfil the EMIR requirements?
The execution of EMIR is a responsibility of the European Securities and Markets Authority. EMIR establishes common rules for central counterparties, insinuating between parties in a contract to serve as a focal point of each trade, as well as trade repositories which gather and preserve all records of trades. The regulation demands reporting of all derivatives to a trade repository, whether OTC or exchange traded. Covering entities that meet the requirements of derivative contracts in regards to equity, foreign exchange, interest rates, or credit and commodity derivatives. Whilst outlining three sets of obligations, including the clearing, reporting and risk mitigation of applicable products. EMIR’s set of obligations were designed to take effect within phases over a number of years.
The European Securities and Markets Authority (ESMA) applies mandatory clearing obligations for certain over-the-counter derivative contracts if a contract has been assigned a central counterparty under EMIR. The obligation calls for OTC derivatives trades to be cleared through central counterparties. The only current temporary exemption being pension funds, which will be reviewed 18th of June 2021.
All parties involved in trades must inform of approaching, exceeding and no longer exceeding the clearing threshold as defined by EMIR. This regulation applies to financial counterparties such as banks, insurers, asset managers and non-financial counterparties.
It’s demanded by EMIT that all entities entering into derivative contracts have to submit reports to their corresponding trade repositories, outlining every OTC trade. These reports will also need to include a Unique Transaction Identifier (UTI), legal entity identifier (LEI), information on the trading capacity of the counterparty, and the marked-to-market valuation of the position. The reports of counterparty data enconpass 26 fields for data and the common data includes 59 fields of data. Containing an LEI – a unique 20 digit alphanumeric code that may be used for eight of the 26 counterparty data fields, as well as a unique trade identifier, that are generated based on the report’s LEI.
In order to deliver EMIR obligations in the area of reporting, the Legal Entity Identifier (LEI) is required.
One of EMIR’s central purposes is to steer clear from and avoid systemic risk (collapse of an entire financial system or entire market). In part with other similar legislation the focus is to reduce systemic risk by increasing regulations on clearing and trading, which decreases returns (profits of an investment) and industry efforts. The risk mitigation regime includes contracts involving both EU, and OTC derivative contracts involving third country entities. Some of the risk mitigation techniques involve urging against front-loading (assigning costs or benefits to the early stages) OTC derivatives, or applying any associated fees to sellers alone. As these procedures typically increase systemic risk.
Second risk mitigation tactic defined by EMIR includes timely submission of reports and confirmations of adherence to regulation by all counterparties, and open reconciliation and compression of portfolios (collection of investments) between parties. There’s also a new dispute settlement process, daily market reports and exchanges and the public exchange of guaranty between parties.