EMIR - Which risk-mitigation techniques are obligatory?

What are risk-mitigation techniques?

Article 11 of EMIR stipulates that financial counterparties and non-financial counterparties concluding OTC derivative contracts not cleared by a CCP must ensure that they have appropriate procedures and rules in place to measure, monitor and limit operational risks and counterparty risks.

Which risk-mitigation techniques are obligatory?

Article 11 of EMIR in conjunction with Chapter VIII of RTS 149/2013 state the risk-mitigation techniques for non-centrally cleared OTC derivatives. You can find an overview of these techniques and a brief explanation below.

(Note that this only applies to non-centrally cleared OTC derivatives)

The conditions governing the OTC derivative contract must be confirmed in good time ('timely confirmation')

The parties to OTC derivative contracts must confirm the transaction as soon as possible in order to ensure their mutual legal position. This also applies to more complex OTC derivative contracts. See also preamble 27 of RTS 149/2013.

Under Article 11 of EMIR, the parties are required to confirm the conditions governing OTC derivative contracts by electronic means, insofar this is possible. This obligation became effective on 15 March 2013. Article 1 of RTS 149/2013 states that "confirmation" means the documentation of the counterparties' agreement to all the terms of the specified OTC derivative contract. The agreement is confirmed upon the execution of the transaction.

Article 12 of RTS 149/2013 lays down the time limits within which the various classes of OTC derivatives must be confirmed.

Portfolio reconciliation

Portfolio reconciliation is also part of the mandatory risk-mitigating techniques to be applied to non-centrally cleared OTC derivative transactions. It allows the parties involved in non-centrally cleared OTC derivatives contracts to verify whether the counterparty interprets the terms and conditions governing the contract in the same way, based on a portfolio of transactions with that counterparty. Not only does this concern key transaction terms such as valuation, but also termination dates, payment dates, clearing dates, nominal value, currency, underlying value, and fixed and floating interest rates. See also preambles 28 and 29 and Article 13 of RTS 149/2013. Article 13 also stipulates the reconciliation schedule, depending on the number of outstanding contracts between the parties and the types of parties involved (financial or non-financial counterparties). The requirements relating to portfolio reconciliation have been in effect since 15 September 2013.

Portfolio compression

As part of the risk-mitigating techniques, financial and non-financial counterparties with 500 or more non-centrally cleared OTC derivative contracts outstanding with the same counterparty must have procedures in place to analyse, on a regular basis and at least twice a year, the possibility of portfolio compression, and to perform such portfolio compression if possible. The aim of portfolio compression is to reduce counterparty credit risk. Counterparties must be able to provide a reasonable and valid explanation to the relevant competent authority if they decide not to perform portfolio compression. See Article 14 of RTS 149/2013. The requirements relating to portfolio compression have been in effect since 15 September 2013.

Procedure for dispute resolution

Article 15 of RTS 149/2013 stipulates that financial and non-financial counterparties must agree on procedures and processes to identify, record and monitor disputes at an early stage. They must resolve disputes promptly and must have specific procedures in place for disputes that are not resolved within five business days. This obligation became effective on 15 September 2013.

Mark-to-market valuation

As part of the required risk-mitigating techniques, financial counterparties and specific non-financial counterparties must mark their outstanding contracts to market daily. This obligation became effective on 15 March 2013. If market conditions make mark-to-market valuation impossible, the transaction parties must make a reliable and prudent valuation based on a model approach (mark-to-model valuation). Article 16 of RTS 149/2013 lists the market conditions that prevent mark-to-market valuation, e.g. when the market is inactive. A market for OTC derivative contracts is considered inactive if quoted prices are not readily and regularly available and the prices available do not represent actual and regularly occurring market transactions on an arm’s length basis. Article 17 of RTS 149/2013 lists the criteria which mark-to-model valuations must meet, including the requirement that models must be validated and monitored independently, by another division than the division taking the risk.

Appropriate exchange of collateral and capital funding

As part of the risk-mitigating techniques, bilateral margining has been made compulsory for financial counterparties in relation to OTC derivative contracts concluded on or after 16 August 2012. This obligation also applies to non-financial counterparties (see Article 11 of EMIR for further details). No RTS have as yet been adopted for this technique. ESMA has put up draft RTS for consultation, however, based on recommendations by BCBS, IOSCO and the BIS. Under Article 11(4) of EMIR, financial counterparties must hold an appropriate and proportionate amount of capital to manage risks not covered by appropriate exchange of collateral. Specific RTS will be drafted for this technique (see Article 11(15), under b, of EMIR).

Exemption for intragroup transactions

As part of the required risk-mitigating techniques, counterparties must ensure appropriate exchange of collateral for non-centrally cleared OTC derivative contracts. This requirement does not apply to intragroup transactions as meant in Article 3 of EMIR, provided specific conditions are met. See Article 11 (5-10) of EMIR for further details. The requirement for appropriate exchange of collateral does not apply if:

• a financial counterparty concludes OTC derivative contracts with another counterparty belonging to the same group (as defined in EMIR);
• the conditions under Article 3(2), under a, under i)-iv) of EMIR are met;
• the counterparties have their registered offices in the same Member State.

In addition, there must be no practical or legal obstacles between these parties that could impede immediate transfer of own funds or repayment of liabilities between them.

Notification of unconfirmed trades to DNB

Since 15 March 2013, Banks, insurers, reinsurers, pension funds and premium pension institutions have been required to have procedures in place allowing them to notify DNB on a monthly basis of the number of unconfirmed OTC derivative transactions outstanding more than five business days (from the moment these transactions should have been confirmed pursuant to EMIR). Please note that this only relates to non-centrally cleared OTC derivative transactions. You can find the notification form for unconfirmed trades below. You must notify us within ten business days of the end of the month in question. Please send the completed form by regular mail to DNB, PO Box 98, 1000 AB Amsterdam, stating the name of your DNB contact or examining officer. You can also email the form to us at: toezichtsloket@dnb.nl You can find more information on secure emailing on our website.

Notification of disputes to DNB

Since 15 September 2013, banks, insurers, reinsurers, pension funds and premium pension institutions have been required to DNB of disputes with counterparties about OTC derivative contracts, the valuation of such contracts, or the exchange of collateral. This concerns disputes representing a minimum value of EUR 15 million, which have not been resolved within fifteen business days. Please note that this only relates to disputes relating to non-centrally cleared OTC derivative transactions.

You can find the notification form for disputes below. Please send the completed form by regular mail to DNB, PO Box 98, 1000 AB Amsterdam, stating the name of your DNB contact or examining officer. You can also email the form to us at: toezichtsloket@dnb.nl You can find more information on secure emailing on our website.