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Defining the Clearing Threshold for Non-Financial Counterparties Under EMIR

On 31 July 2012, the European Systemic Risk Board (“ESRB”) submitted advice to the European Securities and Markets Authority (“ESMA”) on aspects of the draft regulatory technical standards (“RTS”) that ESMA is required to submit to the EU Commission under Article 10(4) of EMIR regarding:

  • criteria for establishing which OTC derivative contracts are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity referred to in Article 10(3) of EMIR; and
  • values of the clearing threshold above which non-financial counterparties (“NFCs”) will be obliged to clear their OTC derivative contracts through CCPs.

Definition of “commercial and treasury financing activities”

Commercial Activities

The ESRB believes that the concept of “commercial activities” should refer to specific core business items which appear on the balance sheet of a NFC, namely:

  • stocks;
  • payables;
  • receivables;
  • property;
  • plant; and
  • equipment.

According to the ESRB, the maximum level of derivatives linked to the commercial activities of a NFC should be the carrying amount of each of the above items, as specified in the NFC’s balance sheet.

Treasury Financing Activities

The ESRB believes that treasury financing activities should be defined using the cash flow statement of the NFC and should be limited to the cash flows from the financing activities of the NFC generated during the relevant year.

Clearing Threshold

The ESRB states that any definition of a clearing threshold should ensure that:

  • the integrity of the market is defended and transparency ensured, meaning that:
    • the maximum possible percentage of overall non-financial derivative transactions should be centrally cleared, and
    • all corporations which are exposed to derivative activities at a given proportion of their overall balance sheet are treated equally, whatever their size; and
  • the total amount of derivatives held by a NFC, irrespective of their intended use, should be appropriately reflected in the basis of the clearing threshold calculation.

The ESRB believes that clearing thresholds should be low initially, with the possibility of increasing them later if appropriate.  The calculation itself should be performed on a fixed frequency which can be increased in times of financial crisis, although the ESRB does not mention a specific frequency within its advice.  However, it does recognise that a balance should be struck between the complexity of the calculation of the clearing threshold and the mitigation of risks arising from OTC derivatives.

Clearing thresholds should not be defined as specific counterparty limits.  Rather, they should be defined with reference to the gross market value (and not the notional value) of the following classes of OTC derivative:

  • credit derivatives
  • equity derivatives
  • interest rate derivatives
  • foreign exchange derivatives
  • commodity derivatives; and
  • other derivatives.

In light of these policy goals, the ESRB proposes calculating thresholds using a two-step process.  This process is defined in broad terms below.  Please see the schedule to this article for further detail.

Step 1: Allocation

Firstly, each NFC will be placed into a bucket according to the amount which the gross market value of its derivatives represents as a proportion of its capital and reserves.

Step 2: Calculation of Applicable Threshold

NFCs with derivatives that exceed 3% of their capital and reserves

Broadly speaking, an NFC in this bucket will trigger a requirement to clear if the gross market value of its ‘non-hedging’ derivatives as a proportion of the global market value of derivatives (assessed on a per asset class basis and as published by the Bank for International Settlements (“BIS”)) exceeds a limit ranging between 0.00084% (in the case of credit derivatives) to 0.00134% (in the case of foreign exchange derivatives).  In addition, as an absolute amount, the value of the ‘non-hedging’ derivatives held by the NFC (as calculated on a per asset basis) is to be limited.  This limit ranges from EUR 7 million (in the case of equity derivatives) to EUR 151 million (in the case of interest rate derivatives).

NFCs with derivatives that do not exceed 3% of their capital and reserves

NFCs falling into this category are subject to the same assessment as NFCs with derivatives that exceed 3% of their capital and reserves.  However, the limit before which the clearing threshold is triggered is approximately 3 times higher than was previously the case.

SCHEDULE

The flow-chart accesible via the link below details the ESRB’s proposed process to be followed in determining whether a NFC is subject to the clearing obligation:

ESRB Advice to ESMA

where:

“CR” is the carrying amount of the capital and reserves of the NFC;

“GMVCD” is the gross market value, per class of OTC derivatives, for all counterparts reported on a global basis in the BIS database on OTC derivative market statistics;

“NCNTFD” is the gross market value of the non-commercial or non-treasury financing derivatives held by the NFC;

“TD” is the gross market value of all the derivatives held by the NFC; and

The values of ε , ε’, γ and γ’ are determined by reference to the following table:

Class of OTC Derivative

ε

ε’

       γ

γ’

Credit Derivatives

8.4

EUR 13,000,000

25.2

EUR 39,000,000

Equity Derivatives

9.4

EUR 7,000,000

28.2

EUR 20,000,000

Interest Rate Derivatives

12.4

EUR 151,000,000

37.2

EUR 453,000,000

Foreign Exchange Derivatives

13.4

EUR 31,000,000

40.2

EUR 92,000,000

Commodity Derivatives

9.4

EUR 16,000,000

28.2

EUR 48,000,000

Other Derivatives

9.4

EUR 16,000,000

28.2

EUR 48,000,000

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