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The EMIR Delusion


Under EMIR, parties to OTC derivative transactions are classified as either:

  • financial counterparties (“FC”);
  • non-financial counterparties which have exceeded the clearing threshold (“NFC+”); or
  • non-financial counterparties which have not exceeded the clearing threshold (“NFC-”).

Whilst primarily used to determine whether a counterparty is subject to the obligation to clear, in reality a number of different EMIR requirements can apply depending on the exact counterparty classification.  This poses few practical problems with respect to the sell-side as the definition of “financial counterparty” is relatively static in nature.  However, classification as an NFC+ or NFC- is a function of the gross notional value of derivatives contracts executed by the party in question and so is liable to change over time.  Unfortunately, the impact of the consequences that flow from this fact are not restricted to the non-dealer community, highlighting the fact that understanding, confirming and monitoring of counterparty classification represents the first step in ensuring general EMIR compliance for both buy-side and sell-side firms – a step which many firms are yet to take.

EMIR Current Status

EMIR came into force on 16 August 2012.  However, the regulation is, in part, an example of enabling legislation in which many of the detailed provisions are published in secondary legislation (in the form of regulatory technical standards (RTS) and implementing technical standards).  As a result, many EMIR obligations – including those relating to reporting and clearing (generally regarded as the main focus of EMIR) – do not yet apply.  Current estimates suggest that the EMIR reporting requirement is unlikely to take effect before 23 September 2013 (and then only with respect to interest rate derivatives and credit derivatives) and the first clearing of trades under EMIR is unlikely to occur before Q1/Q2 2014.  Nonetheless, this should not be taken to mean that aspects of EMIR do not currently impact market participants or that planning for its implementation can be delayed.  In reality, a number of EMIR provisions which require an understanding of counterparty classification are already in force and more are looming on the horizon, as detailed below.

EMIR Provisions Already in Force

EMIR Counterparty Classification Reporting

Under Article 10(1) of EMIR, from 15 March 2013, all non-financial counterparties (i.e. both NFC+ and NFC-) that enter into OTC derivatives contracts that exceed the clearing threshold must notify their competent authority.  In practice, regulators such as the Financial Conduct Authority (FCA) require non-financial counterparties to notify both when they exceed, and no longer exceed, the clearing threshold.

Timely Confirmation Requirements

Under Article 11(1)(a) of EMIR, from 15 March 2013, FCs, NFCs+ and NFCs- have been required to put in place documented policies and procedures with their counterparties to facilitate the confirmation of non-cleared OTC derivative contracts within specified deadlines.  The exact deadlines are a function of transaction type, the date upon which the transaction was executed, but also counterparty classification.

Unconfirmed Transaction Reporting

Under Article 12(4) of the “Risk Mitigation RTS”[1], from 15 March 2013, FCs are required to establish procedures to report, on a monthly basis, the number of unconfirmed OTC derivative transactions that have been outstanding for more than five business days.  Whether a transaction has been unconfirmed for more than five business days depends on when it should have originally been confirmed, itself a function of counterparty classification.

Upcoming EMIR Obligations

Portfolio Reconciliation

Under Article 11(1)(b) of EMIR, from 15 September 2013, counterparties to OTC derivatives transactions are required to establish “formalised…robust, resilient and auditable” processes in order to facilitate portfolio reconciliation.  Furthermore, pursuant to Article 13 of the Risk Mitigation RTS, the frequency with which any reconciliation must be performed is again a function of counterparty classification.

The Reporting Obligation

Under the RTS dealing with trade reporting[2], a number of the data points to be reported to trade repositories (as detailed in Table 1 of the Annex to the RTS) are a function of EMIR counterparty classification.  For example, in reporting the “Financial or non-financial nature of the counterparty”, parties to OTC derivatives transactions are required to distinguish between FC and NFC status.  Additionally, in reporting against the “Clearing threshold” field, counterparties are required to further distinguish between NFC+ and NFC- status.  Finally, NFCs- are not subject to the requirement to report collateral, mark to market, or mark to model valuations, an exemption which implies an understanding of whether the reporting party actually has NFC- status.

The EMIR Delusion

Anecdotal and empirical evidence would suggest that the market is currently doing very little in the way of understanding, confirming or monitoring EMIR counterparty classifications.  As of 14 May 2013, only seven entities had adhered to the ISDA 2013 NFC Representation Protocol, the purpose of which is to enable parties to amend ISDA Master Agreements to reflect their status under EMIR as FCs, NFC+ or NFC-.  Moreover, the alternative solution offered by the British Bankers’ Association seems yet to have been adopted to any material extent by the dealer community.  Although there is some encouraging talk within the market regarding the creation of a central database to house EMIR counterparty classification data, by its very nature, this will take a significant amount of time to develop and will face many legal and logistical hurdles along the way.

The current situation will not be allowed to persist for much longer.  Buy-side firms cannot simply avoid the issue or expect dealers to ride to the rescue.  As per the ESMA EMIR Questions and Answers[3] document, from 15 March 2013, NFCs which trade OTC derivatives have been obliged to determine their own status against the clearing threshold and notify their National Competent Authority accordingly.  This can only be right given that the clearing threshold is calculated by reference to the total gross notional value of OTC derivatives executed by a party (calculated on a 30-day rolling average basis) – a metric that, in almost all circumstances, will be available only to the party in question and not to any single dealer.

For their part, sell-side firms must avoid the misconception that EMIR counterparty classification is entirely the responsibility of clients, that counterparty classification information will simply fall into their laps or that there is currently nothing that needs to be done once this information is acquired.  The ESMA EMIR Questions and Answer document makes clear[4] that dealers must obtain representations from their counterparties as to EMIR status.  Once obtained, these may be relied upon unless the dealer is in possession of information which clearly demonstrates that they are incorrect.  This implies both a requirement to make contact with clients for the purposes of initial classification and the establishment of a process to monitor continuing accuracy of EMIR status.

Once obtained, robust procedures will be necessary in order to govern the maintenance and use of counterparty classification data.  In reality, it is likely that much of the obligation to report will be delegated, either to dealers or to third parties.   As a consequence of this, the reporting party will understandably require trade counterparties to accurately reflect their EMIR status at all times.  Moreover, the limits on the extent to which dealers can rely on client representations regarding EMIR classification implies a change of process in order to mitigate risk in this area.  Similarly, changes in process will be required in order to comply with unconfirmed transaction reporting requirements, as even those regulators (such as the FCA) which do not require FCs to submit information unless requested, still require firms to have procedures in place to do so when requested.  Timely confirmation and Portfolio Reconciliation requirements promise to go even further, requiring firms to apply counterparty classifications (and recognising that these classifications may be subject to change) in the context of executing potentially large-scale amendments to portfolios of derivative documentation.

Both FCs and NFCs need to act now in relation to client classification.  The nature and impact of the EMIR obligations which reference client classification should be fully scoped.  A remediation plan which makes realistic assumptions about the level of resource and timeframes required in order to implement change should follow.  The process is unlikely to be quick or easy.  However, the current situation will not continue for much longer and any firm that can show its regulator that it is making efforts to tackle the issue of EMIR compliance generally and counterparty classification specifically is likely to be in a much better position that those who continue to operate under the EMIR delusion.


[1] Regulatory Technical Standard on “indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP” (Commission Delegated Regulation (EU) No 149/2013)

[2] Regulatory Technical Standard on “minimum details of the data to be reported to trade repositories” (Commission Delegated Regulation (EU) No 148/2013)

[3] See “OTC Answer 2” and “OTC Answer 4”

[4] See “OTC Answer 4”

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