OTC derivatives and EMIR

Just like options, swaps and futures in general, OTC derivatives are also financial derivatives. OTC derivatives are the abbreviation for over-the-counter.

Significant for OTC derivatives is the fact that they are only traded over-the-counter. But it is not only OTC trading that distinguishes OTC derivatives. OTC derivatives are not only characterised by inconsistent termination clauses, but also by widely varying collateral and service descriptions.

Due to these circumstances, OTC derivatives are characterised by an exceptional lack of transparency. To prevent systemic risks, the so-called EMIR Directive was introduced.

What exactly does EMIR mean and how does it affect OTC derivatives?

The major financial market crisis of 2008 led to numerous new regulations to make the financial market more transparent and safer for investors.

At the G20 summit in Pittsburgh in 2009, the Heads of State and Government decided to make trading in OTC derivatives (over-the-counter) more transparent and thus also less risky.

The European Market Infrastructure Regulation (EMIR)

The main stipulation of the European Market Infrastructure Regulation was that all standardised OTC derivatives must not only be transmitted to so-called transaction registers but also that trading in OTC derivatives must be settled via central counterparties. EMIR came into force in August 2012 to implement these objectives and create a uniform framework for central counterparties.

Since only sufficiently liquid and standardised derivative transactions are economically suitable for central clearing, both contracting parties must comply with extremely high requirements. This must be done concerning operational risk management when trading OTC derivatives if they are not subject to the central clearing obligation.

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Who is affected by EMIR?

Parties engaged in derivatives transactions and, logically, OTC derivatives trading, are subject to the requirements set out in the EU Regulation. It is important to take note that some conditions apply regardless of whether a company provides financial services or not. The EU Regulation makes a thorough distinction between financial and non-financial counter-parties.

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Financial and non-financial counter-parties

The EU Regulation makes a thorough distinction between two types of counterparties: financial and non-financial. Financial counterparties under EMIR are all authorised reinsurance undertakings, authorised insurance undertakings, authorised investment firms, alternative investment funds (if authorised or managed by registered managers of alternative investment funds), authorised management companies (where applicable) and also authorised UCITS and institutions for occupational retirement provision.

All other undertakings which do not fall within this field must be regarded as non-financial counterparties within the definition of EMIR.

EMIR at a glance

In brief, EMIR regulates the following matters:

  • If a larger number of derivatives or OTC derivatives are used, non-financial counterparties are also subject to the clearing obligation.
  • If due to their structure, transactions are not intended for central clearing, the parties are subject to special requirements about risk management.
  • There is also a clearing obligation for all standardised OTC derivatives. Financial counterparties subject to the supervision of the European Union are affected by the clearing obligation.
  • Derivatives transactions must be reported to a trade repository. This should help to increase transparency. In addition, EMIR regulates the conditions necessary for authorisation as a central counterparty and also assumes ongoing supervision. The aim is also to strengthen cooperation between the supervisory authorities.

Emir and new regulations regarding OTC derivatives

The financial crisis has made it clear that OTC trading, i.e. over-the-counter OTC trading, is not sufficiently hedged. Especially concerning default risk swaps. The big goal is to counteract these risks. EMIR, which came into force in August 2012 as already mentioned above, shows that the effort to contain the risk is already on the right track.

Nevertheless, further regulation of OTC derivatives trading is needed to create transparency and security.

On 12.7.2013 the EU Commission issued a Delegated Regulation. The Regulation sets fees to be invoiced to ESMA’s trade repositories.

Also on 12.7.2013, a further regulation was issued to add the public sector bodies and central banks responsible for public debt management in the United States and Japan to the list of EMIR Article 1(4) exempted entities.

It is also clear that the EU Commission will also closely monitor developments in all other G20 countries. The focus of the observation is the determination of the legal regulations for OTC derivatives in these countries.

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