The European market infrastructure regulation (EMIR)
A derivative is a financial contract linked to the fluctuation in the price of an underlying asset or a basket of assets. Common examples of assets on which a derivative contract can be written are interest rates instruments, equities or commodities.
An over-the-counter (OTC) derivative is one which is privately negotiated and not traded on an exchange.
OTC derivatives account for almost 95% of the derivatives markets. They have a significant impact on the real economy, from mortgages to food prices.
Central clearing counterparties (CCPs)
CCPs interpose themselves between counterparties to a derivative contract, becoming the buyer to every seller and the seller to every buyer. In doing so, CCPs become the focal point for derivative transactions thus increasing market transparency and reducing the risks inherent in derivatives markets.
Every day CCPs clear thousands of financial transactions in a range of financial instruments including
Before the financial crisis, derivatives traded outside regulated markets were usually not cleared through CCPs.
Trade repositories (TRs) are central data centres which collect and maintain the records of derivatives. They play a key role in enhancing the transparency of derivative markets and reducing risks to financial stability.
EU rules on derivatives contracts
Derivatives play an important role in the economy, but they also bring certain risks. These risks were highlighted during the 2008 financial crisis, when significant weaknesses in the OTC derivatives markets became evident. In 2012 the EU adopted the European market infrastructure regulation (EMIR). The aims were to
- increase transparency in the OTC derivatives markets
- mitigate credit risk
- reduce operational risk
EMIR introduces reporting requirements to make derivatives markets more transparent. Under the regulation
- detailed information on each derivative contract has to be reported to trade repositories and made available to supervisory authorities
- trade repositories have to publish aggregate positions by class of derivatives, for both OTC and listed derivatives
- the European Securities and Markets Authority (ESMA) is responsible for surveillance of trade repositories and for granting and withdrawing accreditation
Mitigating credit risk
EMIR introduces rules to reduce the counterparty credit risk of derivatives contracts. In particular
- all standardised OTC derivatives contracts must be centrally cleared through CCPs
- if a contract is not cleared by a CCP, risk mitigation techniques must be applied
- CCPs must comply with stringent prudential, organisational and conduct of business requirements
Reducing operational risk
The regulation also requires market participants to monitor and mitigate the operational risks associated with trade in derivatives such as fraud and human error, for example by using electronic means to promptly confirm the terms of OTC derivatives contracts.
Equivalence decisions under EMIR
EMIR provides a mechanism for recognising CCPs and trade repositories based outside of the EU. Once recognised, EU and non-EU counterparties may use a non EU-based CCP to meet their clearing obligations and a non EU-based trade repository to report their transactions to.
The recognition is based on equivalence decisions adopted by the Commission. These decisions confirm that the legal and supervisory framework for CCPs or trade repositories of a certain country is equivalent to the EU regime.
A CCP or trade repository established in this country can then apply to obtain EU recognition from ESMA. Once recognition has been granted, the CCP or trade repository can be used by market participants to clear OTC derivatives or report transactions as required by EMIR.
In addition to the equivalence of CCPs and trade repositories, the Commission can also develop equivalence decisions for other areas of EMIR, such as reporting, margins for uncleared derivatives and risk mitigation techniques, and non-EU trading venues.