Article: EMIR and Non Financials. A "love to hate" relationship....

08 May 2013 | Maria Leontiou

A really good update by Herbert Smith Freehills LLP over at Lexology about EMIR and three areas of change that will mostly affect Non Financial counterparties and the way they use derivatives. Analysis is provided on clearing obligation , along with the thresholds and the hedging exemption, risk mitigation for non cleared trades and the reporting obligation. Check more details here. Maria L.


As previously mentioned, I don't believe there is a sound systemic risk rationale for exempting either corporates or sovereigns from bilateral margin, clearing or anything else (other than the effects of political lobbying). Exempts' OTC derivatives are a much bigger slice (maybe 30+%) of the net current and potential future counterparty exposures of banks than their open notionals (less than 10% of total notionals) might suggest. These counterparties today rarely put up initial margin and many sovereigns don't put up VM either when they are net out of the money. Thus they will be about 30% of the counterparty risk driven capital under Basel III and this percentage will increase over time as financial firms portfolios transition to being margined and/or cleared.Consequences include:- Disproportionate bilateral bank capital usage on a small fraction of OTC trading book- Aggregate imbalance in bank CCP facing risk given the exempt trade doesn't clear but the market risk hedge will clear causing CCP IM and default fund contribution and capital to be higher- Sovereign defaults / downgrades weigh even more heavily on banks.Possible outcomes:- Banks will likely seek ways to pass back the above additional capital costs to the exempt counterparties through trade pricing or other means or curtail trading with those counterparties leading to a loss of liquidity from the exempt participants perspective.- Exempts are incentivized to electively clear or put up bilateral initial margin anyway. Possible change:- It may make sense to keep the clearing exemption and simply include them in bilateral mandatory VM/IM rules.

I think these outcomes are very possible, although how much so for the second one depends on whether the uncleared bilateral margin rules are applied to corporates. The IOSCO paper is pushing against this so we will need to see what ESMA ends up implementing.