FRONT ARENA

WHITE PAPER SERIESWHAT SHOULD YOU DO ABOUT THE EUROPEAN MARKET INFRASTRUCTURE REGULATION (EMIR)?

Tim DoddHead of product management, Front Arena, in SunGard’s capital markets business

4 What should you do about the European Market Infrastructure Regulation (EMIR)

On March 28, 2012 the European Parliament voted through the European Markets and Infrastructure Regulation (EMIR) following months of negotiations between the European Council and Commission. More lobbying from market participants will take place behind the scenes before the regulations are fi nalized but the Parliament vote is an important milestone in Europe’s quest to reform the over-the-counter (OTC) derivatives market.

Many of the actions taken by market participants so far have focused on the obvious, the pragmatic and the sensible – in other words, participants have so far done what they had to do or what they have deemed to be good for their business.

But there will be much more activity in the coming months despite the fact that the regulations have yet to be fi nalized. Work will focus on the system changes, upgrades and implementations needed to adapt to the new trading environment that will result from EMIR and other like-minded regulations.

What is EMIR?

At the end of 2009, the G20 leaders expressed the need to regulate the over-the-counter derivatives market:

The US regulators responded with parts of the Dodd-Frank Act. Meanwhile the European Parliament drew up the European Market Infrastructure Regulation (EMIR). However, to call EMIR Europe’s version of Dodd-Frank would not be wholly accurate as there are some notable differences.

EMIR’s main focus is on reporting and transparency for OTC derivatives transactions to drive down credit risk.

The main thrust is that all OTC derivatives transactions should be reported to a trade repository which will enable regulators to access data on the various counterparties in the market that are transacting away from exchanges or central counterparties (CCP’s). This will require the involvement of several supernational bodies to collate, store and provide this information to the various national regulators. Like Dodd-Frank, CCPs will be used to standardize much of the clearing of OTC derivatives.

However, for derivatives, the main variation is that EMIR does not address execution where the use of CCPs is mandated. In the US, any OTC derivatives that are centrally cleared will need to be transacted on a swaps execution facility (SEF). The European equivalent of that is an organized trading facility (OTF) – where you can set up a regulated market. This will be covered within MiFID II.

Even though it is smaller in scope than Dodd-Frank, we believe that, in practise, EMIR will be harder to implement consistently across the many nations in Europe.

All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.

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What has already been decided?

We have seen published drafts and are currently in the lobbying phase of the legislation. What is already known is that market participants will report to Triana for OTC interest rate derivatives and to the DTCC for credit derivatives. But in terms of central clearing, there are still things to be done. A redraft is scheduled for July 31 and the fi nalized rules are due to be implemented on November 31. This is an extremely short timeline given both the magnitude of the proposed changes and the controversy around them.

This timeline does, however, signal the regulators’ resolve and their intention not be overly swayed by the lobbying of the various interested parties: investment banks, high frequency traders and more long term investors. If the passage of Dodd Frank is anything to go by, there are likely to be exclusions and delays before EMIR is passed into practice.

What is controversial?

There are fi ve things that are not yet clear and, consequently, are open to controversy.

Interoperability: The wish to create a harmonized, pan-European securities market has underlined all of the European Union’s regulations in the last decade and EMIR is likely to further intensify the push for interoperability between the various CCPs and OTFs that will be established. This is the strongest push for interoperability across European institutions.

Nevertheless, interoperability across the various EU markets is a far more complex task than in the US market where there is generally one national clearing body for each asset class as opposed to the 40 or more operating in Europe for equities alone!

If interoperability in Europe is going to be achieved, it will require the market to decide on, for example, a single messaging standard and a single contingency process if one CCP should go down, enabling fi rms to move their assets to an alternative venue.

Even simply setting up a bilateral process for trading derivatives requires legal agreements and new workfl ow and it is no small task.

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6 What should you do about the European Market Infrastructure Regulation (EMIR)

Thresholds: The threshold for centrally clearing OTC derivatives, under which fi rms would not be required to use CCPs, is an area of debate at present. The original threshold was set at €50 million in exposures. However this has subsequently been increased substantially to €8 billion. The mandating of central clearing will be a considerable expense to those fi rms those fi rms that are larger than the stated threshold. New software will be required, more paperwork will be generated and new workfl ow will be needed to ensure central clearing operates smoothly.

Moving of the threshold has led to further lobbying and ‘noise’ before the regulations are fi nalized, especially from buy-side fi rms or non-fi nancial institutions that still remain above the threshold. A compromise is likely to materialize that enables these participants to use a sell-side counterpart to centrally clear on their behalf, therefore saving on the considerable cost of establishing their own central clearing capability.

The US and Dodd-Frank: Any market participant with trading interests in the US will have to comply with Dodd-Frank and execute on SEFs for any US-based OTC derivative transactions so for these fi rms there is already a process underway. But Dodd-Frank is a more onerous mandate for fi rms, creating an extra burden for fi rms with a US interest as opposed to those solely focused on European business. This creates an extra burden as EMIR progresses to ensure that the two regulations are at least compatible.

Margins: Margin calculations for many OTC derivatives is an opaque process. It is diffi cult to price the risk in a closed form, there are numerous variations and margins are not dictated by the regulations so there is no easy consistency between the various margins. This leads to acceptance of complex calculations by participants or the expense of matching those calculations to the best of a fi rm’s abilities.

More established clearing houses are generally able to offer a service for netting margins between exchange-traded and OTC derivatives. This puts them at a signifi cant advantage as running VaR calculations across larger portfolios can reduce margin. For participants this is an even harder calculation.

The cost of margin and the cost of checking margins are added expense to doing business in these derivatives, making them more expensive (and thus less attractive) to those who have a genuine hedging need to use them.

FX transactions: For the record, central clearing for FX transactions was originally considered for inclusion within EMIR but has subsequently been excluded due to the high volume of transactions that would be involved and the existing effectiveness of Continuous Linked Settlement (CLS) as a means to lessen settlement risk.

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How has the market responded?

Market participants are spending money on EMIR-related activity despite the fact that the regulations have not been fi nalized. The vast majority of the market is doing what is obvious (such as reporting) and what is good for their business (dealing with Dodd-Frank for any US counterparties or divisions). It is one thing to have the necessary paperwork in order to pursue compliance, however there are more proactive steps that can be taken to achieve some commercial advantages.

For example, broker dealers can set up enhanced APIs to their clients that are fully stress-tested to receive entire counterparties positions from another clearer; clearers can set themselves up to be CCPs in the new world; dealers can apply for single-dealer SEF/OTF status and start to build their own approved OTFs.

Whatever happens, participants do need to adapt to the new world where there will be electronic transaction venues for OTC derivatives. Whether quote-driven exchanges like venues or request-for-quote-driven automated broker venues have the necessary connections will be vital for participation.

Some providers have already developed services for this task and the connectivity issue in general offers great commercial incentives to trading system providers.

What answers does Front Arena provide in this undefi ned future?

As we have already observed, there are essentially three areas that any derivatives dealing platforms must address under EMIR and MiFID II (and Dodd-Frank): electronic trading, central and bilateral clearing and reporting.

SunGard Front Arena is an OTC derivatives trading and clearing platform that has always had electronic market making in swaps and derivatives and a bilateral clearing capability. It has also gone beyond these and now provides direct connections and workfl ows for electronic swap and derivatives transactions and effective workfl ow for both bilateral and central clearing.

Front Arena is an OTC derivatives trading and clearing platform that is ready to provide whatever the fi nal regulations will bring.

ABOUT THE AUTHOR

Tim Dodd has been head of product management for SunGard’s Front Arena for the last fi ve years. He has extensive experience in trading and risk management as well as software design, product management and customer services. Starting with SunGard more than twelve years ago, he initially held the position of head of professional services in London with responsibility for European-wide project management for SunGard’s Panorama. He then became product manager for equities, followed by Panorama and Adaptiv Trading before being put in charge of Front Arena product strategy. Tim’s diverse background gives him a deep understanding of the needs of trading organizations, and an appreciation for the complexities of cross-asset trading from front-offi ce through risk management to operations.

Tim would value any feedback at tim.dodd@sungard.com.

©2012 SunGard.Trademark Information: SunGard, the SunGard and Front Arena are trademarks or registered trademarks of SunGard Data Systems Inc. or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders.

About Front Arena

SunGard’s Front Arena is a global capital markets solution that delivers electronic trading and position control across multiple asset classes and business lines. Integrating sales and distribution, trading and risk management, and settlement and accounting, Front Arena helps capital markets businesses around the world improve performance, transparency and automation.

About SunGard

SunGard is one of the world’s leading software and technology services companies. SunGard has more than 20,000 employees and serves 25,000 customers in 70 countries. SunGard provides software and processing solutions for fi nancial services, higher education and the public sector. SunGard also provides disaster recovery services, managed IT services, information availability consulting services and business continuity management software. With annual revenue exceeding $5 billion, SunGard is ranked 435 on the Fortune 500 and is the largest privately held business software and IT services company.

For more information, please visit: www.sungard.com/frontarena

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