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Derivative transparency rules an 'increasing challenge' for asset managers

28 October 2019

Mirroring MiFID II compliance struggle

The European Market Infrastructure Regulation (EMIR) was introduced to increase transparency in the derivatives market, against a wider backdrop of regulatory change.

 

So far, however, reporting quality has been low as firms are still grappling with the complexities of the rules, ultimately undermining the regulations' aims and objectives. 

As the regulator begins to crack down, asset managers are seeking straightforward and scalable solutions that can ease the requirements of compliance and help asset managers not only meet their obligations, but effectively plan for future regulation change.

In this Investment Week article, Matt Smith, CEO of SteelEye, discusses the challenges firms have faced with regard to their derivative transparency requirements and outlines how firms can better approach their EMIR compliance. 


Evolving landscape

EMIR was initially introduced in 2012 following the financial crisis to better mitigate risks associated with the derivative markets. The essential aim of the regulation was to reduce systematic risk by increasing the transparency of over-the counter (OTC) derivatives, reducing counterparty credit risk and the operational risk of the OTC derivatives market.

Measures taken to achieve this goal include clearing all standardised OTC derivatives contracts through central counterparties (CCPs) and OTC derivatives contracts being reported to trade repositories.

But as recent as June this year, the EMIR regulation has been revisited by the EU and updated to create the ‘EMIR Refit’ or ‘EMIR 2.1’ as it is colloquially known, presenting a new set of challenges asset managers need to address.

The most significant alteration is the redefinition of ‘financial counterparty’ i.e. those who must report their trade derivative transactions. The previous iteration of EMIR treated most alternative investment funds as non-financial counterparties or equivalent third-country entities.

 

Data quality a growing issue

What EMIR requires, like all of the relatively recent number of EU financial regulation, is high quality data. However, since the regulation was implemented, it has become clear that this has been significantly harder to obtain than first thought, mirroring the also well-publicised struggle with current MiFID II compliance.

The most significant data challenges are the pairing and matching of trades. In sum, the pairing of trades is the bringing together of two trade reports that are submitted by counterparties to the trade. In theory this should be straight forward but current data suggests that more than one in ten trades is failing to pair.

Matching demands are slightly more complicated, requiring 47 data fields to match (or be within a certain range of each other). Regardless, only four in ten trades are matched currently.

Overall, recent Freedom of Information request submitted to ESMA showed the reconciliation statistics for February 2019 had an average pairing rate of 86% and matching rates of 40%.

Clearly, this is illustrative of the poor quality of compliance that exists within EMIR’s remit.

 

Increasing regulatory crack down

These discrepancies have not gone unnoticed by the Financial Conduct Authority (FCA) and have resulted in substantial fines for EMIR violations. Merrill Lynch International was fined £34.5 million for failing to report 68.5 million exchange traded derivative transactions over a two year period, in 2017. This is against the backdrop of sizeable MiFID II fines issued to UBS and Goldman Sachs, costing them £27.6 million and £34.3 million respectively.

 

Better practices, better outcomes

As such, derivative trading entities need to assess their applicability for EMIR reporting and take appropriate action before being investigated by the FCA. Part of the reason that matching and pairing rates are so low is because of the sheer quantity of data that must be reported.

Smaller financial entities are obviously more heavily affected by this regulation because of the size of the data sets and the man hours needed to organise and analyse them. Their limited resources make them more susceptible to falling foul of EMIR compliance and risking fines.

In reaction to the EU’s financial regulations, innovative solutions have emerged to help reporting requirements. Currently, 80% of asset managers outsource their EMIR reporting at a great expense but investment in holistic, scalable reporting solutions are the best way to ensure an organisation is complying in the most cost-effective manner.

Thus far, EMIR has taken backseat to the reporting of MiFID II requirements but large fines like those given to Merrill Lynch International serve as a warning to those that wish to ignore proper compliance. The noticeably low quality of the submitted data invites regulators to assess businesses and perhaps even punish them. A true understanding of the regulation and investment in modern technology can alleviate the burden, help compliance and increase transparency in derivative markets, meanwhile future-proofing firms to manage all of their complex data requirements.