Risk-mitigation techniques for OTC derivative contracts not cleared by a CCP - EMIR Provision

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Article 11(1), EMIR Regulation
11(1). Financial counterparties and non-financial counterparties that enter into an OTC derivative contract not cleared by a CCP, shall ensure, exercising due diligence, that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least:

(a) the timely confirmation, where available, by electronic means, of the terms of the relevant OTC derivative contract;
(b) formalised processes which are robust, resilient and auditable in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them, and to monitor the value of outstanding contracts.

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The really interesting aspect of this article - straight face, now - will be the regulatory technical standards that set out in a lot more detail who has to post what, how and when. There is an early draft consultation paper of that floating round.

The European Supervisory Authorities (ESAs) have been mandated to develop common draft regulatory technical standards (RTS) implementing Article 11 of EMIR, which introduces a requirement to exchange a margin on non-centrally cleared OTC derivatives.

The RTS will set out in greater detail the specific aspects of this framework, including margin models, the eligibility of collateral to be used for margins, operational processes and risk-management procedures. In developing these standards, the ESAs have also kept in mind the need for international consistency and have consequently used the internationally agreed standards as the natural starting point. In addition, a number of specific issues have been clarified so that the proposal will implement the internationally agreed minimum standards while taking into account the specific aspects of the European financial market. This Consultation Paper consequently specifies the complete framework to be used.

The RTS prescribe the minimum amount of initial margin and variation margin to be posted and collected and the methodologies by which that minimum amount would be calculated. Under both approaches, VM is to be collected to cover the mark-to-market exposure of the OTC derivative contract. For IM, counterparties can choose between a standard pre-defined schedule based on the notional value of the contracts and an internal modelling approach, where the IM is determined based on the modelling of the exposures. This allows counterparties to decide on the complexity of the framework to be used.

The RTS also outline the collateral eligible for the exchange of margins. The eligible collateral covers a broad set of securities, such as sovereign securities, covered bonds, specific securitisations, corporate bonds, gold and equities. In addition, criteria to ensure that collateral is sufficiently diversified and not subject to wrong-way risk have been established.

Finally, to reflect the potential market and FX volatility on the collateral the RTS prescribes the methods for determining appropriate collateral haircuts.