In 2023, changes in reporting requirements remain a constant in the OTC derivatives market. More disruption and cost lie ahead for traders—resulting from ongoing revisions of European and U.S. rules as well as the International Swaps and Derivatives Association’s (ISDA’s) interpretation of those rules.
With each change, rules need to be parsed and systems need to be adapted—again. This article summarizes the evolution of reporting requirements, highlighting any differences and discussing how derivative counterparties can tackle the complex and ever-changing rules they face.
Background
Stable economic growth requires an efficiently operating financial system. The financial crisis of 2007–2008 highlighted a lack of transparency and systemic risk within certain financial markets—specifically, the opaqueness of derivatives contracts—forcing authorities around the world to reevaluate existing financial regulations. In 2009, the G20 leaders agreed to reforms in the OTC derivatives market in an attempt to reduce operational risk, increase transparency, and improve market integrity. One such reform was the requirement for counterparties trading OTC derivatives to report all transactions to trade repositories.
A trade repository is an entity that collects and maintains the records of all derivates contracts. This information is provided to financial regulators who use it to monitor for systemic risks within the market. These electronic platforms provide an effective tool for mitigating the intrinsic opacity of the OTC derivatives market. This market infrastructure is defined and supervised in Europe by the European Securities and Markets Authority (ESMA) under the European Market Infrastructure Regulation (EMIR). In the United States, trade repositories are regulated by the Commodity Futures Trading Commission (CFTC) under the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Over the last 10 years, such regulations have evolved to further strengthen the financial markets by improving disclosure and market transparency. Emerging from increased regulatory reporting requirements is the development of new regulatory technology (regtech) that helps to streamline the reporting process, increasing accuracy and reducing costs for both firms and regulators.
EMIR Reporting
As a result of the G20’s call for increased transparency in the OTC derivates market, reforms have been implemented globally through legislative and regulatory measures. EMIR came into effect in the European Union in August 2012, applying to any derivative counterparties established in the EU that have entered into a derivatives contract. EMIR applies to all entities (excluding individuals) established in the UK or EU that enter into, modify, or terminate a derivative transaction. It can also apply to counterparties outside the EU when trading with an EU entity. What should be reported under EMIR, from a legal standpoint, is set out in Annex 1, Section C, points (4) to (10) of the MIFID II Directive 2014/65/EU of the European Parliament and European Council of 15 May 2014. In summary, EMIR requires reporting of the transaction details for exchange traded derivatives (ETD) and OTC derivatives, excluding transferable securities, money-market instruments, and units in collective investment undertakings. Any entity involved in a derivative transaction must file a report by the end of the day after the transaction was executed (i.e. T+1). Violation of the EMIR reporting rules will trigger Article 12 of EMIR, allowing the national competent authority in whichever member state to apply penalties.
Dodd-Frank Reporting
The equivalent of EMIR in the United States is the Dodd-Frank Act. In July 2010, the act was signed into law, with final rules adopted by the CFTC in August 2012 under section 4s(i) of the Commodity Exchange Act (CEA, added by section 731 of the Dodd-Frank Act). The purpose of the act was to restructure the financial regulatory system to restore public confidence following the 2008 financial crisis and to prevent another crisis from occurring. Comprehensive mandatory regulations were introduced applying to the OTC derivatives, or swaps, market. Part 43 introduced real-time reporting to provide transparency on pricing to the market and Part 45 introduced transaction reporting, allowing regulators to monitor for systemic risk.
Reporting Challenges
One of the major differences between the reporting requirements under EMIR in the EU and the Dodd-Frank Act in the U.S. is in identifying who needs to report. EMIR requires both counterparties (excluding individuals) to a trade to report the transaction to a trade repository, whereas the Dodd-Frank Act mandates only one side to report, simplifying the operational challenge. Furthermore, the CFTC rules only apply to swap dealers and major swap participants (as defined under the Dodd-Frank Act). There are also differences between the scope of application of the CFTC and EMIR rules, due to differing definitions of swaps and derivatives under the Dodd-Frank Act and EMIR (particularly in relation to foreign exchange transactions).
The introduction of these regulations signalled a huge change for counterparties entering into derivative contracts. There were now many more considerations to take into account, including the requirement to clear certain derivative trades, the need for sweeping amendments to legal documentation to try and combat systemic risk, and the obligation to promptly and accurately report trades entered in order to give a transparent view into the derivative market and reduce risks to financial stability.
Following on from this sea change, the regulations have not remained static. In June 2019, EMIR Refit came into force, making large changes to the EMIR regulations. Included in this package of changes was an amendment to the definition of financial counterparty (FC) to pull in alternative investment funds (AIFs) if managed by an alternative investment fund manager or if established in the EU. A further small FC (SFC) class of counterparty was added which, similarly to the NFC+/NFC- differentiation, will be exempt from the clearing obligation, depending on whether or not it exceeds the relevant clearing threshold.
Looking Ahead: EMIR Refit, CFTC Rewrite, ISDA DRR
Further changes to EMIR Refit are expected to come into play near the end of 2023/early 2024. These changes will deal mainly with the reporting requirements introduced by EMIR, expanding the reporting fields and standardizing the format of reports to ISO 20022, among other amendments.
Similarly, the CFTC has recently enacted changes within its CFTC Rewrite, the first phase of which went live in December. The majority of changes introduced by the rewrite deal with new and updated data fields required for trade reporting. The second phase of this rewrite, expected in 2023, will also mandate the ISO 20022 format when reporting to trade repositories.
From the amendments that have been enacted, or that we can see on the horizon, it is clear that data harmonization and fidelity represent a cornerstone for safe and transparent markets in the future. These changes, while welcomed, bring with them initial upheaval and cost to derivative counterparties. Rules need to be parsed and systems need to be adapted to deal with the reporting requirements. The CFTC has already had to postpone the go-live of the initial phase of its rewrite from May 2022 to December 2022. This is a clear indication that counterparties are taking longer to come to grips with the changes than originally expected.
In conjunction with the announced changes, ISDA announced the creation and launch of its Digital Regulatory Reporting (DRR) model. ISDA has recognized the global Financial Stability Board’s comments that “regulatory reporting has become increasingly complex and expensive for regulated institutions. In addition, poor quality and/or delayed data can create challenges for authorities.” In light of this, the association has put forward a solution with the hope that this will allow derivative counterparties to face the current planned changes in a more efficient manner.
ISDA’s aim with the DRR is “a mutualized industry-wide initiative championed by ISDA that will enable firms to interpret and implement regulatory reporting rules consistently via a common machine-readable code based on the CDM (Common Domain Model).” To take this one step back, the CDM is a human-readable and machine-executable data model that will bring together the myriad of disparate processes that exist in the market. Having all derivative counterparties acting under a unified process for reporting should reduce the cost and time needed to be spent on this process.
The DRR will leverage the standardization led by EMIR and CFTC to also adopt ISO 20022. Critical data elements (CDEs) will be used to ensure that all derivative counterparties are reporting what is needed in line with regulations. A unique trade identifier (UTI) will be used to uniquely identify individual OTC derivative transactions on reports submitted. A unique product identifier (UPI) will identify the particular product that is the subject of the OTC derivative transaction. Finally, the counterparties will each have a legal entity identifier (LEI) to uniquely identify any derivative counterparties that engage in financial transactions. These changes will drive improvements in accuracy and consistency of reporting across the industry.
In November 2022, ISDA announced that BNP had successfully implemented and tested the DRR for reporting under the CFTC’s amended swap data reporting rules ahead of the December 2022 CFTC Rewrite compliance date. With only the first phase of the CFTC Rewrite behind us, and future changes to EMIR on the horizon, it would seem that ISDA’s next challenge will be retooling the DRR to incorporate any changes that are coming down the line. ISDA will need to continue to be reactive to regulatory changes and requirements, and derivative counterparties will need to continue to ensure that they are adhering to the ever-changing reporting requirements that are asked of them.
How Treliant Can Help
Treliant is a financial services and regulatory compliance consulting firm that can help banks navigate the complexities of changing regulations. Here are a few ways in which Treliant can assist banks in this regard:
- Legal roles: Treliant has a dedicated team of legal negotiators who can draft and negotiate ISDA master agreements and bilateral documents.
- Regulatory guidance: Our firm can provide guidance and support to banks on the interpretation and implementation of regulatory changes. This includes helping banks understand the requirements of the regulations, as well as providing practical advice on how to meet those requirements in a cost-effective and efficient manner.
- Risk management: Treliant can help banks identify and manage the risks associated with large-scale changes, including operational, reputational, and financial risks. This includes developing risk management strategies and implementing controls to mitigate these risks.
- Training and education: Our firm can provide training and education to bank staff on the specifics of the regulatory change. This includes conducting workshops and seminars, as well as providing ongoing support and guidance to ensure that staff are up to date on the latest developments in the industry.
Overall, Treliant can help banks effectively comply with regulatory change and manage the associated risks. By leveraging Treliant’s expertise and resources, banks can better understand and meet their obligations, while also protecting their businesses and reputation.
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