European Market Infrastructure Regulation (EMIR 3): AAR, Representativeness, and Stress Testing

1.Overview of the European Market Infrastructure Regulation (EMIR 3) Updates

On November 20, 2024, the European Securities and Markets Authority (ESMA) announced major updates to the European Market Infrastructure Regulation (EMIR 3). These updates center on the Active Account Requirement (AAR), a critical regulatory step aimed at enhancing financial stability by reducing the EU financial system’s reliance on third-country Tier 2 Central Counterparties (CCPs).

The changes will significantly impact a wide range of institutions, including banks, asset management firms, insurance companies, and corporates actively involved in derivative trading. Specifically, financial and non-financial counterparties with substantial exposure to OTC interest rate derivatives (IRD) or short-term interest rate derivatives (STIR) denominated in euro or Polish zloty will be required to comply. This includes entities clearing more than EUR 3 billion in monthly average notional positions in these derivatives.

Source

[1]

Active Account Requirement - ESMA is seeking first input under EMIR 3

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[2]

Consultation on the Conditions of the Active Account Requirement under EMIR 3

Responding to this paper ESMA invites comments on all matters in this paper and in particular on the specific questions summarised in Annex I. Comments are most helpful if they: respond to the question stated; indicate the specific question to which the comment relates; contain a clear rationale; and describe any alternatives ESMA should consider. ESMA will consider all comments received by 27 January 2025.

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Timeline for Implementation

The updates include a phased implementation plan to ensure a smooth transition:

1. November 20, 2024: Publication of the updates and start of the consultation period.
2. January 27, 2025: Deadline for stakeholders to submit feedback to ESMA’s consultation.
3. Q1 2025: ESMA to finalize and submit the Regulatory Technical Standards (RTS) to the European Commission for approval.
4. Mid-2025: Expected publication of the finalized rules in the EU Official Journal.
5. Late 2025: Entry into force of the regulations, with institutions required to establish compliance frameworks within six months of becoming subject to the AAR.

These updates reflect the EU’s commitment to fostering greater transparency and stability in its financial markets. By mandating that certain clearing activities remain within EU-authorized CCPs, the regulation aims to protect the financial ecosystem from systemic risks while strengthening the EU’s market infrastructure. Institutions subject to the regulation must begin preparing immediately to meet the compliance deadlines effectively.

2. Key Points of the European Market Infrastructure Regulation (EMIR 3) Updates

a. Introduction of the Active Account Requirement (AAR)

Regulatory Details

The AAR obliges financial and non-financial counterparties engaging in specific derivative trades to maintain at least one active account at an EU CCP. The derivatives in focus include:

1. Euro-denominated OTC interest rate derivatives (IRD).
2. Polish zloty OTC interest rate derivatives.
3. Euro-denominated short-term interest rate derivatives (STIR).

Institutions must demonstrate readiness to:

• Manage a threefold increase in transaction volumes, simulating market disruptions or clearing obligations transitioning from Tier 2 CCPs.
• Fulfill operational requirements such as IT connectivity, legal documentation, and robust internal clearing processes.

Compliance Actions

1. Establish Active Accounts:
   • Open accounts with EU CCPs authorized to clear derivatives under EMIR.
   • Ensure accounts are provisioned with sufficient financial resources, including margin collateral and liquidity buffers.
2. IT Infrastructure Enhancement:
   • Integrate with CCPs using live and operational IT systems capable of handling high-speed, high-volume data transfers.
   • Implement failover mechanisms to ensure connectivity remains uninterrupted during market volatility.
3. Legal Framework Alignment:
   • Develop legally binding agreements with CCPs or clearing members specifying obligations, rights, and contingency plans for clearing disruptions.
   • Ensure compliance with Article 37 of EMIR, which mandates transparent and standardized contractual agreements.
4. Internal Governance and Training:

• Establish governance policies for clearing operations, assigning roles to dedicated teams responsible for active account compliance.
• Train staff on regulatory requirements, operational protocols, and reporting standards under EMIR 3.

b. Representativeness Obligation

Regulatory Details

Institutions must ensure their active accounts reflect their derivative activity across Tier 2 CCPs, covering:

1. A representative number of trades across selected derivative classes (e.g., interest rate swaps, forward rate agreements).
2. Multiple subcategories of trades defined by:
   • Maturity ranges (short-term to long-term derivatives).
   • Trade size ranges (small to large transactions).

These requirements align with Article 7a(4), which mandates that trades cleared at EU CCPs are proportional to historical activity at Tier 2 CCPs.

Compliance Actions

1. Assess Trade Portfolios:
   • Evaluate historical trading patterns at Tier 2 CCPs to identify classes and subcategories requiring representation.
   • Use data analytics tools to segment trades based on maturity and size ranges.
2. Adjust Clearing Activities:
   • Modify clearing strategies to align activity with ESMA’s defined representativeness criteria.
   • Engage with CCPs to ensure the ability to execute trades within required subcategories and classes.
3. Develop Monitoring Mechanisms:
   • Implement systems to track and report trade distributions across derivative classes.
   • Automate alerts for deviations from compliance thresholds, enabling real-time corrective action.
4. Engage Clearing Partners:

• Collaborate with clearing members to ensure access to necessary clearing services for each derivative class and subcategory.
• Establish agreements to prioritize trades that enhance representativeness.

c. Operational Conditions and Stress Testing

Regulatory Details

Institutions must demonstrate compliance with three operational conditions:

1. Permanently Functional Accounts: Ensure accounts are continuously operational with fully implemented IT and legal frameworks.
2. Capacity to Handle Volume Increases: Accounts must withstand a threefold increase in clearing activity, simulating crisis scenarios or abrupt shifts from Tier 2 CCPs.
3. Clearing of All New Trades: Active accounts should clear all new trades under both normal and stress conditions.

Stress testing, mandated under Article 7a(8), must simulate large-volume clearing scenarios using industry-standard methodologies.

Compliance Actions

1. Establish Stress-Testing Frameworks:
   • Develop internal policies for annual and semi-annual stress tests, incorporating liquidity and operational capacity assessments.
   • Simulate transaction surges based on historical data and anticipated market shifts.
2. Obtain CCP Certifications:
   • Request certifications from EU CCPs confirming accounts can handle threefold activity increases.
   • For client-clearing arrangements, secure assurances from clearing members validating their capacity to manage stress scenarios.
3. Optimize Clearing Systems:
   • Invest in scalable IT solutions to handle large transaction volumes and meet ESMA’s operational benchmarks.
   • Maintain redundancy systems to prevent service interruptions during high-stress periods.
4. Document Compliance:

• Maintain detailed records of stress-testing results, operational changes, and system enhancements.
• Ensure documentation is audit-ready and aligned with regulatory reporting requirements.

d. Reporting Requirements

Regulatory Details

Institutions must comply with semi-annual reporting obligations outlined in Article 7b, including:

1. Activity Metrics: Gross and net notional exposures, margin activity, and number of trades.
2. Operational Readiness: IT connectivity, governance frameworks, and CCP certifications.
3. Stress-Testing Results: Details of compliance with capacity and representativeness requirements.

Compliance Action

1. Develop Automated Reporting Systems:
   • Integrate trade repository data into centralized reporting systems for seamless aggregation and submission.
   • Implement data validation checks to ensure accuracy and completeness.
2. Coordinate with CCPs:
   • Obtain required data from CCPs and clearing members, ensuring alignment with reporting standards.
   • Establish data-sharing agreements to facilitate timely information exchange.
3. Implement Reporting Workflows:
   • Create internal workflows to compile, review, and submit reports within regulatory deadlines.
   • Train compliance teams to interpret reporting requirements and resolve discrepancies.
4. Audit Reporting Processes:

• Conduct periodic audits of reporting systems and practices to identify gaps and enhance accuracy.
• Address feedback from regulators to refine reporting protocols.

e. Exemptions and Thresholds

Regulatory Details

Institutions meeting specific criteria can qualify for exemptions:

1. Clearing 85% or more of relevant derivative contracts at EU CCPs exempts institutions from operational and reporting requirements.
2. Institutions clearing less than EUR 6 billion in notional derivative volumes are exempt from representativeness obligations.

These exemptions are designed to reduce compliance burdens for smaller institutions and entities already prioritizing EU-based clearing.

Compliance Actions

1. Evaluate Exemption Eligibility:
   • Analyze clearing activity to determine if thresholds for exemptions are met.
   • Regularly update compliance assessments to reflect changes in market activity.
2. Document Clearing Activity:
   • Maintain detailed records of transaction volumes and CCP allocations to support exemption claims during audits.
   • Ensure data is readily available for regulatory inquiries.
3. Streamline Exemption Workflows:
   • Create automated processes to track and confirm exemption eligibility on an ongoing basis.
   • Allocate compliance resources to high-priority areas for institutions qualifying for exemptions.
4. Engage with Regulators:
   • Proactively communicate with national regulators to confirm eligibility and resolve disputes over exemption status.
   • Use regulatory feedback to refine compliance practices.

EMIR 3: Benefits and Challenges

a. Benefits

1. Strengthened Financial Stability:
   • Reduces exposure to Tier 2 CCPs, mitigating systemic risks from external disruptions.
   • Improves the EU’s ability to manage clearing activities during crises.
2. Increased Transparency:
   • Enhanced reporting obligations provide regulators with a clearer view of market risks and clearing patterns.
3. Boosted EU Competitiveness:
   • Encourages institutions to use EU CCPs, fostering market growth and innovation.

b. Challenges

1. High Compliance Costs: Institutions face substantial investments in IT infrastructure, stress testing, and reporting systems.
2. Operational Complexity: Smaller institutions may struggle to adapt to rigorous operational and representativeness requirements.
3. Liquidity Concerns: Shifting clearing activity from Tier 2 CCPs may reduce liquidity in specific derivative markets.

4. Recommendations for Financial Institutions

1. Conduct Early Gap Assessments:
   • Evaluate existing systems and processes against EMIR 3 requirements.
   • Identify gaps in IT, governance, and clearing practices that need immediate attention.
2. Collaborate with CCPs: Strengthen partnerships with EU CCPs to streamline compliance and optimize clearing operations.
3. Invest in Scalable Solutions: Upgrade systems to handle increased transaction volumes, detailed reporting, and real-time compliance tracking.
4. Leverage Exemptions Strategically: Focus compliance efforts on high-impact areas while benefiting from available exemptions to reduce costs.
5. Engage Regulatory Experts: Partner with compliance advisors and legal experts to navigate complex requirements and mitigate risks.

EMIR 3 Strategic Outlook

The updates to the European Market Infrastructure Regulation (EMIR 3) represent a transformative shift in the EU’s financial regulatory framework. By introducing the Active Account Requirement (AAR) and strengthening reporting and operational standards, EMIR 3 reinforces the EU’s commitment to safeguarding financial stability and enhancing market transparency. These changes not only reduce systemic risks associated with third-country Tier 2 CCPs but also position the EU as a more robust and competitive clearing ecosystem.

For financial institutions, the road ahead requires strategic preparation:

• Institutions must act quickly to assess their current clearing activities and compliance gaps.
• Proactive engagement with EU-authorized CCPs and investment in scalable IT and governance frameworks will be crucial to achieving compliance without disruptions.
• Leveraging available exemptions strategically can help optimize resources and focus compliance efforts on high-impact areas.

While the compliance requirements are demanding, they present an opportunity for institutions to streamline operations, strengthen risk management, and align with the EU’s long-term regulatory vision. With careful planning and investment, institutions can not only meet these new standards but also enhance their market positioning in an evolving financial landscape.

EMIR 3 is not just a regulatory mandate—it’s a strategic call for institutions to rethink their clearing strategies and reinforce their commitment to financial resilience and operational excellence. Those that prepare effectively will be well-positioned to navigate future regulatory developments and capitalize on the growing competitiveness of the EU’s financial markets.