Interest Rate Derivatives in a volatile interest rate environment

Interest rate derivatives act as a crucial tool for interest rate hedging in banks. The interest rate environment has changed drastically in recent years; a long period of decreasing and eventually negative Euribor rates came to an end in the first half of 2022 [1]. The Russian invasion of Ukraine resulted in a sharp rise of volatility in the interest rate market, reflecting heightened uncertainty on the economic and policy outlook [2].

These changes in the interest rate environment underlined the importance of banks’ requirements to hedge themselves against interest rate risks. In a publication from 2022, ECB has estimated that Between March 2021 and September 2022, gross notional on EURIBOR swaps – the most traded and liquid derivatives used to hedge interest rate risk for euro-denominated exposures – increased by around 50%. It is also stated that almost all euro area banks are active in the EURIBOR swaps market, emphasising the importance of the aforesaid derivatives instruments.[3]

Over the last few years, there has been a slow but constant increase in the notional principal amount of Euro-nominated OTC Derivatives. Since 2022 these notional amounts have experienced a steep ascending trend [4]. The significance of these instruments in banks’ risk management cannot be stressed enough.

EMIR Framework

The increasing volume of derivatives trading highlights the importance of regulatory requirements and guidance concerning the derivatives market. A major actor in the regulatory scene on derivatives is the EMIR regulation framework.

Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories (European Market Infrastructure Regulation, EMIR) aims to increase transparency and reduce risks in the derivatives market. EMIR regulates the performance of activities of central counterparties and trade repositories and also sets out a number of obligations for all undertakings that enter into derivative contracts. [5]

One of these obligations is EMIR Reporting (Reporting to trade repositories). This compels both counterparties of a derivative contract to report the details of their contract to a trade repository recognized under the regulation. In addition to transaction reporting, the counterparties are also obligated to report valuation and collateral related to the reported derivatives contracts. [5]

EMIR Refit

EMIR Reporting took effect initially over 10 years ago, when the first technical standards for the reporting were published in 2012, and mandatory transaction reporting for OTC derivatives began in 2014.[6]

After the review period of the first version of EMIR Reporting between 2015 and 2019, new EMIR Guidelines were published in 2022, and reporting under the new regulation framework started on 29 April 2024.

The new framework “EMIR Refit” brought many changes and amendments to the daily EMIR reporting workflow. The first major change affected the technical format and contents of the reports. Reporting under EMIR Refit is done in the format defined by ISO 20022 XML schemas [7]. The change of the schema did not only affect the format and layout of the report, but also introduced a number of new reported fields, including, for example, unique identification codes for the reported derivatives. The second major change in the regulation is the obligation for reporting entities to notify the competent authority of errors in and obstacles to EMIR reporting [8].

Thirdly, EMIR Refit introduced an obligation to monitor the reconciliation feedback provided by trade repositories. Reporting entities must actively monitor the response messages from trade repositories and have sufficient arrangements in place to take reconciliation failures into account. [8]

These changes in EMIR regulation forced banks to take action on developing their derivatives reporting processes. Our work with Finnish banks and banking groups allowed them to define workflows to overcome the challenges of transitioning to EMIR Refit. By utilizing an EMIR Reporting module in their treasury management system “FIS Treasury and Risk Manager – Quantum Edition”, the banks were able to tackle the new requirements and transition to the new reporting regulation in time.

The solution implemented by ALM Partners was able to tackle the three major aspects of the new regulatory framework mentioned above. Firstly, the new ISO 20022 XML reporting schema was implemented with an ability to also provide delegated reporting for subsidiary banks. The reporting covers all required report types: transaction, valuation, and collateral reporting. The solution provides a complete automatic process: creating the reports from treasury data, calculating valuations and respective collateral, and sending the reports over to the trade repository of choice. Secondly, the solution helps to comply with the obligation of managing erroneous reporting: the solution provides a capability to send modification reports if a contract has previously been reported incorrectly. The third aspect, obligation to monitor the reconciliation feedback, was covered by the automatic download of the feedback messages generated by the trade repository. The messages are read into the treasury management system, providing end-users an instant review of the status of the reports and any possible error messages.

Having the reporting process fully automated and complying with all the new requirements introduced by EMIR Refit, treasury departments have one less tedious task to do and can better focus on managing the operations that matter the most.

What is expected after EMIR Refit?

Not long after the adoption of EMIR Refit, another amendment to the regulatory framework, EMIR 3.0, took effect on the 24th of December 2024. While the scope of EMIR Refit had major changes to the contents of EMIR Reporting, EMIR 3.0 focused more on other regulatory aspects of derivatives trading, further enhancing the safety and efficiency of EU’s derivatives market.

One of the key discussion points of EMIR 3.0 is the Active Account Obligation, the goal of which is to compel EU counterparties to clear a specific number of derivatives at EU-authorized CCPs. This aims to increase the clearing of certain derivatives at EU CCPs and reduce the reliance of EU counterparties on large third-country, mostly UK Tier 2 type CCPs [9]. As a result, certain EU market participants will be required to maintain active accounts with EU CCPs and clear a representative number of trades through these accounts [10].

Besides Active Account Obligation, there are other smaller amendments in EMIR 3.0. Most of the changes are focusing on improving transparency, efficiency, and risk management of the clearing process with CCPs.

As discussed, EMIR Refit targeted the process and schema of EMIR Reporting, whereas EMIR 3.0. had a different scope, mostly focusing on improving the clearing process. The next amendment in sight to the EMIR framework is the EMIR Refit Phase 2, going live in 2026. This Phase 2 amendment will again affect the reporting process, as it will introduce 66 new reconcilable fields, along with a new “Valuation Reconciliation Status” field that requires counterparties of derivatives contracts to reconcile mark-to-market valuations [11].

Conclusion

The introduction of EMIR and its subsequent iterations, including EMIR Refit and EMIR 3.0, reflect ongoing efforts to enhance transparency, reduce systemic risk, and ensure the stability of the derivatives market. These regulations impose stringent reporting and clearing requirements, compelling market participants to adapt their practices and systems to comply with ever-evolving standards.

The transition to EMIR Refit brought substantial changes in reporting formats, error management, and reconciliation processes. Financial institutions must navigate these types of changes, ensuring compliance and maintaining the integrity of their reporting processes.

Looking ahead, the implementation of EMIR 3.0 and the forthcoming EMIR Refit Phase 2 will continue to shape the regulatory landscape. The Active Account Obligation and additional transparency measures will further strengthen the EU’s derivatives market, promoting greater reliance on EU-based CCPs, and enhancing overall market resilience.

In conclusion, the dynamic nature of the regulatory environment necessitates continuous adaptation and vigilance. EMIR Refit Phase 2 is no exception. By staying informed and proactive, financial institutions can effectively comply with evolving regulatory requirements, thereby safeguarding their operations and contributing to the stability of the broader financial system.

Photo by Kari Koski