Welcome to EMIR: the known unknowns of customer classification

Will existing classification systems be good enough?

With EMIR in force, firms are now wrestling with the challenge of classifying their customers – without an industry viewpoint the dialogue could get ugly …

EMIR’s first implementation date has now been passed. From 15 March, investment firms and corporates will now need to notify ESMA if they have passed the clearing threshold, confirm their uncleared OTC trades and begin preparations to implement EMIR’s risk mitigation techniques. In order to do this, you need to know your counterparties’ classification; whether they are a Financial Counterparty (FC), Non-Financial Counterparty (NFC), or a NFC over the clearing threshold (NFC+).

Of course, it is not a huge issue to identify a financial counterparty. JWG research shows that 95.6% of commonly used industry codes can be used to identify non-financial counterparties with a high degree of certainty. The real complexity of this classification exercise comes with identifying non-financial counterparties over the clearing threshold. Unlike other regulatory regimes this classification relies on a firm’s partial view of the marketplace that may not be shared by others.

For example, a big firm must now make a judgement on whether a large oil company’s subsidiary in Paris can be considered to be a NFC when the trade being conducted is likely to put it over the clearing threshold.

Client classification will have a bearing on the timely confirmation of uncleared trades and eventually the clearing of trades subject to the clearing obligation and the correct posting of margin. Failure to correctly classify counterparties or, just as importantly, classification of clients which is different from that of your competitors, may adversely impact a firm’s ability to do business.

What’s the problem then? Firstly, unlike MiFID, firms cannot rely completely on self-certification. This is because, while there is an EMIR requirement for NFCs to notify authorities when they, or any others in their group, have breached the threshold, there is no such obligation to inform the marketplace of their status. This means that a firm’s customer is under no obligation to ensure all its trading partners classify it in the same way.  Even the NFC that breaches the clearing threshold (NFC+) is under no regulatory obligation to inform its counterparties – it must only inform its competent authorities and ESMA.  And ESMA is under no obligation to share its NFC+ register.

For these reasons, ESMA stated in public forum in Mid-2012 that self-certification of status ‘may not be sufficient’. Some take the view that it would be very easy for regulators to leverage this uncertainty to obtain ‘easy wins’ by finding fault with current approaches in a transparent manner (e.g. through fines, speeches, etc.).

The ISDA Protocol is one attempt to solve the problem of the NFC+ in a legal fashion, but does not attempt to make the initial division between FCs and NFCs. While the contract provides legal certainty on counterparties’ status, in that liability for mis-classification lies with the self-certifier, it only focuses on whether or not the threshold has been breached.  As such, this may only provide a partial answer.

Many corporates will not be willing to legally self-certify their status. This is due to the complexity of assessing whether they have breached the asset threshold on a group-wide basis. Many do not have the extensive internal monitoring systems required to maintain the accuracy of their classification, especially when they may be in danger of breaching the threshold on a trade-by-trade basis. This means that a large part of the certainty required by a firm will need to be obtained directly.

In addition, it is worth mentioning the British Bankers’ Association Data Management Advisory Panel, which has been working on a methodology for using industry codes to classify counterparties on ‘day 1’.

The fundamental barrier to a consistent interpretation across Europe is the lack of clarity as to what, exactly, the politicians and regulators meant about what counterparties should know about each other. Did they mean that every firm should know their customer’s precise status in intimate detail – including up to the minute knowledge of how much trading they are doing with other firms? Or, did they merely mean that we should have a general understanding of what was likely to be their status based on a profile?

Firms are facing many of the same practical challenges for EMIR as they do for AML, FATCA and a host of other regulations in 2013. This speaks to the larger challenge facing the industry, the inability to get guidance needed to be able to implement requirements in a consistent and cost-effective way.

With a number of regulations requiring changes to the way you classify customers, this is not an issue that is going away anytime soon.