New clearing, risk mitigation, and reporting obligations imposed on certain derivative contracts.
On 15 March, the first six implementing measures of the European Market Infrastructure Regulation (EMIR) entered into force, marking the beginning of the gradual implementation of EMIR over the next two years. EMIR applies widely to both financial and nonfinancial counterparties to derivative contracts, including energy derivatives. In particular, new clearing and risk mitigation requirements for uncleared trades will apply to over-the-counter (OTC) derivative contracts, and a new reporting requirement will apply to both OTC and exchange-based derivative contracts. Some of these requirements are already in force.
In the short term, firms entering into derivative contracts should ensure that compliant recordkeeping and valuation measures are in place and that OTC trades are promptly confirmed to counterparties. In the longer term, firms should prepare for the implementation of a full suite of EMIR reporting obligations, further risk mitigation measures, and the entry into force of a clearing obligation for eligible derivative contracts.
What is EMIR?
EMIR entered into force on 16 August 2012, with the aims of managing counterparty credit risk more effectively and increasing the transparency and stability of OTC derivative markets. Until the first six implementing measures took effect on 15 March, almost all aspects of EMIR had yet to take effect under secondary implementing measures.
EMIR creates a new regulatory framework for counterparties to derivative contracts, central counterparties (CCPs), and trade repositories. This LawFlash addresses the regime in respect of counterparties to derivative contracts.
What Obligations Does EMIR Impose?
EMIR imposes the following three broad categories of obligations on most undertakings established in the European Economic Area (EEA) (and, in some cases, those established elsewhere) that enter into derivative contracts:
- A clearing obligation for OTC derivatives. This obligation requires all eligible derivative contracts between certain counterparties (as discussed below) to be cleared through a CCP. A register of eligible derivative contracts will be made available on the European Securities and Markets Authority’s (ESMA’s) website. However, in some cases, the clearing obligation will have retrospective effect for the period between approval of a CCP for clearing a specific class of derivatives and the date on which the clearing obligation for a particular eligible derivative contract takes effect. In this way, clearing of derivative contracts will be “frontloaded”.
- Risk mitigation requirements for uncleared OTC derivatives. Pending the authorisation of CCPs, all OTC derivatives that would otherwise be subject to the clearing obligation will be subject to the risk mitigation requirements for uncleared OTC derivatives, insofar as those requirements are in force. After the implementation of the clearing obligation, OTC derivative contracts falling outside the scope of the clearing obligation will remain subject to the risk mitigation requirements. Timely confirmation, portfolio compression and reconciliation, marking-to-market, collateral exchange, and capital requirements are the main categories of risk mitigation techniques.
- A reporting obligation for all derivative contracts. This obligation requires all derivative contracts entered into in the EEA to be reported to a trade repository. When phasing-in is complete, details of the conclusion, modification, or termination of a derivative contract must be reported by the end of the following working day but will likely amount to almost real-time reporting. One aspect of the reporting obligation already in force is the obligation on counterparties to keep a record of any derivative contract for at least five years following the termination of the contract.
To Which Derivatives Does EMIR Apply?
The derivative contracts falling within the scope of EMIR are derived from Annex I, Section C (4)–(10) of the Markets in Financial Instruments Directive (MiFID) and include options, swaps, forwards, and contracts for difference. This includes foreign exchange derivatives and both cash-settled and physically settled commodities derivatives. The European Commission has confirmed that energy spot transactions do not fall within the scope of EMIR because, like foreign exchange spot trades, they are not derivatives under the relevant provisions of MiFID.
Certain EMIR obligations apply only to “OTC derivatives”, which are defined as derivative contracts not executed on an EEA-regulated market (such as ICE Futures Europe, Eurex, and NYSE Euronext London) or an equivalent third-country market.
To Whom Do the EMIR Obligations Apply?
The extent to which the above obligations apply to an undertaking established in the EEA depends on whether the undertaking is a financial or nonfinancial counterparty and, if it is the latter, whether it exceeds certain thresholds. Where one counterparty is established in a third country (TC) (i.e., outside the EEA), the EMIR reporting obligation continues to apply, and transactions that would be subject to the clearing obligation if the non-EEA counterparty were established in the EEA must be cleared. The tables at the end of this LawFlash provide an overview of the circumstances in which derivative contracts involving TCs trigger obligations under EMIR.
“Financial counterparties” (FCs) are broadly defined in EMIR as investment firms authorised in accordance with MiFID; credit institutions authorised in accordance with the Banking Consolidation Directive; insurance, assurance, and reinsurance undertakings authorised in accordance with the First Non-Life Directive, the recast Life Directive, and the Reinsurance Directive, respectively; Undertakings for Collective Investment in Transferable Securities (UCITS) funds and their managers authorised in accordance with the UCITS IV Directive; “institutions for occupational retirement provisions”, as defined in the Occupational Pension Funds Directive; and alternative investment funds managed by alternative investment fund managers authorised or registered in accordance with the Alternative Investment Fund Managers Directive.
Nonfinancial counterparties (NFCs) are undertakings established in the EEA that are not FCs or central counterparties (CCPs). NFCs are divided into the following two subcategories:
- Qualifying NFCs are those NFCs that exceed one or more of the thresholds set out below. Qualifying NFCs are subject to the clearing obligation (as discussed below) and most of the risk mitigation requirements.
- Nonqualifying NFCs are not subject to the clearing obligation and are required to comply with a reduced number of risk mitigation requirements for uncleared trades.
Table of Clearing Thresholds for NFCs
|Asset Class||Threshold (gross notional value of outstanding OTC derivative contracts over a rolling 30-working-day period)|
|Credit derivatives||€1 billion|
|Equity derivatives||€1 billion|
|Interest rate derivatives||€3 billion|
|Foreign exchange derivatives||€3 billion|
|Commodity derivatives and other OTC derivatives not listed above||€3 billion|
For the purposes of the thresholds above, hedges (that is, derivative contracts that are “objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity” of the nonfinancial counterparty) are disregarded.1 Where a clearing threshold for one asset class is reached, an NFC is treated as having reached the clearing thresholds for all other asset classes. The UK Financial Conduct Authority (FCA) has published notification forms that must be used when notifying the FCA that the clearing threshold has been reached.2
The tables at the end of this LawFlash provide an overview of the EMIR obligations applicable to FCs, qualifying NFCs, and nonqualifying NFCs. It is noteworthy that the clearing obligation applies only to certain combinations of counterparties. For example, a derivative contract between a qualifying NFC and a nonqualifying NFC is not subject to the clearing obligation.
Are Exemptions Available for Intragroup Transactions?
Intragroup exemptions from both the clearing obligation and the risk mitigation requirements are available, although there is no exemption from the reporting obligation. The exemptions are detailed and beyond the scope of this LawFlash. Please do not hesitate to contact us if you require assistance with these exemptions.
Does EMIR Apply to Undertakings Established Outside the EEA?
The clearing obligation and risk mitigation requirements for uncleared derivative contracts apply to certain undertakings established outside the EEA (see the tables below). However, the precise practical application of EMIR TCs remains unclear. ESMA is preparing technical advice on equivalence between certain third countries, including the United States and Japan. The European Commission has recently extended the deadlines by which ESMA is required to deliver technical advice on the equivalence of third country legal and supervisory frameworks to 15 June 2013 (for the United States and Japan) and 15 July 2013 (for Hong Kong, Switzerland, Canada, and Australia). This advice, along with the European Commission’s subsequent guidance, is likely to provide greater insight into the treatment of TCs under EMIR.
Parties to cross-border derivative contracts should also be increasingly aware of the regulatory regime in their counterparty’s jurisdiction. For example, in some cases it may be necessary to clear trades both with a US and EEA CCP, and different registration or reporting requirements may apply in each jurisdiction.
How Similar Are the Provisions of EMIR to the US Provisions Under Dodd-Frank?
There is a significant degree of overlap between the EMIR obligations described above and the provisions of the US Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which was passed in July 2010. Both EMIR and Dodd-Frank represent the implementation of the G-20’s commitment to improving risk management and reducing systemic risk in OTC derivative contracts by the end of 2012.
As with EMIR, Dodd-Frank requires a number of implementing rules and technical standards to enter into force before it will take effect. Although some aspects of Dodd-Frank are already in force, some of Dodd-Frank’s rulemaking requirements have yet to be proposed and/or finalised.
Like EMIR, Dodd-Frank imposes a reporting obligation on parties entering all derivative contracts. A clearing obligation under Dodd-Frank applies to all parties trading eligible derivative contracts (although hedging transactions are excluded for qualifying nonfinancial end users). Risk mitigation requirements will also apply to “major swap participants”, representing a narrower approach than EMIR, under which some risk mitigation requirements apply even to NFCs. Both EMIR and Dodd-Frank make provisions for extraterritorial trading, although it remains unclear how these provisions will apply in practice.
In contrast to EMIR, Dodd-Frank seeks to address the execution of OTC derivative contracts that become subject to a trading mandate on electronic trading platforms, position limits for specified physical commodity derivatives, and post-trade transparency. In the European Union (EU), these issues will be addressed in a recast Markets in Financial Instruments Directive (MiFID II) and supporting regulation (MiFIR), which both remain under discussion, with implementation not expected until mid-2014 at the earliest.
Finally, Dodd-Frank includes some rules that currently have no EU equivalent. Under the EU regime, there is no version of the Volcker rule, which restricts “banking entities” from entering into proprietary trading or acquiring interests in private equity and hedge funds (the details of the Volcker rule have yet to be finalised). There is also no EU version of the “push out” rule, which restricts the derivative trading activities of federally supported financial institutions. In the EU, a report by the EU high-level expert group on reforming the structure of the EU banking sector, chaired by Erkki Liikanen, recently made recommendations to implement similar (although not identical) rules under the EU regime, and legislative proposals are expected later in the year.
EMIR Tables: Who Is Affected, and When Do the Obligations Take Effect?
The Clearing Obligation
WHO IS AFFECTED?
In the absence of an available exemption (such as the intragroup exemption), the clearing obligation applies to eligible derivative contracts concluded between counterparties marked with an “X” in the table below.
|FCs||Qualifying NFCs||Nonqualifying NFCs||Qualifying TCs||Nonqualifying TCs|
*EMIR states that, where both counterparties are TCs, the clearing obligation will only apply where “the contract has a direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent the evasion of any provisions of [EMIR]”. Clarity is still required on what this may mean, and further secondary legislation is expected in due course.
WHEN DO THE OBLIGATIONS TAKE EFFECT?
It is thought that the first CCPs will be authorised later this year, with the first clearing obligations likely to take effect in the fourth quarter of 2013.
Risk Mitigation Requirements for Uncleared OTC Derivatives
|Requirement||Who is affected?*||When do the obligations take effect?|
|Procedures to measure, monitor, and mitigate risk (including the confirmation within a stipulated time frame of the terms of the relevant OTC derivative contract, portfolio reconciliation and compression, and associated risk management)||FCs and NFCs||15 March 2013: Timely confirmation† 15 September 2013: Portfolio reconciliation and compression and dispute resolution procedures|
|Marking-to-market/Marking-to-model (valuation of outstanding derivative contracts on a daily basis)||FCs and Qualifying NFCs||15 March 2013|
|Exchange of collateral||FCs and Qualifying NFCs||The relevant Regulatory Technical Specifications have not yet been published. In the interim, the European Commission has indicated that “counterparties have the freedom to apply their own rules on collateral in accordance with the conditions laid down in Article 11(3) [of EMIR]”.|
|Capital (appropriate to manage the risk not covered by appropriate exchange of collateral)||FCs||The relevant Regulatory Technical Specifications have not yet been published.|
*The above requirements also apply to OTC derivative contracts entered into between TCs that would be subject to those obligations if they were established in the EU and provided that “the contract has a direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent the evasion of any provisions of [EMIR]”. It is not yet clear whether or how some of the obligations will apply to TCs in practice.
†The International Swaps and Derivatives Association (ISDA) has recently produced an EMIR Non-Financial Counterparty Representation Protocol and a Timely Confirmation Amendment Agreement, which allow swap market participants to simultaneously amend multiple ISDA Master Agreements to facilitate compliance with EMIR.
The Reporting Obligation
WHO IS AFFECTED?
The EMIR reporting obligation applies to FCs and NFCs (whether qualifying or not) entering into derivative contracts (whether OTC or otherwise) as defined above.
WHEN DO THE OBLIGATIONS TAKE EFFECT?
The reporting obligation applies to derivative contracts entered into before 16 August 2012 that remain outstanding on that date and those entered into on or after 16 August 2012. However, the reporting obligations are not yet “live”, and it is expected that the reporting requirements will apply as follows:
|Derivative class||Derivative contracts entered into on/after 16 August 2012 and still outstanding on reporting start date||Derivative contracts outstanding on 16 August 2012 and still outstanding on reporting start date||Derivative contracts not outstanding on the reporting start date|
|Credit derivative and interest rate derivative contracts||1 July 2013 (where a trade repository for the derivative class is registered before 1 April 2013), otherwise 90 days after the registration of a trade repository for that derivative class, subject to a 1 July 2015 long-stop||29 September 2013 or 90 days after the reporting start date for the derivative class, whichever is later||1 July 2016 or three years after the eventual start date for reporting the derivative class, whichever is later|
|All other derivative contracts||1 January 2014 (where a trade repository for the derivative class is registered before 1 October 2013), otherwise 90 days after the registration of a trade repository for that derivative class, subject to a 1 July 2015 long-stop||1 April 2014 or 90 days after the reporting start date for the derivative class, whichever is later||1 July 2016 or three years after the eventual start date for reporting the derivative class, whichever is later|
Note: The reporting start date for reporting of collateral requirements pursuant to Article 3 of Commission Delegated Regulation No.148/2013 is 180 days after the relevant start date shown in the table above.
Copyright 2013. Morgan, Lewis & Bockius LLP. All Rights Reserved. This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.
William Yonge is a partner in Morgan, Lewis & Bockius LLP’s Business and Finance Practice and a member of the Investment Management and Securities Practice, resident in London. William focuses his practice on providing UK and European financial services regulatory advice to financial services institutions, asset managers, corporate financiers, hedge, private equity and UCITS (Undertakings for Collective Investment in Transferable Securities) funds.
Torsten Schwarze is a partner in Morgan Lewis's Business and Finance Practice and a member of its Investment Management and Securities Practice. Dr. Schwarze has represented financial service institutions, stock and derivatives exchanges, and companies in connection with various capital markets and acquisition finance transactions, regulatory matters, and derivatives law. Dr. Schwarze’s practice is currently focused on regulatory and derivatives matters.
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