• European Markets and Infrastructures Regulation: An Overview and Update on Timing
  • March 19, 2013 | Authors: Christopher Leonard; Ezra Zahabi
  • Law Firm: Bingham McCutchen (London) LLP - London Office
  • Although the EU regulation, “EMIR”, on OTC derivatives, central counterparties and trade repositories came into force in August 2012, it is only now that market participants are beginning to be required to comply with its provisions.

    From 15 March 2013, financial counterparties1 (“FCs”) and non-financial counterparties2 (in each case, domiciled in the EU) will be subject to certain risk mitigation requirements.

    In the following 9-12 months the remaining operative provisions of EMIR will come into effect. Certain provisions will have retrospective effect and will impose obligations in respect of contracts entered into before the relevant rule came into effect (see “frontloading” and “backloading” below).

    This alert summarises the clearing obligation, reporting requirement and the risk mitigation requirements imposed by EMIR, and the expected timetable for implementation of these obligations.

    1. Clearing Obligation

    The clearing obligation applies to all transactions between FCs, non-financial counterparties whose aggregate derivatives positions exceed the threshold specified under EMIR (“Large NFCs”)3 and non-EU entities who would be subject to the clearing obligation if they were established in the EU (“In-Scope Non-EU Entities”). The clearing obligation applies to transactions in derivatives that have been included in a register, maintained by the European Securities and Markets Authority (“ESMA”), which lists the classes of derivatives subject to the clearing obligation (such classes of derivatives being “Clearing Derivatives”). All transactions in Clearing Derivatives between FCs and Large NFCs must be cleared through an authorised4 or recognised5 central counterparty.

    Non-EU entities: The clearing obligation will apply to a transaction in Clearing Derivatives between an FC or a Large NFC and an In-Scope Non-EU Entity. In addition, the clearing obligation will apply to a derivative transaction between two In-Scope Non-EU Entities if the transaction is deemed to have a direct, substantial and foreseeable effect in the EU, or if such application is necessary to prevent the evasion of EMIR. Further secondary legislation relating to the scope of the application of EMIR to non-EU entities is expected to be issued for public consultation, but is not yet published. It is likely that, at least, transactions in derivatives between two EU branches of In-Scope Non-EU Entities will be subject to the clearing obligation.

    Derivatives subject to the clearing obligation: ESMA shall determine whether a given class of derivatives should be included in the register of Clearing Derivatives (and therefore subject to the clearing obligation) following, inter alia, discussions with national regulators and a public consultation. In addition, ESMA may identify classes of derivatives that should be subject to the clearing obligation, but for which no central counterparty has received authorisation to clear, and, following a public consultation, call for proposals to develop central clearing of such classes of derivatives.

    Frontloading: The clearing obligation will apply to outstanding contracts in Clearing Derivatives entered into after a central counterparty is approved for clearing a specific class of derivatives, but before the clearing obligation actually takes effect. This means that certain outstanding derivatives contracts will be required to be cleared by a central counterparty after the contract has been entered into. In practice, this may result in the parties having to amend the terms to reflect central clearing, and, possibly, the contract being repriced.

    If it is not possible to reopen the trade and to clear it through a central counterparty, e.g. because the other party to the trade does not agree to central clearing, in order to ensure compliance with EMIR, a counterparty subject to EMIR must close out the contract.6

    Timing: ESMA will begin assessing which classes of derivatives should be included in the register of Clearing Derivatives in Q2/2013. It is possible that ESMA will phase in the implementation of the clearing obligation in relation to many classes of derivatives, however, it is currently expected that the clearing obligation will come into effect in Q1/2014 with respect to the first Clearing Derivatives.

    2. Reporting Requirement

    Any FC and non-financial counterparty that is party7 to a derivatives contract, whether exchange-traded or over-the-counter, must report details of the derivatives contract to a registered or recognised trade repository (effectively a database to provide market transparency). The reporting requirement applies to all trades in the EU. It is expected that a number of existing trade repositories8 will apply to be registered or recognised under EMIR.

    Content of the reports: The information that must be reported to trade repositories is set out in a pro forma reporting form.9 Some of the information, including the collateral value and basis (transaction or portfolio) of the contract10 and the mark-to-market/mark-to-model value of the contract,11 will only apply to FCs and Large NFCs.

    Reporting mechanics: The reporting requirement includes all derivatives transactions, including exchange and over-the-counter derivative trades, intra-group trades, and trades with non-financial counterparties. The reporting requirement applies to the counterparties to a derivatives transaction and to a central counterparty (in case of a centrally cleared derivatives transaction). A counterparty may delegate the reporting to the other party to the trade, to a central counterparty or to another person, e.g. a trading venue, subject to the prior explicit agreement of such delegate.12

    Backloading: The reporting requirement applies to all derivatives contracts that were outstanding on 16 August 2012, or entered into on or after 16 August 2012 (“Reportable Derivative Contract”), resulting in a backlog of reports required to be made to trade repositories.

    If a derivative contract is outstanding on the date the reporting obligation for the relevant class of derivatives takes effect (“Reporting Requirement Date”), the report to a trade repository may be made within 90 days of the Reporting Requirement Date. If a Reportable Derivative Contract is not outstanding on the Reporting Requirement Date, but was outstanding on 16 August 2012, the report to the trade repository may be made within three years of the Reporting Requirement Date.

    Timing: The reporting requirement with respect to credit and interest rate derivatives will take effect on 1 July 2013 if a trade repository for those classes of derivatives is registered by 1 April 2013, otherwise 90 days after registration of a trade repository.13 The reporting requirement with respect to all other derivatives will take effect on 1 January 2014 if a trade repository for the relevant class of derivatives has been registered by 1 October 2013, otherwise 90 days after registration of a trade repository.14

    3. Risk Mitigation Requirements for Uncleared Derivatives

    EMIR introduces new risk mitigation requirements for all bilateral derivative trades that are not subject to the clearing obligation, including:

    • Timely confirmations: FCs and Large NFCs must confirm transactions in uncleared derivatives as follows:

      • for credit default swaps and interest rate swaps, T+2 until 28 February 2014, and T+1 thereafter;15

      • for other derivatives,16 T+3 until 31 August 2013, then T+2 until 31 August 2014, and T+1 thereafter.17

    • In addition, FCs must have in place procedures to allow for monthly reporting of any uncleared derivatives transactions that have been unconfirmed for more than five business days.18

    • Portfolio reconciliation/portfolio compression exercises: FCs and non-financial counterparties must undertake portfolio reconciliation with their counterparties at regular intervals19 and have in place processes to establish when portfolio compression is reasonably possible and effect the same.

    • Capital: FCs must have appropriate capital resources to effectively absorb uncollateralised risks arising from trading uncleared derivatives.

    • Dispute resolution: FCs and non-financial counterparties must agree on procedures for identification, recording, monitoring and resolution of disputes. FCs must provide regulatory reports on unresolved disputes.

    • Daily valuation: FCs and Large NFCs must carry out daily mark-to-market or, if not possible, mark-to-model valuation of their uncleared derivatives positions.

    • Margin: FCs and Large NFCs must have in place procedures to exchange collateral of acceptable quality.20

    Timing: The requirements for timely confirmations and daily valuation take effect on 15 March 2013. The portfolio reconciliation and compression requirements and the dispute resolution requirement are anticipated to take effect in September 2013.


    Endnotes

    1 A financial counterparty is an investment firm, credit institution, insurance/reinsurance undertaking, UCITS/UCITS manager, pension scheme and alternative investment fund managed by an alternative investment fund manager, in each case where authorised or registered in accordance with the relevant EU directive.

    2 A non-financial counterparty is an undertaking which is not a financial counterparty or a central counterparty.

    3 If a non-financial counterparty breaches any of the following thresholds, it will be subject to the clearing obligation: €1 billion in gross notional value for over-the-counter credit and equity derivatives (individual thresholds), €3 billion in gross notional value for interest rate and FX (individual thresholds), or €3 billion in gross notional value for commodities and others (combined threshold). Derivatives entered into for the purposes of hedging the commercial or business risk of the non-financial counterparty should not be included when calculating the aggregate derivatives positions for the purposes of assessing whether a non-financial counterparty meets the threshold.

    4 This is, authorised by a competent regulatory authority in the EU to act as a central counterparty under EMIR.

    5 This is, a non-EU central counterparty authorised in its home jurisdiction, which meets certain criteria, including being subject to effective supervision and enforcement to ensure compliance with the prudential requirements applicable to it, and registered by ESMA as a recognised central counterparty under EMIR.

    6 As a result, those entering into a trading contract before EMIR comes into force, or once EMIR has come into force but before the clearing requirements come into effect, should keep track of the maturity dates of the derivatives contracts to ascertain if the contracts will mature before or after the clearing obligation comes into force and to ensure they are operationally and financially prepared for the additional obligations resulting from the clearing obligation.

    7 Including non-financial counterparties that are not Large NFCs.

    8 For example, DTCC and Regis-TR (multiple asset classes), ICE Trade Vault (commodities).

    9 The information includes, inter alia, the parties to the contract (or the beneficiary), the type of contract, the notional value of the contract, the price of the contract and the settlement date of the contract.

    10 This information is not required of non-financial counterparties that are not Large NFCs.

    11 This information is not required of non-financial counterparties that are not Large NFCs.

    12 In addition, parties to a derivative transaction must keep a record of the transaction, and any modification to the same, for at least five years following the termination of the derivative contract.

    13 Subject to a long-stop date of 1 July 2015.

    14 Subject to a long-stop date of 1 July 2015.

    15 With respect to non-financial counterparties other than Large NFCs, the confirmations must be concluded T+5 until 31 August 2013, T+3 until 31 August 2014 and T+2 thereafter.

    16 Including equity swaps, foreign exchange swaps and commodity swaps.

    17 With respect to non-financial counterparties other than Large NFCs, the confirmations must be concluded T+7 until 31 August 2013, T+4 until 31 August 2014 and T+2 thereafter.

    18 It is expected that the most significant broker-dealers must report this information to the regulator monthly. However, other entities will merely be required to have in place appropriate procedures and arrangements to ensure that they are able to provide the information regarding confirmations for transactions in uncleared derivatives to the regulator upon request.

    19 FCs and Large NFCs must engage in portfolio reconciliation daily for >500, once per week for 51-499, and once per quarter for <50 outstanding uncleared derivatives contracts with an FC or a Large NFC. Non-financial counterparties other than Large NFCs must perform portfolio reconciliation once per quarter for >100, and once per year for <100 outstanding uncleared contracts with any counterparty.

    20 It is likely that the European regulators will issue a public consultation in 2013 on the implementation of the rules for the collateral requirements for uncleared derivatives, after the results of the BCBS-IOSCO consultation on margin requirements for uncleared derivatives have been published. It is possible that the collateral rules could be in force in 2013, but they may be delayed until 2014. It is currently expected that all counterparties will be required to exchange variation margin, but only some counterparties will be required to exchange initial margin.