On 12 June 2015 the International Swaps and Derivatives Association, Inc. (ISDA) announced the launch of the ISDA EMIR Frontloading Additional Termination Event Amendment Agreement (the Frontloading ATE).
The Frontloading ATE allows counterparties to terminate transactions subject to mandatory clearing under EMIR (Regulation (EU) No 648/2012) if those transactions are not cleared by the mandatory clearing start date. This helps parties to reduce the additional risk of regulatory breach which is associated with the frontloading requirement.
This client briefing provides a short overview of the background to the Frontloading ATE, the regulatory requirements it seeks to address and a brief summary of its scope and structure. It can be read in conjunction with ISDA’s explanatory memorandum to the Frontloading ATE, which explains why the Frontloading ATE was created and provides more guidance and detail on its structure and language, as well as practical issues. Given that such guidance is available, we have not sought to replicate it in this client briefing.
Allen & Overy acted as drafting counsel to ISDA in the preparation of both the Frontloading ATE and the accompanying explanatory memorandum.
EMIR introduces a number of key obligations for counterparties in the derivatives market. Already in effect are the obligation to report to a trade repository and most of the risk mitigation requirements (including daily valuation, timely confirmation, portfolio reconciliation, dispute resolution and portfolio compression). However, mandatory clearing – seen by many as one of the most challenging requirements – is still to take effect.
The application of many of these EMIR requirements depends upon how the counterparties involved are categorised. Broadly, EMIR divides counterparties into financial counterparties (FCs) and non-financial counterparties (NFCs), with NFCs further divided into those which exceed the clearing threshold (NFC+s) and those which fall below it (NFC-s). Third country entities (TCEs) may also be subject to EMIR, directly or indirectly.
THE CLEARING OBLIGATION
Article 4 of EMIR requires that OTC derivative transactions are cleared through an authorized or recognized central counterparty (CCP). The application of this clearing obligation depends on (i) the class of the transaction; (ii) the classification of the parties to the transaction; (iii) the date the transaction is entered into; and (iv) whether certain exemptions from the clearing obligation apply.
In respect of the class of transaction, the European Securities and Markets Authority (ESMA) has confirmed that the first class to be subject to the clearing obligation will be certain interest rate products. ESMA is considering further classes, such as credit default swaps, but consultation on these has been put on hold while ESMA focuses on finalising the interest rate product regulatory technical standards (the IRP RTS). The indication at the time of publication of this briefing was that the remaining few differences of opinion that existed between ESMA and the European Commission, which had been delaying publication of the IRP RTS, have now been resolved. However, the IRP RTS has not yet been published.
In respect of the classification of the parties to the transaction, EMIR mandates clearing of transactions between FCs, NFC+s and their TCE equivalents. NFC-s are not subject to the clearing obligation, neither are members of the European system of central banks and certain other national or supranational bodies.
EMIR provides certain additional, limited exemptions to the clearing obligation, including for certain European pension scheme arrangements (as detailed in Article 89 of EMIR and as recently extended by the European Commission to August 2017) and certain intragroup transactions.
The draft IRP RTS adds detail as to:
- the classification of counterparties subject to the clearing obligation:
- Category 1 (certain clearing members of CCPs);
- Category 2 (FCs and NFC+s which are Alternative Investment Funds (AIFs), in either case, whose aggregate month-end average of outstanding gross notional amount of uncleared derivatives during a specified three month period is above EUR 8 billion);
- Category 3 (FCs and NFC+s which are AIFs which are not in Category 1 or 2); and
- Category 4 (NFC+s which are not in Categories 1 to 3);
- the timing of mandatory clearing, which is being phased in over a three year period to apply first to Category 1, then Category 2, then Category 3 and, finally, Category 4; and
- whether frontloading applies.
Market participants who are subject to mandatory clearing and who are entering into a class of transaction which is subject to mandatory clearing will need to clear new transactions entered into on or after the clearing start date.
However, certain market participants will also be required to clear, by the clearing start date, transactions entered into during a ‘frontloading period’ running up to that clearing start date. The frontloading period for a given class of transaction will be specified in the relevant RTS. FCs in Category 1 and 2 are subject to frontloading; FCs in Category 3 and all NFCs are not subject to frontloading.
Where a transaction is subject to the frontloading obligation, the only way to avoid regulatory breach is to either (i) clear the transaction; or (ii) terminate the transaction, in each case by the clearing start date.
THE FRONTLOADING ATE
The frontloading requirement introduces additional regulatory risk for relevant counterparties entering into relevant transactions during the frontloading period. Parties may enter into a transaction with the intention to satisfy EMIR requirements by clearing before or on the clearing start date, but there are a number of possible reasons why this may not happen. This could be due, for example, to general delays with documentation or failure to agree (on issues such as the CCP through which to clear), or events beyond the parties’ control.
The Frontloading ATE is designed to help counterparties reduce this risk by allowing them to terminate transactions subject to mandatory clearing if they are not cleared by the clearing start date (or a specified date before then). Neither the 1992 nor the 2002 versions of the ISDA Master Agreement currently provides the mechanics for this.
SCOPE AND CONTENT
The Frontloading ATE is a standard form ISDA Additional Termination Event (as defined in the ISDA Master Agreement) incorporated by way of a bilateral amendment agreement. It is intended for use by counterparties to either the 1992 or 2002 ISDA Master Agreement.
Incorporated as an amendment to Part 5 of the Schedule to the ISDA Master Agreement, it provides that if one or more transactions required to be cleared under EMIR are not cleared by their “Clearing Deadlines”, it will constitute an Additional Termination Event granting a right of termination in respect of “Affected Transactions”. It is drafted so as to provide that only those transactions subject to the clearing obligation and not cleared by the relevant date can be terminated, rather than all transactions under the relevant ISDA Master Agreement.
It is intended that users of the Frontloading ATE will amend and adapt it to their particular needs. To facilitate this, optional variations are built in. For example:
- “Affected Parties”. Users can choose whether there will be one or two Affected Parties, which will determine which party(/ies) has the right to terminate and which party(/ies) will perform the close-out valuations. The Frontloading ATE sets out some standard variations and further guidance is provided in the footnotes.
- Valuation of terminated transactions. Again, the Frontloading ATE provides amendments and substitutions to standard valuation methods. Parties can opt for “Loss” as a payment measure, for example, and specify which facts should be taken into account when valuing the trade and its hypothetical replacement.
- “Clearing Deadline”. Users are invited to specify when the “Clearing Deadline” (by which transactions must be cleared) will be. This can be the mandatory clearing start date, or a number of days before. This optionality may be helpful to parties wanting an extra ‘buffer’ to avoid regulatory breach, but ISDA have also noted that it could mitigate the risk of market disruption where large numbers of transactions are terminated on one date.
- Governing law. Parties are invited to choose the governing law.
The above are just some examples of possible amendments that counterparties could make. The footnotes to the ATE suggest further revisions; explore the options for users of the Frontloading ATE and note points to consider and issues to be aware of.
Market participants considering using the Frontloading ATE may also find it helpful to consider the following points.
- How to determine whether clearing and frontloading obligations apply: what is your classification for clearing purposes and how will you determine that of your counterparties? For FCs and NFC+s in particular, it is necessary to determine the status of every counterparty to an OTC derivative transaction in order to assess how EMIR applies. Market participants could consider using the ISDA Amend EMIR Clearing Classification Tool.
- How and where transactions are going to be cleared, so as to avoid needing to terminate using the Frontloading ATE. Experience from the US shows that it is better to start negotiating the relevant documentation as early as possible in order to achieve the best terms. Parties should consider whether they will clear as a clearing member (for themselves and/or for their clients) or as the client of a clearing member. Indirect clearing may also be available, though this remains an area of on-going development.
- Practical difficulties: although the Frontloading ATE allows parties to amend the standard ISDA Master Agreement language, too much variation might create practical difficulties for market participants negotiating the Frontloading ATE with a large number of counterparties. Equally, some parties may feel that a bilateral amendment format is not workable given the number of transactions which may be subject to the frontloading obligation.
- Whether the final form of the relevant clearing RTS (when published) necessitate changes to the drafting of the Frontloading ATE. Counterparties need to be alert to changing regulatory requirements.