EMIR is the European Market Infrastructure Regulation (technically the Regulation on OTC derivatives, central counterparties and trade repositories) It is the European legislative response to the G20 2009 meeting in Pittsburgh, where global leaders agreed several initiatives aiming to reduce risk and increase transparency in the OTC derivatives markets.
EMIR will introduce several new requirements on certain parties entering into OTC derivatives, including mandatory clearing, reporting derivatives and risk mitigation. It will also set out obligations with which central clearing counterparties (CCPs) must comply, including the criteria they must fulfil to be authorised. Any entity, whether a bank, other regulated firm, or a non-financially regulated firm, that trades OTC derivatives should be aware of EMIR and urgently assess its effects on trading.
What trades will be subject to mandatory clearing?
EMIR imposes an obligation on counterparties to clear certain OTC derivatives. The clearing obligation is likely apply to standardised types of trades, in particular those that are already cleared by clearing houses. However, a recital in EMIR recognises that clearing may not be appropriate for certain trades, such as FX trades, where credit risk (which clearing is intended to mitigate) is not the principal risk.
There are two conditions necessary for the clearing obligation to apply:
- the OTC derivative must fall within a class of OTC derivatives designated as subject to the clearing obligation; and
- the contract must be between certain counterparties.
To be subject to clearing, where a financial counterparty enters into an OTC derivative, it must do so:
- with another financial counterparty (broadly, a regulated financial market participant);
- with a non-financial counterparty that meets certain required thresholds; or
- with an entity established outside the EU that would be subject to the clearing obligation if it were an EU-established entity.
What are the information reporting requirements?
EMIR will also introduce wide ranging obligations to report the details of derivative contracts. These reporting obligations apply to all derivative contracts, whether or not these are cleared trades.
EMIR requires the reporting of details of any derivative contract that a counterparty has concluded, modified or terminated to a trade repository or, if a trade repository is not available, to the European Securities and Markets Authority (ESMA). The required details include the parties to the contract and the main characteristics of the contract. Reports must be made no later than the working day following the conclusion, modification or termination of the contract.
What are the risk mitigation obligations?
Where an OTC derivative is not subject to the clearing obligation, EMIR imposes extra obligations on the counterparties to that OTC derivative. The aim of these obligations is to ensure that parties mitigate credit risk, even though these OTC derivatives are not cleared.
These risk mitigation obligations will require counterparties to ensure there are appropriate procedures and arrangements in place to measure, monitor and mitigate operational counterparty credit risk.
As part of these risk mitigation obligations, financial counterparties may have to post both initial margin and variation margin as collateral for OTC derivatives.
When will these EMIR obligations come into effect?
The European Parliament approved the text of EMIR on 29 March 2012 (the EMIR Text). The European Council should approve the EMIR Text by August 2012. Although the original target date for EMIR to come into effect was the end of 2012 (in line with the G-20 deadline), the Commission has indicated that this is unlikely.
EMIR is framework legislation. Much detail is missing from the EMIR Text. ESMA has the task of producing technical standards for EMIR (the Technical Standards). There were discussion papers on the Technical Standards in February and March. ESMA is now consulting on regulatory technical standards under EMIR. The consultation is open until 5 August and there is a public hearing on 12 July.
Until the Technical Standards are published we will not know the precise requirements under EMIR. In particular, ESMA will decide:
- the clearing threshold;
- the criteria to apply a “hedging exemption”; and
- which derivatives are eligible for central clearing.
Added to this, the European Banking Authority is consulting on authorisation and operating conditions for CCPs, and ESMA must put in place a process to trade repositories.
What are other jurisdictions doing?
Both Europe and the US are advanced in their approaches to meeting the G20 requirements. The US is meeting the requirements on OTC derivatives under the Dodd Frank Act. However, as is proving the case with most initiatives to support G20 recommendations, the proposals from each side of the Atlantic are drafted, formed and scoped differently. This means firms that may fall under both sets of regulations need to carry out a detailed compare and contrast exercise to accurately assess their position. Most controversial is the US CFTC proposals to apply the Dodd Frank Act extra-territorially.
SNR Denton is currently acting for several clients wishing to understand what their regulatory obligations might be post-clearing, and which clearing solutions to pick. We have developed several presentations comparing the position in the US with that in Europe, which we are happy to share with clients grappling with these challenging developments.