European Market Infrastructure Regulation (EU) No. 648/2012 (EMIR) requires certain classes of OTC derivatives to be cleared through a central counterparty (a CCP). This is colloquially referred to as the “clearing obligation” or “mandatory clearing”.
All EU financial counterparties (FCs) and EU non-financial counterparties over the clearing threshold (as specified in Art. 11 of Regulation No. 149/2013) (NFC+s, and together with FCs, In-scope Counterparties) will be subject to the clearing obligation when they transact with (i) another FC or NFC+; or (ii) a non-EU entity which would be classified as an FC or an NFC+ if it was established in the EU.
OTC derivatives involving pension schemes, as well as intra-group OTC derivatives, are exempt from the clearing obligation (in the case of the former, currently until 16 August 2017) subject to certain conditions.
The clearing procedure started in Q1 2014 following the first authorisations of EU CCPs. Since then, the European Securities and Markets Authority (ESMA) has analysed interest rate, credit, equity and foreign-exchange OTC derivatives and proposed that interest rate and credit OTC derivatives become subject to central clearing by developing relevant regulatory technical standards.
Recapping the most recent developments:
- On 10 November 2015, the final version of the regulatory technical standards on the clearing of certain interest rate OTC derivatives settled in relevant EEA currencies was submitted by ESMA to the European Commission (the EC) for endorsement.
- On 21 December 2015, the regulatory technical standards (the G4 IRS RTS) on the clearing of certain interest rate OTC derivatives (each a G4 IRS Contract) settled in EUR, GBP, JPY or USD entered into force.
- On 1 March 2016, the regulatory technical standards on the clearing of certain credit OTC derivatives (index credit default swaps) were adopted by the EC. The final draft must now be accepted by the European Parliament and the Council and published in the Official Journal of the EU before it takes effect. However, it is not expected that there will be any amendments.
Timeline for G4 IRS Contracts
Following the effectiveness of the G4 IRS RTS, In-scope Counterparties must comply with:
- the clearing obligation: this requires all G4 IRS Contracts between In-scope Counterparties that are entered into on or after the effective date for the clearing obligation for those In-scope Counterparties to be cleared through a CCP (unless exempt); and
- the frontloading obligation: this requires all G4 IRS Contracts between In-scope Counterparties that are entered into (i) after the effective date for the frontloading obligation for those In-scope Counterparties but (ii) before the effective date for the clearing obligation for those In-scope Counterparties, to be cleared (by such effective date) through a CCP (unless exempt).
Both the clearing obligation and the frontloading obligation are to be “phased in” . The phase-in start dates are based on the categorisation of In-scope Counterparties:
- Category 1 (Clearing Members): (i) clearing obligation – 21 June 2016; (ii) frontloading obligation – 21 February 2016 (to Category 1 clearing start date);
- Category 2 (FCs and NFC+ alternative investment funds (AIFs) above the clearing threshold of EUR 8 billion): (i) clearing obligation – 21 December 2016; (ii) frontloading obligation – 21 May 2016 (to Category 2 clearing start date);
- Category 3 (FCs and NFC+ AIFs below the clearing threshold of EUR 8 billion): (i) clearing obligation – 21 June 2017; (ii) frontloading obligation – does not apply; and
- Category 4 (other NFC+s): (i) clearing obligation – 21 December 2018; (ii) frontloading obligation – does not apply.
Where an OTC derivative is concluded between In-scope Counterparties included in different categories, the phase-in start date for that OTC derivative will be the later date.
In-scope Counterparties to G4 IRS Contracts are advised to start seeking confirmations as to their counterparties’ categorisation for the purposes of the G4 IRS RTS, in order to undertake an assessment by when any G4 IRS Contract will need to be cleared and whether the frontloading obligation applies. Such confirmations can be done bilaterally (and a template ISDA EMIR Classification Letter can be used for these purposes) or using industry platforms (such as the ISDA Amend EMIR Clearing Classification Tool). When providing the requisite information, an In-scope Counterparty should carefully assess if this would constitute a formal representation under its trading documentation with other relevant counterparties the breach of which would result in a default under any such documentation.
Since the clearing obligation is fast approaching, In-scope Counterparties should now also be taking steps to:
- choose a Clearing Member through which they will access the CCP(s). The prevailing market practice is to appoint one primary Clearing Member and one ”back-up” Clearing Member. The reason for appointing the latter is to mitigate the risk of not being able to access the CCP if, for instance, the primary Clearing Member has defaulted;
- consider which CCP(s) they want to access. Any CCP will need to be authorised or recognised in accordance with EMIR. Importantly, In-scope Counterparties should diligence the applicable rules of any considered CCP(s) to understand what protections are available to them as the client clearing offering will differ between CCPs; and
- start negotiating the clearing documentation. If an In-scope Counterparty fails to have in place its client clearing arrangements with at least one Clearing Member by the time it needs to comply with the clearing obligation, it will be unable to access clearing. This may prevent it from entering into G4 IRS Contracts until it has negotiated, and entered into, its clearing documentation. Given the anticipated large number of Inscope Counterparties needing to finalise the client clearing arrangements, all relevant market players should ensure that sufficient time remains in order to do so.