Speed read

The International Swaps and Derivatives Association, Inc. (ISDA) has announced the launch of the ISDA Amend EMIR Clearing Classification Tool (the CCT), working together with Markit, and the complementary publication of the ISDA EMIR Classification Letter (the Letter).

The International Swaps and Derivatives Association, Inc. (ISDA) has announced the launch of the ISDA Amend EMIR Clearing Classification Tool (the CCT), working together with Markit, and the complementary publication of the ISDA EMIR Classification Letter (the Letter).

The CCT allows counterparties to classify themselves according to the EMIR taxonomy, helping parties to achieve compliance with certain requirements imposed by EMIR (Regulation (EU) No 648/2012).  The Letter duplicates the content of the CCT, and the related ISDA Amend EMIR Counterparty Classification Tool, but in bilateral form for use by entities which do not use ISDA Amend.

This client briefing provides a short overview of the background to the CCT and the Letter, the regulatory requirements they address and a brief summary of their scope and structure.

Allen & Overy acted as drafting counsel to ISDA in the preparation of the Letter and the CCT.

BACKGROUND

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).  Still to take effect are the two requirements seen by many as the most challenging: mandatory clearing and prescribed collateral exchange.

The application of many of these EMIR requirements depends upon how the counterparties involved are categorized.  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.

In 2013, with the entry into force of many of the risk mitigation requirements, ISDA released the ISDA Amend EMIR Counterparty Classification Tool: a web-based system for market participants to notify each other of certain classification information, including as to FC, NFC+, NFC- or TCE status.

With clearing fast approaching, ISDA has released the CCT and the Letter to help market participants ensure they achieve compliance with the EMIR clearing obligation and to minimise some of the practical difficulties in implementation that clearing brings.

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 first of these four points, the European Securities and Markets Authority (ESMA) has confirmed that the first class of transactions to be subject to the clearing obligation will be 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 end of May this year being that the remaining few differences of opinion that existed between ESMA and the European Commission, which had been delaying publication, have now been resolved.  The draft IRP RTS provides detail as to the characteristics of transactions subject to mandatory clearing, splitting the main class of interest rate products into four types (interest rate swaps, basis swaps, forward rate agreements and overnight index swaps) and identifying sub-characteristics such as the reference index, settlement currency, maturity and notional type.

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.

The draft IRP RTS adds detail as to:

  1. the classification of counterparties subject to the clearing obligation:
  2. Category 1 (certain clearing members of CCPs);
  3. 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);
  4. Category 3 (FCs and NFC+s which are AIFs which are not in Category 1 or 2); and
  5. Category 4 (NFC+s which are not in Categories 1 to 3);
  6. 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
  7. whether frontloading applies.  Frontloading is the requirement to clear, by the mandatory clearing deadline, transactions entered into during a given period running up to the mandatory clearing deadline.  FCs in Categories 1 and 2 are subject to frontloading.  FCs in Category 3 and all NFCs are not subject to frontloading.

EMIR provides certain exemptions to the clearing obligation.  The key exemption addressed by the CCT and the Letter is the temporary exemption from mandatory clearing afforded to certain transactions entered into by certain European pension scheme arrangements, as detailed in Article 89 of EMIR.

THE CCT AND THE LETTER

The CCT and the earlier Counterparty Classification Tool, available through ISDA Amend, provide an online system for entities to notify (and automatically update) their counterparties of their EMIR classification by answering a series of simple questions, assisting both parties to a transaction determine the application of certain EMIR requirements to help ensure compliance.  Where one or both parties to a transaction do not use ISDA Amend, the Letter provides an alternative form of notification, duplicating the content of both the CCT and the Counterparty Classification Tool.  As the Letter is “manual”, so needs to be sent to each counterparty in turn, updates to classification would also need to be sent manually.

SCOPE AND CONTENT

Classification statements

The Counterparty Classification Tool allows each user to state whether it is out of scope of EMIR and, if so, what type of out of scope entity it is.  If the user is in scope of EMIR, it can state if it is a FC, NFC+, NFC- or a TCE equivalent to a FC, NFC+ or NFC- and also if it is a pension scheme arrangement.  If the user is a pension scheme arrangement, it can make a general statement as to its intention to use the pension scheme arrangement exemption.

The CCT addresses the categorization of counterparties for the purposes of the clearing obligation, allowing each user to state if it is in Category 1, Category 2, Category 3 or Category 4 and also if it is an AIF.  If the user is a pension scheme arrangement, the CCT allows the user to specify which type of pension scheme arrangement it is and also to make a specific statement as to its use of the pension scheme arrangement exemption.

The Letter is completed by the “Named Entity” (the entity making the statements) and can be addressed to an individual counterparty or simply “to whom it may concern”, copied to relevant counterparties.  The Named Entity makes the statements in Appendix I and/or Appendix II: Appendix I duplicates the content of the CCT, Appendix II duplicates the content of the Counterparty Classification Tool.  Appendix III provides the supporting definitions.  One point of difference between Appendix I to the Letter and the CCT is that the Letter provides that the statement as to Category 1 to 4 will continue to apply in respect of further classes of OTC derivative transactions subject to mandatory clearing (such as CDS) unless the Named Entity notifies the recipient to the contrary.  Appendix IV contains a form of notice that can be used for such notification.

Guidance and definitions

Both the Counterparty Classification Tool and the CCT provide “pop-ups” which give guidance as to their use and the meaning of certain key terms, including a number of definitions copied from the source regulation.  While the Letter does contain its supporting definitions, ISDA is also publishing standard form guidance notes to be used with the Letter, based closely on the pop-ups available in the Counterparty Classification Tool and the CCT.

With such guidance being available, we have not sought to replicate it in this client briefing.

FURTHER POINTS

The Letter and CCT are intended to help market participants notify their counterparties of their EMIR classification.  This is just one part of EMIR compliance, however: market participants considering using the Letter, the CCT and/or the Counterparty Classification Tool should also consider the following.

  • Whether using the CCT is better suited to their circumstances or whether the slightly more operationally intensive process of using the Letter is more appropriate.
  • As the CCT and the Letter are based on a draft form of the IRP RTS, whether the final form of the IRP RTS necessitates changes to the Letter or the refreshing of statements made through the CCT.
  • How market participants will manage counterparties which are unwilling to classify themselves using the Letter, the CCT or another form.  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.
  • Where they will become subject to the clearing obligation, how and where they will clear transactions either as a clearing member (for themselves and/or for their clients) or as the client of a clearing member.  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.  We note that indirect clearing may also be available, though this remains an area of on-going development.
  • Where they will be subject to frontloading, how they will manage transactions entered into during the frontloading period, potentially before clearing documentation has been finalised, and whether contingency plans are needed for transactions which are not cleared by their applicable deadline (see also our client briefing on The ISDA EMIR Frontloading Additional Termination Event Amendment Agreement).
  • Where they or their counterparty are not incorporated in the EU, to what extent the EMIR requirements apply to their transactions and whether equivalence and/or substituted compliance or similar might allow them and their counterparty to choose between applicable legislation.  Similarly, where they and/or their counterparty are subject to other regimes, such as the Dodd-Frank Act, whether conflicts exist between the legislation of the different jurisdictions.