As part of the on-going implementation of EMIR, the EC has adopted a delegated regulation in August 2015 relating to the introduction of the mandatory clearing obligation for certain interest rate swap transactions (the IRS Clearing RTS). 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.
This alert summarises the contracts and counterparties in scope and suggests practical steps to prepare for the start of mandatory clearing.
Part IA. Background to the Clearing Obligation
The European Market Infrastructure Regulation (EMIR) is introducing a number of key obligations for counterparties in the derivatives markets. These Level 1 obligations are being phased-in over time with the details of each obligation set out in the relevant Level 2 regulatory technical standards (RTS) and implementing technical standards. Certain reporting and risk mitigation obligations (namely the obligations to (i) report derivatives contracts to a trade repository, (ii) confirm contracts in a timely manner, (iii) periodically reconcile and compress portfolios, (iv) value transactions, and (v) ensure dispute resolution procedures are in place) are already in effect. Other obligations, such as the mandatory clearing obligation (the focus of this briefing) and collateral requirements for uncleared transactions, are yet to become effective.
The IRS Clearing RTS provide the details of the obligation to clear certain over-the-counter (OTC) interest rate derivatives products through a central counterparty (CCP), as originally mandated by Article 4 of EMIR. Following finalisation of the IRS Clearing RTS, it is expected that further RTS relating to additional asset classes will be published and will be substantially similar in content.
There is no confirmed timing for the publication of the IRS Clearing RTS in the Official Journal of the EU, however, current market expectation is that mandatory clearing for the first set of counterparties (Category 1) could commence in May 2016 (with frontloading starting as early as January 2016 for such counterparties).
Part IB. Application of the Clearing Obligation
In summary, the mandatory clearing obligation will apply where both parties belong to a class of counterparty subject to the clearing obligation (see Part II below), they enter into a type of contract identified in the IRS Clearing RTS (see Part III below) and there are no exemptions available (see Part V below). This obligation to clear will also apply to certain contracts entered into before the IRS Clearing RTS actually become effective (see Part IV below).
In particular, the IRS Clearing RTS bring clarity on the following key issues:
- which contracts? Fixed-to-float interest rate swaps, float-to-float swaps/basis swaps, forward rate agreements and overnight index swaps with certain features will be the first classes of OTC derivatives subject to the to mandatory central clearing obligation;
- when will the clearing obligation will take effect? 6, 12,18 or 36 months after the entry into force of the IRS Clearing RTS depending on whether the counterparty is classified as Category 1, 2, 3 or 4 (see further below); and
- must existing contracts be cleared (often referred to as ‘frontloading’)? In some cases, yes. In particular, Category 1 and 2 financial counterparties will be obliged to frontload certain contracts depending on the remaining maturity of the contract.
Part II. Classification of Parties
Pursuant to EMIR, the following types of entities are subject to the clearing obligation:
- financial counterparties (FCs)i ;
- non-financial counterpartiesii exceeding the clearing threshold (NFC+s); and
- entities established outside the EU which would be FCs or NFC+s if they were established in the Union (known as third country entities or TCEs).
A transaction between any of these entities will therefore be subject to the clearing obligation once the relevant RTS, identifying the relevant transactions within scope, become effective. There is one caveat to this general rule – a transaction between two TCEs need only be cleared if it has a “direct, substantial and foreseeable effect” within the Union or in order to prevent evasion of EMIR. Please refer to our bulletin "EMIR: EU extra-territorial rules on "direct, substantial and forseeable effect" to apply from October 2014" for further information. For completeness, we note that if a transaction is entered into between any of the above parties and a NFC below the clearing threshold (a NFC-), then such trade will not be subject to mandatory clearing. Further, we note that both parties to a trade must be subject to the clearing obligation in order for a transaction between those parties to be mandatorily clearable.
The IRS Clearing RTS add further granularity by dividing the relevant counterparties into four ‘Categories’, in respect of each of which the start date for clearing differs, as follows:
Click here to view table.
Where a relevant contract is entered into between counterparties in different categories, the relevant Clearing Start Date for such contract shall be the Clearing Start Date applicable to the counterparty with the longest phase-in period. We note that, subject to certain conditions, a deferred Clearing Start Date or an exemption from clearing (for counterparties in Category 1, 2 and/or 3) may apply in respect of transactions concluded between counterparties belonging to the same group.
Part III. Relevant Classes of Transaction
The IRS Clearing RTS detail which interest rate products will be the first classes of OTC derivative transactions subject to the mandatory clearing obligation including, for example, the transaction type (see below), reference index (EURIBOR, LIBOR, EONIA, FEDFUNDS and SONIA), settlement currency (for example, EUR, GBP, JPY and USD), maturity (varying from 3 days to 50 years), settlement currency type, optionality and notional type (currently only transactions with a constant or variable notional amount are included). The transaction types are:
- float-to-float swaps/basis swaps (as set out in table 1 of Annex 1 of the IRS Clearing RTS);
- fixed-to-float interest rate swaps (as set out in table 2 of Annex 1 of the IRS Clearing RTS);
- forward rate agreements (as set out in table 3 of Annex 1 of the IRS Clearing RTS); and
- overnight index swaps (as set out in table 4 of Annex 1 of the IRS Clearing RTS).
ESMA has also proposed rules relating to the mandatory clearing of additional classes of OTC interest rate derivatives and is expected to propose rules relating to the mandatory clearing of further classes of transaction, such as credit default swaps, in the near future. The timing for the mandatory clearing of additional classes of OTC derivative contracts will of course differ as set out in the relevant rules.
Part IV. Frontloading
For the majority of market participants which are in a category subject to mandatory clearing and which are entering into transactions of a class subject to mandatory clearing, only new transactions, entered into on or after the Clearing Start Date, will have to be cleared.
However, some market participants will have to clear transactions entered into during a given period (known as the frontloading window) leading up to the Clearing Start Date. This additional EMIR requirement is known as “frontloading”.
In respect of the IRS Clearing RTS, frontloading applies to FCs which are in:
- Category 1: These counterparties will be required to frontload relevant derivatives transactions entered into or novated on or after the date which is 2 months following entry into force of the IRS Clearing RTS until the Clearing Start Date. This requirement applies to relevant derivatives transactions with a minimum remaining maturity of 6 months.
- Category 2: These counterparties will be required to frontload relevant derivatives transactions entered into or novated on or after the date which is 5 months following entry into force of the IRS Clearing RTS until the Clearing Start Date. This requirement applies to relevant derivatives transactions with a minimum remaining maturity of 6 months.
Frontloading does not apply to NFC+s or Category 3 financial counterparties.
Part V. Exemptions from the Clearing Obligation
EMIR provides certain limited exemptions to the clearing obligation, including for certain European pension scheme arrangements (as detailed in Article 89 of EMIR and as the European Commission recently proposed be extended to 16 August 2017) and certain intragroup transactions.
The IRS Clearing RTS also exempt from the clearing obligation contracts concluded with covered bond issuers or with cover pools for covered bonds, provided that certain criteria are met including, for instance, that the contract is used solely for the purposes of interest rate or currency hedging.
With clearing for Category 1 counterparties anticipated to potentially start in May 2016, mandatory clearing is inching ever closer and counterparties to derivative transactions would be wise to:
- check whether they are in scope of the IRS Clearing RTS and, if so, (a) under which Category they fall, and (b) whether they will be obliged to frontload;
- if they are in scope, ensure that the necessary documentation is in place to clear transactions through a CCP (including clearing agreements and execution agreements); and
- if they are in scope, ensure there is access to sufficient and appropriate collateral to support cleared trades.
Experience from the introduction of mandatory clearing in the US shows that parties are best advised to start the negotiation of the relevant documentation as early as possible. Market standard positions are still relatively fluid and the outcome of commercial and documentation negotiations may have a significant financial impact for counterparties, so negotiation of the relevant documentation can be time consuming. There may also be capacity and prioritisation constraints at clearing member institutions as the relevant Clearing Start Dates draw near which, in the US at least, resulted in some clients finding their opportunity to negotiate was reduced. As such, counterparties should ensure that client clearing documentation is in place and there is time to conduct test clearing of trades with a clearing member and CCP well in advance of the relevant Clearing Start Date.
As discussed above, RTS relating to the mandatory clearing of additional classes of OTC derivatives are expected to be published following the finalisation of the IRS Clearing RTS. Whilst these are expected to be substantially similar in content, it is possible that certain amendments may subsequently be made as a result of the European Commission’s EMIR review which is currently underway.