On August 6, 2015, the European Commission (EC) adopted new rules that will require the clearing of certain over-the-counter (OTC) interest rate swaps pursuant to the European Market Infrastructure Regulation (EMIR) (the EU IRS Clearing Rules). The EU IRS Clearing Rules are subject to approval by the European Parliament (Parliament) and Council of the European Union (Council); however, if the Parliament and Council do not act by the end of November 2015, the EU IRS Clearing Rules will enter into force and become effective 20 days after being published in the Official Journal of the European Union. Per the EU IRS Clearing Rules, the clearing requirement will be implemented on a phased-in basis over the next three years, as described further below.
Covered Interest Rate Swaps
The EU IRS Clearing Rules would subject the following four classes of interest rate swaps to mandatory clearing (collectively, the Covered Interest Rate Swaps):
- Basis swaps denominated in EUR, GBP, JPY and USD with a maturity of 28 days to 50 years and referencing EURIBOR or LIBOR;
- Fixed-to-float swaps denominated in EUR, GBP, JPY and USD with a maturity of 28 days to 50 years and referencing EURIBOR or LIBOR;
- Forward rate agreements denominated in EUR, GBP and USD with a maturity of three days to three years and referencing EURIBOR or LIBOR; and
- Overnight index swaps denominated in EUR, GBP and USD with a maturity of seven days to three years and referencing FedFunds, EONIA or SONIA.1
Generally, the classes of interest rate swaps that are subject to mandatory clearing under the EU IRS Clearing Rules align with the classes of interest rate swaps that are subject to mandatory clearing in the United States pursuant to the rules of the U.S. Commodity Futures Trading Commission (CFTC). There are a couple of differences, however:
- CFTC rules require the clearing of forward rate agreements denominated in JPY, whereas forward rate agreements denominated in JPY are not included in the EU IRS Clearing Rules; and
- The maximum maturity for the overnight index swap class is two years under the CFTC’s rules, whereas it is three years under the EU IRS Clearing Rules.
Who Has to Clear?
EMIR classifies persons in the European Union (EU), who are counterparties to derivatives transactions, as “financial counterparties” (FCs) or “non-financial counterparties” (NFCs), with the latter category further broken down into entities above a designated clearing threshold (NFC+) and those below it (NFC-).2 EMIR generally mandates the clearing of certain OTC derivatives transactions entered into by FC and NFC+ entities.
The EU IRS Clearing Rules establish four categories of persons for the purpose of implementing the clearing requirement on a phased-in basis. The clearing categories of persons are as follows:
- “Category 1” includes persons that, on the date of entry into force of the EU IRS Clearing Rules, are clearing members of at least one of the clearinghouses authorized or recognized to clear Covered Interest Rate Swaps.
- “Category 2” includes persons that (a) are not Category 1 persons, (b) belong to a group whose aggregate month-end average of outstanding gross notional amount of non-centrally cleared derivatives (including foreign exchange forwards, swaps and currency swaps) is above EUR 8 billion in each of the three months following publication of the EU IRS Clearing Rules in the Official Journal of the European Union (excluding the month of publication) and (c) are FCs or alternative investment funds that are NFC+s.
- “Category 3” includes persons that are not Category 1 or Category 2 persons and that are FCs or alternative investment funds that are NFC+s.
- “Category 4” includes persons that are NFC+s that are not Category 1, 2 or 3 persons.
The EU IRS Clearing Rules provide for the clearing obligation to be implemented on a phased-in basis, so as to allow additional time for smaller market participants to comply with the requirements. The timeline for compliance is as follows:
- Category 1 persons will be required to clear their Covered Interest Rate Swaps beginning six months after the EU IRS Clearing Rules enter into force.
- Category 2 persons will be required to clear their Covered Interest Rate Swaps beginning 12 months after the EU IRS Clearing Rules enter into force.
- Category 3 persons will be required to clear their Covered Interest Rate Swaps beginning 18 months after the EU IRS Clearing Rules enter into force.
- Category 4 persons will be required to clear their Covered Interest Rate Swaps beginning three years after the EU IRS Clearing Rules enter into force.
Where the counterparties to a swap fall into different clearing categories of persons, the later compliance date will apply. So, for example, if a Category 2 person enters into a Covered Interest Rate Swap with a Category 3 person, the 18-month compliance deadline would apply instead of the 12-month deadline.
“Frontloading” refers to the requirement, under EMIR, to retroactively clear Covered Interest Rate Swaps that were entered into during the period of time between March 18, 2014 (the date the first central clearing counterparty (CCP) was authorized to clear interest rate swaps under EMIR) and the applicable compliance date for mandatory clearing in the EU. Frontloading has been widely criticized by market participants. The EU IRS Clearing Rules attempt to mitigate the effect of frontloading by (a) taking steps to ensure that frontloading will only apply to persons falling into Category 1 or Category 2 and (b) postponing the start date of frontloading until two and five months after the EU IRS Clearing Rules enter into force for Category 1 and Category 2 persons, respectively.3 As a result, Category 1 persons will only be required to frontload Covered Interest Rate Swaps that are executed between two months after the EU IRS Clearing Rules enter into force and the applicable Category 1 compliance deadline. Category 2 persons will only be required to frontload Covered Interest Rate Swaps that are executed between five months after the EU IRS Clearing Rules enter into force and the applicable Category 2 compliance deadline. Notably, in a response to the EC’s request for comments on the implementation of EMIR, ESMA recommended doing away with the frontloading requirement. In order for this to be the case the language of EMIR itself would need to be amended.
Application of the EU IRS Clearing Rules to TCEs
Persons outside of the EU are considered “third country entities” or “TCEs” for purposes of EMIR. A TCE would be subject to mandatory clearing in the EU, provided that the TCE would be subject to clearing if it were established in the EU and an FC or NFC+, when trading with (a) an FC or NFC+4 or (b) another TCE if the relevant transaction “has a direct, substantial and foreseeable effect within the EU or where such obligation is necessary or appropriate to prevent the evasion of any provision of [EMIR].”5
The EU IRS Clearing Rules provide additional time for compliance for intragroup Covered Interest Rate Swaps where one of the counterparties is an FC or NFC+ and the other is a TCE.6 In such a circumstance, the EU IRS Clearing Rules afford three years for compliance (after the EU IRS Clearing Rules enter into force), provided that the EC has not issued an equivalence determination with respect to the mandatory clearing regime in the TCE’s jurisdiction (equivalence is discussed below). If the EC has issued an equivalence determination, the later of the relevant compliance date listed above and the date of the equivalence determination will apply.
Items that are Still on the Horizon
One question often raised by market participants is whether compliance with the clearing obligation of one jurisdiction (e.g., the United States) would satisfy the EMIR clearing obligation. This question is typically asked by TCEs that regularly trade with FCs or NFC+s. In order for this to be permissible one of the counterparties must be a TCE and two criteria must be met:
- The EC must make a determination that the non-EU jurisdiction’s mandatory clearing regime is “equivalent” to the clearing regime under EMIR. This requires a general review of the non-EU jurisdiction’s clearing regime and is “outcomes” based; and
- ESMA must “recognize” the CCPs of the non-EU jurisdiction.
To date, although ESMA has recommended equivalence for the United States, the EC has not yet deemed the U.S. mandatory clearing regime “equivalent” to the EMIR regime. It has, however, adopted equivalence decisions for the regulatory regimes of central counterparties in Australia, Hong Kong, Japan and Singapore. ESMA has also not recognized any United States CCPs, despite having received applications from several of them.
EU and United States regulators are expected to reach agreement on equivalence before the end of the year.
It should be noted that a finding of equivalence by the EC might not permit a TCE to comply with the clearing requirements of its home jurisdiction in lieu of the EMIR clearing requirements altogether. This would depend on the scope of the equivalence determination but could be the case where there is a mismatch between the regulatory requirements of the two jurisdictions (e.g., the different maximum maturity for overnight index swaps subject to mandatory clearing, which was highlighted above). In such a scenario, compliance with the EU clearing obligation may still be necessary.
Mandatory Clearing of Other Product Types
The EU IRS Clearing Rules represent the first clearing obligation to be implemented under EMIR. ESMA previously released consultation papers for draft regulations that would impose the clearing obligation on certain classes of credit default swaps and non-deliverable foreign exchange forwards (FX NDFs). ESMA subsequently released a statement indicating that it is not planning to finalize regulations, for consideration by the EC, to impose a clearing obligation with respect to FX NDFs. However, ESMA is expected, in the near future, to finalize proposed regulations for consideration by the EC that would require certain credit default swaps to be cleared. ESMA’s delay of the credit default swap clearing regulations is intended to ensure that it can incorporate certain items that overlap with the interest rate swaps clearing regulations into the credit default swap clearing regulations.