Five years on from the G20's commitment to implement measures to increase transparency and reduce counterparty credit risk and operational risk in the derivative markets, there have been significant changes to regulations affecting the derivatives markets in the European Union. However, many new rules are still not yet in force and some, such as the margin requirements under the European Market Infrastructure Regulation (EMIR), will not be fully implemented until 2020. Nevertheless, the European Commission intends to propose a legislative review of EMIR in 2017, which will look at specific issues, including adjusting the requirements for non-financial counterparties (NFCs).
Although the G20 leaders pledged to implement global standards in a way that ensures a level playing field and avoids fragmentation of markets, protectionism and regulatory arbitrage, there has been some inconsistency globally ? for example, the implementation of the margin requirements.
This update takes stock of the main requirements affecting derivative transactions in the European Union that are already in force and looks ahead to those new requirements that are on the horizon and likely to come into force in 2017 and beyond.
Under EMIR, financial counterparties (FCs) and non-financial counterparties over certain clearing thresholds (NFC+s) need to clear certain derivative trades if they have been declared subject to the clearing obligation. To date, certain interest rate swaps denominated in euros, dollars or pounds (G4 IRS swaps), certain interest rate swaps denominated in Swedish kroner, Polish zloty or Norwegian kroner (non-G4 IRS swaps) and certain index credit default swaps have been declared subject to the clearing obligation, although the requirements will be phased in depending on the type of counterparties concerned.
Category 1 counterparties comprises clearing members which need to start clearing these instruments first. Category 2 counterparties are broadly FCs and alternative investment funds (AIFs), which are NFC+s that belong to a group whose aggregate month-end aggregate notional amount of non-centrally cleared derivatives is calculated to be above €8 billion during a specified three-month period. Counterparties in Categories 1 and 2 will also need to frontload and clear their relevant over-the-counter (OTC) derivative contracts that are above the relevant minimum remaining maturity. Counterparties which may be FCs or AIFs but will not meet the requirements for either of the preceding categories, as they will have a much more limited volume of activity in derivatives (which could therefore include many pension funds), will fall into Category 3. Finally, Category 4 consists of NFC+s, which broadly have over two years to comply with the clearing obligation.
The phase-in date for the clearing of OTC derivatives applicable to Category 3 firms under EMIR is likely to be postponed by up to two years ? until June 21 2019 ? following a final report published by the European Securities and Markets Association (ESMA) on November 14 2016. This is in response to the difficulties that financial counterparties with a limited volume of activity are facing in establishing the necessary clearing arrangements to meet their compliance deadline and the limited impact in terms of systemic risk that these counterparties represent. The European Commission now has three months to endorse this final report and accept this proposal.
Under EMIR, FCs and NFC+s will be subject to initial and variation margin requirements for uncleared trades. However, participants need exchange initial margin from the relevant phase-in date only if they and their counterparty both have or belong to groups with an aggregate month-end average notional amount of uncleared derivatives that is above €8 billion. This €8 billion threshold does not apply to the requirement to post variation margin, which will apply from March 1 2017 for all FCs and NFC+s. The phase-in dates (which fall behind the globally agreed timeline) are set out below.
Uncleared derivatives trades subject to the initial margin rules
Feburary 4 2017
If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2016 that is above €3 billion.
September 1 2017
If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2017 that is above €2.25 billion.
September 1 2018
If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2018 that is above €1.5 billion.
September 1 2019
If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives for March, April and May 2019 that is above €7.5 billion.
September 1 2020
If both counterparties have or belong to groups each of which has an aggregate month-end average notional amount of uncleared derivatives that is above €8 billion.
All uncleared OTC derivatives ? except physically settled foreign exchange (FX) swaps and forwards and currency swaps ? are in scope of the initial margin requirements. The variation margin requirements will apply to all uncleared OTC derivatives, including physically settled FX swaps and forwards and currency swaps. Given the inconsistent interpretation of FX derivatives across the European Union, there is a delayed application of the variation margin requirements to physically settled FX forwards until December 31 2018 or the date of entry into force on the delegated act under the EU Markets in Financial Instruments Directive (2014/65) (MiFID II), which would provide a common definition of 'FX forwards'.
There is also a three-year phase-in of the initial and variation margin requirements for uncleared OTC derivatives on single-stock equity options and index options, and an exemption for OTC derivatives associated to covered bonds subject to certain conditions being met.
The margin requirements apply throughout the life of all new derivatives contracts entered into after the applicable phase-in dates. Existing contracts will be unaffected.
Counterparties must identify the extent to which they will be affected by the rules, as this will determine the exact amendments to existing documentation that may be required.
The International Swaps and Derivatives Association, Inc (ISDA) has published, among other documents, the EMIR Supplement to the ISDA 2016 Variation Margin Protocol to help counterparties comply with the new variation margin requirements, either by putting new contractual documentation in place or by making changes to existing documentation to bring it into compliance. In addition, counterparties must put in place robust operational requirements, including clear senior management reporting and an escalation procedure in the case of a dispute.
On November 23 2016 the European Commission published a report on the review of EMIR, following its previous consultation in May 2015. The report proposes that the scope of the clearing and margin requirements be adjusted to address the challenges faced by NFCs, pension funds and small FCs. The commission agrees with ESMA that, for some NFCs, the application of the current approach under EMIR could be overly burdensome, as it may not reliably reduce systemic risk. The report suggests exploring whether:
- FCs should report trades on behalf of NFCs;
- FCs, but not NFCs, should ensure that operational risk mitigation techniques are in place; and
- NFCs should be exempt from reporting their intra-group transactions.
Further consideration should be given as to whether any NFCs, or only some of them based on the volume and type of activity in the derivatives markets, should be captured by the clearing and margin requirements.
The report also notes the significant challenges faced by counterparties in establishing clearing arrangements, mainly due to the leverage ratio requirements anticipated by clearing members under the EU Capital Requirements Regulation (575/2013). The European Commission has subsequently announced that it plans to adjust the leverage ratio in response to concerns raised.
Certain pension schemes currently benefit from a temporary exemption from the clearing obligation, which the commission plans to extend until August 2018, due to the difficulties in meeting the cash variation margin requirements (ie, in order to clear trades, pension schemes would need to divest assets in order to meet the requirement to post cash as collateral). Given that the market is no closer to resolving this issue, the report proposes that the legislative review of EMIR should assess whether the current exemption could be prolonged or made permanent in order to provide some certainty.
The report also proposes streamlining trade reporting to ease compliance burdens and suggests a review of the following:
- whether the frontloading requirement is proportionate given the limited number of contracts it captures;
- the uncertainty of applying the clearing obligation retrospectively; and
- whether the risk mitigation techniques should still apply to intra-group transactions.
The European Commission will propose a legislative review of EMIR in 2017, in the framework of the commission's better regulation agenda and the Regulatory Fitness and Performance Programme, which will address these issues (and the relevant technical standards) in more depth.
Although EMIR is already in force, some of the definitions in EMIR cross-reference definitions under MiFID, so the ongoing changes in MiFID II will have a significant impact on derivatives.
The MiFID II legislative framework consists of the MiFID II Directive and the Markets in Financial Instruments Regulation (MiFIR), and will come into force on January 3 2018.
All sufficiently liquid derivative trades that are subject to the clearing obligation under EMIR must be traded on a regulated market, multilateral trading facility, organised trading facility or third country (ie, non-EU) trading venue. This MiFID II requirement is known as the 'trading obligation' and will apply to both FCs and NFC+s. Once the European Commission has adopted a clearing obligation in relation to a class of derivatives, ESMA is required to launch a consultation to determine whether such derivatives should be subject to the trading obligation.
In a discussion paper on the trading obligation published in September 2016 ESMA proposed that G4 IRS swaps, non-G4 IRS swaps (although not the forward rate agreements) and credit default swaps that are currently subject to the clearing obligation should also be subject to the trading obligation from January 3 2018. However, ESMA provided no further granularity or a clear and defined product list, without which there may be some confusion as to whether a particular product is in scope of the trading obligation.
The Securities Financing Transactions Regulation applied from January 12 2016 and introduced new rules on reporting securities financing transactions (SFTs), which includes repurchase transactions, securities or commodities lending and margin lending transactions. While the SFTR's reach is broad, it does not include derivative contracts as defined in EMIR, though it does cover transactions that are commonly referred to as liquidity and collateral swaps which do not fall within EMIR. The requirement to report trades (including any modification or termination) by the next working day will be phased in from 2018. In contrast to the EMIR reporting requirements, under the SFTR, FCs will be responsible for reporting on behalf of both counterparties where their counterparty is an NFC.
New collateral reuse requirements which have applied from July 13 2016 must be met before counterparties can reuse financial instruments (but not cash) received as collateral. These obligations apply to all collateral arrangements ? not just SFTs ? and apply equally to collateral provided by way of security and by way of title transfer.
Although the Packaged Retail and Insurance-Based Investment Products (PRIIPs) Regulation was scheduled to enter into force on December 31 2016, the European Commission announced on November 9 2015 that the date of application will be delayed until January 1 2018.
This follows concerns raised by both the European Parliament and European Council, which rejected the final rules relating to the content of the key information document (KID) and called for the postponement of the application date of the PRIIPs Regulation by 12 months in order to provide sufficient time to clarify open questions and achieve the goals of the regulation.
The PRIIPs regulation requires that a KID be prepared for each PRIIP investment. PRIIPs would include the following retail products:
- structured deposits;
- securities issued by certain special purpose vehicles;
- certain insurance-based products; and
- non-undertaking for collective investments in transferable securities retail schemes.
A 'KID' is a standalone standardised document which must contain certain information, such as a description of the product, risks and costs. The final rules include a mandatory template that must be used for the KID, together with the format for the summary risk indicator and requirements relating to performance scenarios and the presentation of costs.
The European Commission has asked the European supervisory authorities (ESAs) to resubmit the revised regulatory technical standards on the KID and to make targeted changes in certain areas to address the concerns raised, including:
- multi-option products;
- performance scenarios;
- comprehension alert; and
- presentation of insurance related costs.
The ESAs have six weeks to resubmit the revised regulatory technical standards.
The European Commission expects the revised PRIIPs framework to be in place during the first half of 2017 and apply as of January 1 2018.
While many laws governing how the derivatives market operate in the United Kingdom derive from EU directives and regulations, the United Kingdom has indicated that it intends to use continuity legislation to import EU rules relating to derivatives into UK law so equivalent provisions will continue to apply. Maintaining equivalent rules would assist the United Kingdom in establishing that it satisfies equivalence standards that may be applicable to retain cross-border access.
Without EU membership, the United Kingdom would be regarded as a third country under EMIR and would need the European Commission to adopt an equivalence act under EMIR in respect of the United Kingdom, which should be simplified if the United Kingdom adopts the requirements under EMIR without amendment; although, as this would be a political decision, it would not be automatic. To date, no equivalence decision in respect of the margin requirements has been granted, so it could take some time. The European Commission is under no specific obligation to grant an equivalence decision within a specific timeframe. For example, it took four years from the time EMIR entered into force in 2012 for the European Commission to grant equivalence to US CCPs in 2016.(1)
In any event, the extraterritorial reach of the clearing and margin requirements would mean that many UK counterparties would still need to comply with the EMIR requirements when transacting with a European Economic Area counterparty.
There has been much commentary as to whether the Donald Trump presidency will signal the repeal of the Dodd-Frank Wall Street Reform and Consumer Protection Act, which implements the G20 commitments relating to the derivatives market in the United States. However, it is unlikely that the clock will be turned back: the derivatives market in the United States will not go back to being unregulated. However, as the major tenets of Dodd-Frank will still be in legislation in one form or another, the regulators' interpretation of those tenets could become much more limited.(2)
European Market Infrastructure Regulation In force:
- August 16 2012 ? EMIR entered into force.
- March 15 2013 ? requirement for timely confirmations and NFC notification in force.
- September 15 2013 ? risk mitigation techniques in force.
- February 12 2014 ? trade reporting requirement in force.
- June 21 2016 ? clearing of G4 IRS products started for Category I counterparties (clearing members).
Not yet in force:
- December 21 2016 ? clearing of G4 IRS products starts for Category 2 counterparties.
- February 4 2017 ? margin requirements start to apply for certain counterparties.
- February 9 2017 ? clearing obligation for certain credit default swaps takes effect for Category 1 counterparties.
- February 9 2017 ? clearing obligation for certain Swedish krona, Polish zloty and Norwegian krone fixed-to-floating swaps and forward rate agreements takes effect for Category 1 counterparties.
- March 1 2017 ? variation margin requirements apply to all counterparties.
- 1H 2017 ? European Commission expected to published a legislative review of EMIR and an assessment of the relevant technical standards under EMIR.
- June 21 2017 ? clearing obligation for certain G4 interest rate swaps takes effect for Category 3 counterparties.
- August 9 2017 ? clearing obligation for certain credit default swaps takes effect for Category 2 counterparties; and clearing obligation for certain Swedish krona, Polish zloty and Norwegian krone fixed-to-floating swaps and forward rate agreements takes effect for Category 2 counterparties.
- February 9 2018 ? clearing obligation for certain credit default swaps takes effect for Category 3 counterparties; and clearing obligation for certain Swedish krona, Polish zloty and Norwegian krone fixed-to-floating swaps and forward rate agreements takes effect for Category 3 counterparties (ESMA's final report extends this until 21 June 2019).
- May 9 2019 ? clearing obligation for certain credit default swaps takes effect for Category 4 counterparties.
- August 9 2019 ? clearing obligation for certain Swedish krona, Polish zloty and Norwegian krone fixed-to-floating swaps and forward rate agreements takes effect for Category 4 counterparties.
- September 1 2020 ? end of phase-in of margin requirements.
Securities Financing Transactions Regulation In force:
- December 23 2015 ? Regulation published in the Official Journal.
- July 13 2016 ? collateral reuse requirements apply to all collateral arrangements, including those already in existence on this date.
Not yet in force:
- Q2 2017 ? regulatory technical standards on the reporting obligation expected to come into force.
- Q2 2018 ? trade reporting requirements for investment firms and credit institutions likely to apply.
- Q3 2018 ? trade reporting requirements for central counterparties and central securities depositories likely to apply.
- Q4 2018 ? trade reporting requirements for insurance and reinsurance firms, undertakings for the collective investment of transferable securities, alternative investment fund managers and pension funds likely to apply.
- Q1 2019 ? trade reporting requirements for NFCs likely to apply.
Packaged Retail and Insurance-Based Investment Products Regulation Not yet in force:
- November 9 2016 ? European Commission extends the application of the PRIIPs Regulation to January 1 2018.
- 1H 2017 ? revised PRIIPs framework expected to be in place.
- January 1 2018 ? PRIIPs Regulation to enter into force.
Directive and regulation replacing the Markets in Financial Instruments Directive (MiFID II/MiFIR known as MiFID II) Not yet in force:
- Summer 2017 ? ESMA to submit a draft technical standard to the European Commission on the trading obligation for derivatives under MiFIR.
- January 3 2018 ? MiFID II/MiFIR comes into force.
For further information on this topic please contact James Doyle or Isobel Wright at Hogan Lovells International LLP by telephone (+44 20 7296 2000) or email (firstname.lastname@example.org or email@example.com). The Hogan Lovells International LLP website can be accessed at www.hoganlovells.com.
(1) For more information on equivalence, please see the following note which explores the key differences between the status quo of 'passporting' and relying on 'equivalence'.
(2) For more information please see here.
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