The European Market Infrastructure Regulation (EMIR) is due to come into force by the end of 2012. Through EMIR, the European Commission is seeking to introduce requirements that will improve the transparency of the over-the-counter (OTC) derivatives market.
EMIR is four-fold in its approach to achieving this objective:
- Trades will have to be reported to trade repositories.
- Trades will have to be cleared through a central clearing counterparty (CCP).
- Risk mitigation requirements will be introduced for uncleared trades.
- Supervision obligations will be introduced for CCPs and trade repositories.
After a series of discussions between the Commission, the European Parliament and the Council of the European Union, political agreement was reached on the level one text (the legislative framework) of EMIR. The text is now being translated into the 23 official languages of the European Union, and once this process is finished the Parliament will be required to rubber stamp the level one text.
EMIR is one of a series of legislative texts designed to regulate the OTC derivatives market. Alongside the revised Markets in Financial Instruments Directive (MiFID), the revised Market Abuse Directive and the Regulation on Wholesale Energy Market Integrity and Transparency (REMIT), EMIR can be described broadly as the European equivalent to the United States’ Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). Discussions on and drafting of these texts commenced after the 2009 G-20 Summit when it was held that all standardised OTC derivative contracts should be traded on exchanges or electronic platforms and cleared through CCPs.
However, with little time until EMIR is due to come into force, many market participants are still uncertain as to how exactly they will be affected and what procedures they will have to put in place to ensure they are fully compliant with the legislation.
All counterparties to all derivative contracts, whether they are undertaken OTC or on-exchange, will be required to report to a registered trade repository certain details about themselves and the trade. The trade should be reported to a trade repository by the end of the business day following the execution of the contract.
The exact information to be reported has not yet been prescribed, but certain elements that will be included are the parties to the contract, or the beneficiary of the contract if this differs, e.g., if an agent is undertaking the trade on behalf of one of the counterparties. The type, maturity, notional value, price and settlement date of the contract will also have to be reported. The obligation to report will lie with both counterparties, however, one counterparty will have the right to delegate the reporting obligation to the other. Equally, if an agent is undertaking the trade on behalf of a third party, the agent may report the transaction. There would be no penalty for reporting the same transaction twice. If a counterparty is reporting a trade to comply with the provisions of REMIT and/or MiFID, then it is unlikely that counterparties will be required to report it again to comply with EMIR.
Counterparties may start reporting their trades from the date the level one text is rubber stamped, however the reporting obligation will not become mandatory until it takes effect in 2013. Reporting obligations under Dodd-Frank are set to come into force later this year, so counterparties subject to both Dodd-Frank and EMIR may choose to start reporting all trades once the Dodd-Frank provisions come into force.
All financial counterparties, as defined in EMIR, and non-financial counterparties, will, in certain circumstances, be required to clear through a CCP any OTC derivatives contracts that the European Securities and Markets Authority (ESMA) determines are subject to mandatory clearing obligations. The clearing obligation will apply when one or more of the counterparties are located in the European Union.
Clearing Obligations for Non-Financial Counterparties
Pursuant to EMIR, non-financial counterparties— defined by elimination as counterparties that are not financial counterparties— will only be required to clear applicable contracts once their exposure crosses a prescribed threshold. ESMA has been tasked with drafting technical standards that will include matters such as the clearing threshold; these standards are due to be published by 30 September 2012.
For non-financial counterparties, trades undertaken for hedging (i.e., risk mitigation) purposes will not count towards determining whether or not the clearing threshold has been crossed. Therefore, if a nonfinancial counterparty undertakes all its trades for hedging purposes, then clearing will not be required. Nevertheless, once the value of a non-financial counterparty’s trades exceeds the prescribed threshold, non-financial counterparties will be required to clear all their trades, regardless of whether or not they have been undertaken for hedging purposes.
Once published, it is expected the clearing threshold will be relatively low, as the definition of hedging, which will also be set out in the technical standards, is anticipated to be relatively broad.
Due to the distinction between financial and non-financial counterparties, there will be uncertainty for financial counterparties when determining whether or not their non-financial counterpart will be required to clear the trade. It is not certain if the onus will be on the non-financial counterparty to disclose that they have crossed the prescribed threshold, or if financial counterparties will have to constantly monitor the status of their non-financial counterpart. A mechanism may have to be put in place whereby the non-financial counterparty discloses to its financial counterpart that it has crossed the relevant threshold. This has not been prescribed by EMIR, but it is expected that sophisticated mechanisms will develop over time.
Interoperability with Non-EU Legislation
Certain counterparties will be subject to the clearing and reporting obligations within both the European Union and other jurisdictions in which they trade. However, to avoid the duplication of obligations, EMIR contains equivalence and reciprocity provisions: when a counter party clears or reports their trade through a third country’s CCP or a trade repository that is recognised as being “equivalent” to an EU CCP or trade repository, they will be considered as having also fulfilled their obligation under EMIR.
For this to work, the Commission will have to have determined that the non-EU country is equivalent to an EU Member State. As it will not be possible for the Commission to assess all countries simultaneously, there might be a period during which reporting and clearing obligations are duplicated. For example, if a transaction is undertaken by an EU-counterparty in a non-EU jurisdiction where clearing applies, but that jurisdiction has yet to be deemed to have equivalent status, the transaction will have to be cleared in that jurisdiction as well as within the European Union.
Much of the precise detail of EMIR is still to be published. Owing to the interoperability of the revised MiFID and EMIR, when MiFID comes into force, it may affect how market participants are required to comply with EMIR, although the obligations themselves are unlikely to change.
Market participants should start registering with CCPs and trade repositories (if they have not done so already), amend existing contracts with counterparties to include provisions regarding, inter alia, which of the counterparties will be responsible for the reporting obligations, and assess whether any clearing or reporting of trades undertaken in a jurisdiction outside the European Union will be sufficient to comply with the provisions of EMIR. Although the penalties for failing to comply with EMIR are still to be delineated, they are likely to be sufficiently punitive to ensure counterparties comply with the new regulation.