From a regulatory viewpoint, 2017 was mostly a year for implementing laws and regulations that had already been agreed in principle. There were no more Brexit bombshells, although there was still one politically controversial move from the European Commission, in the shape of a proposal for the enhanced supervision of clearing counterparties, which included the ability to require certain clearing counterparties to relocate to the EU. Below, we look back at some of the recent regulatory developments that will affect the European structured products market into 2018 and beyond.
Brexit: On 29 March 2017, the UK government formally notified the European Council of the UK's intention to withdraw from the EU. The effect of Article 50 of the Treaty on the European Union is that the UK now has until 29 March 2019 to negotiate and agree the terms of the UK exit.
There is still considerable uncertainty as to what the nature of the UK's relationship with the EU will be, following its exit. At the time of writing, the EU's Brexit negotiating team has indicated that discussions can now begin to take place on the post-Brexit relationship, as a result of it concluding that sufficient progress has been achieved on certain points (including the post-Brexit status of non-UK citizens resident in the UK, the amounts that the UK should pay to the EU in respect of EU budgetary funding that has already been committed to, and the nature of the post-Brexit border between Northern Ireland and the Republic of Ireland). The UK government has indicated that it is working to complete a final deal on the UK's future relationship with the EU by October 2018. It has also said that it wants to reach an outline agreement with the European Union, by the end of March 2018, on the transitional arrangements that will apply temporarily after it leaves the EU on 29 March 2017 (assuming no extension is agreed by the other EU member states to the March 2019 date). It is not yet clear what the desired length of such a transitional period would be, or what the UK's obligations and rights would be during such a period.
It still remains likely that UK financial services firms will no longer be able to take advantage of the MiFID "passport" postBrexit, in which case separate authorisation may be necessary for UK firms carrying out financial activities in the EU, unless they are able to rely on "equivalence" provisions in MiFID II and other EU legislation.15
The UK still remains, for now, a member of the EU, and existing EU-derived laws and regulations continue to apply to the UK.
While the negotiations continue, there still remains considerable uncertainty on various matters, such as:
- the terms of the relationship between the UK and the EU after 29 March 2019, including whether or not the UK will remain part of the single market, and if so whether that would be purely during the period of any agreed transitional period; and
- the extent to which, in a transition period, there would be any difference in the rights and obligations of the UK as they currently stand.
PRIIPs: As discussed in "PRIIPs Implementation Date Fast Approaching" above, the PRIIPs regulation will now become applicable on 1 January 2018. The range of products that are within the scope of the PRIIPs regulation is very broad and the vast majority of structured products will be captured. This regulation will require that whenever a product within the scope of the PRIIPs regulation is offered to an EU retail investor, an additional short form disclosure document, called a KID, must be provided to that investor before they make their investment decision. The obligation to provide the KID falls on the product manufacturer, even if they are located outside the EU, whereas the obligation to provide the KID to the retail investor rests with the person who is selling or advising on the product to the investor.
If sales to EU retail investors are not envisaged by the product manufacturer, then there are various steps that it may be prudent for the manufacturer to take, in order to guard against the product inadvertently ending up in the hands of EU retail investors, including adopting selling restrictions, legends and other contractual provisions.
Benchmark Regulation: As discussed earlier in "Benchmark Regulation: Latest on Grandfathering", the vast majority of the provisions of the EU Benchmarks regulation will become applicable on 1 January 2018 and will regulate the authorisation and supervision of administrators of "benchmarks" (as defined in the Benchmark Regulation) used by EU regulated entities. Where the administrator of a benchmark is located in the EU, it will need to be duly authorised and registered. Where it is located outside the EU, it will have to be either from a jurisdiction which is considered equivalent for the purpose of the Benchmark Regulation (no jurisdictions have yet been declared equivalent) or the administrator must be recognised by its EU member state of reference or its benchmarks must be endorsed by an EU-supervised entity.
Non-EU benchmark administrators will need to start giving consideration to whether an application for recognition or endorsement of their relevant benchmarks should be made, although the transitional provisions of the Benchmark Regulation, and the interpretation of those provisions by ESMA, will provide a reasonable time period within which to formulate and enact their EU strategies.
EMIR: The European Market Infrastructure Regulation ("EMIR"), which regulates derivatives in the EU, has been in force since 2012. In the years since then, much of the relevant subsequent rule-making required under EMIR has been introduced by technical standards, through delegated legislation.
In particular, in relation to mandatory central clearing for derivatives entered into by financial counterparties and certain significant non-financial counterparties ("NFC+s"), as we reported in our special issue of Structured Thoughts dated 27 December 201616, counterparties were categorised as Category 1, Category 2 or Category 3 counterparties, with the effective date for mandatory clearing being staged depending on the category of counterparty. Category 3 counterparties (financial counterparties or alternative investment funds, who are not clearing members of an EU authorised central clearing counterparty, and whose outstanding trades have a gross notional amount of EUR 8 billion or less) were to become subject to the clearing obligation from 21 June 2017 (for OTC interest rate derivatives denominated in EUR, GBP, JPY and USD), and 9 February 2018 for OTC index credit default swaps and OTC interest rate derivatives denominated in NOK, PLN and SEK. On 16 March 2017, the European Commission adopted a delegated regulation which extended the phase-in period for such Category 3 counterparties; the new effective date for the clearing obligation for Category 3 counterparties will now be 21 June 2019, in respect of all the above types of OTC derivatives.
In relation to the required exchange of margin for non-cleared derivatives, the largest counterparties have already had to exchange initial margin for several months now under the relevant EMIR regulatory technical standards ("Risk Mitigation RTS"). Between now and September 2020, all counterparties trading derivatives with an aggregate notional amount in excess of EUR 8 billion will be subject to these requirements, unless another exemption applies. In addition, broadly speaking, the variation margin requirements began to apply to most counterparties from 1 March 2017. However, regulators recognised that many counterparties were not in a position to meet the new variation margin requirements from that date and the FCA, among others, made a statement that they would take a proportionate, risk-based approach to supervision and enforcement and would use judgement as to the adequacy of progress made. The FCA hinted at a policy of forbearance so long as an in-scope firm was able to demonstrate it had made best efforts to achieve full compliance, and to have detailed and realistic plans in place to achieve compliance in as short a time as practicable.
The Risk Mitigation RTS provide detailed rules for the exchange of margin and they currently exempt physically-settled foreign exchange forwards, foreign exchange swaps and currency swaps from the requirement to post initial margin. However, unlike the rules in other jurisdictions, such as Title VII of the Dodd Frank Act in the U.S., the Risk Mitigation RTS did not contain any exemptions for physically-settled foreign exchange forwards from the requirements to exchange variation margin.
On 16 November 2017, the Council of the EU published its second Presidency Compromise Proposal on the proposed regulation to amend EMIR (see below for further discussion), and this proposal stressed the need for international regulatory convergence in relation to the margin treatment of physically-settled foreign exchange forwards, stating "in view of their specific risk profile, it is appropriate to restrict the mandatory exchange of variation margins on physically-settled FX forwards to transactions between the most systemic counterparties."
On 18 December 2017, the Joint Committee of the three European Supervisory Authorities published draft regulatory technical standards to amend the existing Risk Mitigation RTS in relation to physically-settled FX forwards. According to these draft standards, if either counterparty to the FX forward is an entity who is neither (a) an EU credit institution or EU MiFID investment firm (each, an "institution"), nor (b) a non-EU entity that would be an institution if it were established in the EU, then no variation margin will need to be exchanged.
The new standards will only become effective the day after they are published in the Official Journal. As a result, the above changes are unlikely to be effective by 3 January 2018 (the date on which the variation margin requirements for physically-settled FX forwards are scheduled to come into force).
Consequently, the ESAs have stated that, for institution-to-non-institution transactions, competent authorities should apply the EU framework in a risk-based and proportionate manner until the amended RTS enter into force. In practice, this is expected to mean that competent authorities will not seek to enforce variation margin arrangements for trades that will not require variation margin when the amended RTS eventually become effective.
In relation to the review of EMIR, on 4 May 2017, the European Commission published a legislative proposal for a regulation to amend EMIR, as we wrote in our earlier client alert17. In that client alert, we highlighted various concerns with the European Commission's legislative proposals, including the change to the classification of some counterparties, such as securitisation special purpose entities and the range of alternative investment funds that would fall within the definition of "financial counterparty". The latest Council of the EU compromise proposal does not classify SSPEs as financial counterparties and also restricts the range of AIFs that would constitute financial counterparties to those that are established in the EU or whose manager is authorised or registered under the EU's AIFM Directive. If this compromise proposal is ultimately agreed, it will mean that SSPEs and a large proportion of alternative investment funds will (as is currently the case) not be subject to EMIR's clearing and margin provisions, unless they constitute NFC+ entities.
Agreement on the terms of the EMIR II Regulation is expected during the course of 2018.
MiFID II: The MiFID II legislative package, consisting of the recast Markets in Financial Instruments Directive and the Markets in Financial Instruments Regulation ("MiFIR") is required to have been implemented into the national laws of the EU member states by 3 January 2018.
This package includes the new product governance rules that must be observed by MiFID firms that act as either manufacturer or distributor (or both) of financial instruments. These rules revolve principally around the concepts of product manufacturers:
- undertaking a product approval process for each product before it is marketed or distributed;
- identifying the target market for each product and ensuring that the product is designed to meet the needs of such target market;
- ensuring the distribution strategy is consistent with the identified target market; and
- taking reasonable steps to ensure the product is distributed to the target market.
These are all familiar concepts for UK-based manufacturers of structured products, since they are derived from the FCA's 2012 guidelines for structured products manufacturers, but they represent a major set of new obligations for non-UK firms and firms not involved in structured products. These product governance rules will apply in addition to the existing MiFID point-of-sale obligations to determine suitability or appropriateness of a product or service for a particular client. Where a MiFID firm acts as a distributor of a product manufactured by a non-EU firm, it will still have product governance obligations as a distributor (including performing its own target market assessment and identifying its own distribution strategy) and will need to reach agreement with the non-EU manufacturer to provide it with the information it needs to comply with its obligations.
New, more restrictive, rules will apply from 3 January 2018, concerning acceptance by MiFID firms of fees or commissions or non-monetary benefits from third parties. Fees for investment research will need to be unbundled from dealing commission and other execution fees and paid for either by the firm out of its own resources, or from a research payment account, funded by a specific research charge to the client.
The "execution-only" exemption from performing the appropriateness test will be narrowed as from 3 January 2018 and will not be available for bonds or other securitised debt that incorporate a structure which makes it difficult for the client to understand the risks involved, nor will it be available for structured deposits incorporating a structure which makes it difficult for the client to understand the risks involved or the costs of exiting the product before the end of its term.
MiFID II also introduces a new type of market, an organised trading facility ("OTF"), and extends the pre- and post-trading transparency requirements to bonds, structured finance instruments and derivatives traded on OTFs, as well as on regulated markets ("RMs") and multilateral trading facilities ("MTFs"). Waivers from these requirements may still be granted by competent authorities, but on narrower grounds than have been available to date.
MiFID II also finally introduces the requirement for centrally-cleared derivatives, that are determined to be subject to a trading obligation by ESMA, to be traded only on an RM, MTF or OTF, or on a third country venue meeting certain equivalence requirements. On 5 December 2017, the European Commission adopted a decision to determine that U.S. laws and supervisory frameworks for designated contract markets and swap execution facilities are equivalent to the provisions of MiFIR for trading venues.
Also of note is that the advent of MiFID II will trigger the effectiveness of the provisions of the Market Abuse Regulation, which extend the scope of financial instruments covered by MAR to include those traded on an OTF, as well as on a RM or MTF.
Prospectus Regulation (PD3): The EU's new Prospectus Regulation entered into force in July 2017 and the vast majority of its provisions will take effect from 21 July 2019. Work is now under way preparing the detailed implementing legislation, hopefully to be finalised in good time for market participants to prepare for the new rules.
In terms of exemptions from the requirement to prepare a prospectus, the Regulation will not apply at all to an offer of securities to the public with a total consideration of less than EUR1 million over a 12-month period. Such figure may be increased, up to a maximum of EUR8 million, by each member state. Notably, the "wholesale denomination" exemption for public offers of securities with a minimum denomination of EUR100,000 has been retained.
For such high-denomination securities that are admitted to trading on a regulated market, and for other non-equity securities that are to be traded only on markets (or segments thereof) to which only qualified investors have access, lighter (proportionate) disclosure requirements are envisaged, and will be contained in the implementing legislation now being prepared.
For such securities, no prospectus summary will be required under the new regime. In the case of prospectuses for other securities, the prospectus summary must be no longer than seven pages of A4-sized paper, must be presented and laid out in a way that is easy to read, with characters of readable size and written in a style and language that facilitates the understanding of the information. It may contain no more than the 15 most significant risk factors specific to the issuer.
A summary will no longer be required in the base prospectus itself, but the final terms for each issuance of securities must include, as an annex to the final terms, a summary of that issuance.
Risk factors will be required to be presented in a limited number of categories, depending on their nature, and must be ranked by materiality, based on both the probability of their occurrence and the expected negative impact if the relevant risk occurs.
A new Universal Registration Document regime will be brought in by the new Regulation, similar to the U.S. shelf registration system. Issuers with a URD will benefit from a faster approval process and after having had a URD approved by the relevant competent authority for two consecutive years will be allowed to file further URDs without prior approval, although they will still be subject to review by the authority.
The relevant EU competent authority may permit a non-EU issuer to draw up the required prospectus under the rules of its home jurisdiction, provided that those rules are determined to be equivalent to the Regulation and cooperation arrangements are in place between the relevant authorities in its home jurisdiction and the relevant EU competent authority.