Since early 2017, draft legislation1 (the EMIR REFIT proposal) has been under consideration to amend EMIR2 , with the aim of making some of its requirements simpler and more proportionate, particularly for non-financial counterparties (NFCs)3 . Following trilogue discussions among the European Commission, Council and Parliament, political agreement on the amending legislation was reached on 5 February 2019.
This should enable the legislative text to be formally adopted before the end of the term of the current European Commission in May 2019, with publication in the Official Journal and entry into force4 expected by the summer.
Based on the documents currently available (which do not include the final legislative text), we summarise below the key changes that will result from EMIR REFIT.
Clearing requirements and exemptions
“Frontloading” requirement5 to be removed
Therefore, when any type of entity becomes subject to mandatory clearing for new classes of derivatives there will be no requirement for any pre-existing transactions to become cleared.
Clearing obligation for NFC+ to be limited to the asset class(es) for which the clearing threshold is exceeded6
Currently, if (for example) the clearing threshold for credit derivatives is exceeded by an NFC, it becomes subject to the clearing obligation for interest rate products, even though its activities relating to interest rate products are below the relevant clearing threshold. Ahead of mandatory clearing for NFC+s with respect to certain interest rate products coming into effect on 21 December 2018, the European Securities and Markets Authority (ESMA) issued a statement providing that it did not expect national competent authorities (NCAs) to require interest rate transactions with NFC+s that do not exceed the clearing threshold for interest rate products to be cleared from that date (or for the MiFIR trading obligation to apply). Whilst neither the European Supervisory Authorities nor NCAs have formal waiver powers, this is one of a number of examples in the context of EMIR REFIT, of what is commonly referred to as “regulatory forbearance”. Given the anticipated timing of EMIR REFIT, it is to be hoped that this comfort will be extended to NFC+s that do not exceed the clearing threshold for credit derivatives, as the NFC+ phase-in date for credit derivatives is 9 May 2019.
Extension of the clearing exemption for risk-reducing transactions of pension schemes
The current exemption under EMIR expired in August 2018 but the European Securities and Markets Authority (ESMA) issued a statement to the effect that it did not expect national competent authorities to require such transactions to be cleared (or to be subject to the MiFIR7 trading obligation) pending EMIR REFIT coming into force (i.e. regulatory forbearance was granted). The new exemption would initially apply for 2 years, and may be extended thereafter, up to twice, for 12 months at a time (i.e. maximum aggregate extension of 4 years). There are some fairly detailed provisions mandating ongoing work to develop technical solutions to facilitate clearing by pension schemes as quickly as possible.
Some pension schemes will be “small financial counterparties” and therefore able to rely on the clearing exemption referred to below
Exemption from the clearing obligation for small financial counterparties (FCs)
This will apply to FCs whose positions at group level (and with no carve-out for hedging transactions) do not exceed any of the clearing thresholds set for NFCs.
These amendments are not expected to be in force in time to apply when the clearing obligation for Category 3 financial counterparties is phased-in, from 21 June 2019. ESMA has recognised this, recently granting further regulatory forbearance providing comfort for those Category 3 FCs expected to fall within the new exemption for small FCs. While this is to be welcomed, concerns remain as to the practicality of small FCs being able to carry out the calculations to demonstrate that the thresholds are not exceeded.
Suspension of clearing obligation
The Commission (at ESMA’s request, which request may be instigated by a national competent authority) is to have power to temporarily suspend a clearing obligation (and the related trading obligation under MiFIR) for an initial period of up to 3 months, and to extend the suspension for further periods of up to 3 months, for a maximum aggregate period of 12 months. If the clearing obligation is suspended, the MiFIR trading obligation can also be suspended.
Further potential changes on clearing?
The Commission will, following EMIR REFIT coming into force, be required to issue reports to the Council and Parliament on various topics, including on whether trades resulting from post-trade risk reduction services, including portfolio compression, should be exempted from clearing.
CCPs and clearing members
Article 39 of EMIR is amended by inserting a new provision requiring that member states’ national insolvency laws shall not prevent a CCP from distributing client margin of a defaulting clearing member to its underlying clients.
Information from CCPs
CCPs will be required to provide information to clearing members on their initial margin models, and to provide them with a simulation model enabling them to calculate the additional initial margin that the CCP may require to clear a new transaction. This should not represent a significant change to existing practices.
There will be a requirement for clearing members, and clients providing indirect clearing, to offer their clearing services on fair, reasonable, non-discriminatory and transparent (FRANDT) commercial terms. They must also take all reasonable steps to manage conflicts of interests, especially between trading and clearing units, that may adversely affect the provision of clearing services on FRANDT terms.
The conditions under which commercial terms are considered FRANDT are to be specified in more detail in delegated acts by the Commission. The REFIT text does however make clear that the FRANDT principle shall not impose an obligation to clear nor prevent clearing members, or their clients, from controlling risks associated with the clearing services offered.
ESMA will be required to report to the Commission on, among other things, the impact of the REFIT regulation on levels of clearing and the continued appropriateness of the clearing thresholds, and on whether the FRANDT requirement has been effective in facilitating access to clearing.
Risk-mitigation for uncleared derivatives
Scope of margin requirements
As a preliminary comment, FX forwards and swaps are within scope of variation margining (VM) under the Margin RTS8, though not generally subject to margining under the rules in other areas of the world. Draft technical standards to amend the Margin RTS, to exempt from VM physically-settled FX forwards entered into otherwise than between two investment firms or credit institutions, were published in December 2017, but have not yet been adopted by the Commission. The industry is relying on regulatory forbearance from regulators in the meantime. The EMIR REFIT regulation will include a recital acknowledging that the need for international convergence means that margining of both FX forwards and FX swaps should be limited to transactions between the most systemic counterparties (i.e. credit institutions and investment firms). The recital also acknowledges the need for international convergence with respect to other classes of derivatives9.
Validation by regulators
There will be a new requirement (to be spelled out in technical standards) for initial and on-going validation by regulators of counterparties’ procedures for complying with the Margin RTS.
Reporting of derivatives transactions
The changes in this area are probably the most significant and controversial aspect of EMIR REFIT.
The “backloading” requirement (to report transactions that were no longer outstanding when the reporting obligation under EMIR came into effect) is deleted. However, the “backloading” requirement came into effect on 12 February 2019. In order to mitigate the impact of this, ESMA granted regulatory forbearance on 31 January 2019 to the effect that national competent authorities need not prioritise backloading in their supervision and enforcement of EMIR. The removal of this obligation, and the associated regulatory forbearance, are particularly welcome.
The reporting obligation is to be disapplied for intra-group transactions involving an NFC, but only if both parties are part of the same group (and subject to consolidation and centralised risk management) and do not have a parent undertaking that is an FC. It will also be necessary for counterparties that want to rely on this exemption to notify their national competent authority. In practice, it does not seem that this exemption is likely to be of much assistance to NFCs.
Reporting by FCs on behalf of NFC-s
For OTC transactions between an FC and an NFC-, the FC will be required to report on behalf of both counterparties (rather than the FC reporting a single data set as proposed by the European Parliament), and with the FC having legal liability for the reports. The NFC- is required to provide the reporting FC with details about the NFC- that are relevant for reporting purposes and that the FC cannot reasonably be expected to possess. This mandatory delegation has been strongly opposed by the derivatives industry.
An NFC- will also be relieved from the reporting responsibility if it transacts with a third country entity that would be an FC if established in the EU, but only if that entity reports the transaction under its home reporting regime, and that regime has been determined as “equivalent” under article 13 of EMIR10.
An NFC- may elect that it will make its own reports rather than relying on its FC counterparty to report on its behalf – this would require prior notification to the relevant FC.
Reporting by funds and IORPs
The EMIR REFIT regulation will clarify that the management company of a UCITS or AIF is legally responsible for making the reports on the latter’s behalf. The same applies to management companies of institutions for occupational retirement provisions (IORPs) where the IORP does not have legal personality.
Further changes on reporting?
There is provision for follow-up reports to be produced by the Commission as regards avoidance of duplication, and greater alignment, between reports on exchange-traded derivatives made under EMIR and MiFIR. ESMA is also required to report to the Commission on the changes made in EMIR REFIT to the reporting regime, including as regards delegated reporting by FCs, and its impact on the reporting burden for NFC-s.
Definition of financial counterparty
There are some fairly technical changes, with central securities depositories being included, and also all EU AIFs (whether or not its AIFM requires registration under the Alternative Investment Fund Managers Directive to manage that AIF11). However, there will be a carve-out from the definition of FC for UCITS or AIFs related to an employee share purchase plan, and for any securitisation special-purpose entities (SSPEs) that constitute an AIF.
While this note does not cover the various technical changes as regards regulation of trade repositories (TRs), a new article 76a of EMIR is being introduced, to allow the Commission to approve arrangements for EU authorities to have direct access to information held by TRs in a third country, and to allow relevant authorities in that third country to have access to information held by EU TRs. This could potentially be relevant in future years to arrangements between the UK and the EU.
A number of changes in the Commission’s original legislative proposal have not been accepted, and various changes that the industry lobbied for have not been made (or have been included only as matters that will be the subject of reports in due course, that could potentially lead to further changes to EMIR in the future).
An example of an industry proposal that has not been included is that all central banks globally be exempted from EMIR (rather than only central banks that have been the subject of an implementing decision by the Commission).
If the UK leaves the EU on 29 March without an implementation period, the EMIR REFIT regulation is not expected to be in force and applying, so will not be “onshored” under the European Union Withdrawal Act 2018. Instead, the Financial Services (Implementation of Legislation) Bill12 gives the Treasury power, during the 2 years following exit day, to implement EMIR REFIT in the UK by regulation.
If an implementation period up to the end of December 2020 is agreed, EMIR will continue to apply in the UK during that period, and the EMIR REFIT amendments that become applicable during that period will be binding on UK entities.