The proposed amendments to the EU OTC derivatives regulation, commonly known as EMIR, have been politically agreed upon (the EMIR Refit). The final text is expected to be published in the Official Journal of the European Union (Official Journal) by the summer, with most of the changes being directly applicable in all EU member states 20 days later
This alert summarises the key changes that will be relevant to alternative investment funds (AIFs).
Definition of financial counterparty
Broadly, AIFs currently only fall into the definition of a financial counterparty (FC) if they are managed by an authorised or registered alternative investment fund manager (AIFM). Under the EMIR Refit, all EU AIFs (regardless of their manager’s regulatory status) will be treated as FCs unless they are securitisation special purpose entities or established solely for employee share purchase plans.
Categorisation as an FC or as a third-country equivalent is important since it will determine which counterparty obligations apply, and it may mean that (a) the EMIR mandatory clearing or margin rules will apply; and (b) the timeframe for trade confirmations and the frequency of portfolio reconciliation requirements will change. Furthermore, AIFs categorised as FCs will need to update their non-financial counterparty (NFC) representation documentation accordingly.
Non-EU AIFs which are not managed by an authorised or registered AIFM will remain third-country entities, but when entering into OTC derivatives with EU counterparties, they will be treated as equivalent to FCs rather than NFC-s or NFC+s (i.e. NFCs whose OTC derivatives positions exceed certain thresholds). This could have an impact on the nature of the obligations that will apply to OTC transactions entered into between EU counterparties and non-EU AIFs.
Under the EMIR Refit, AIFs categorised as FCs will be required to clear OTC derivatives subject to the clearing obligation (currently only certain OTC interest rate derivatives and OTC credit default swaps are required to be centrally cleared) if their OTC derivatives exceed any of the following thresholds:
- €1 billion in gross notional value for credit derivatives or equity derivatives; or
- €3 billion in gross notional value for interest rate derivatives, FX derivatives, commodity derivatives or any other derivatives asset class.
In accordance with the EMIR Refit, all FCs and NFC+s may calculate their positions in order to verify whether they benefit from the exemption from the clearing obligation.
The EMIR Refit clarifies that counterparties that do not calculate their positions will be deemed to be subject to the clearing obligation.
For an EU AIF, the positions are to be calculated at the level of the fund. The calculation should also include all hedged positions.
FCs and NFC+s will be required to calculate, every 12 months, their aggregate month-end average position for the previous 12 months. These positions must be aggregated at the level of the group1 to which they belong. For some AIFs this may include portfolio companies in which the AIF invests. The first calculation must be made as soon as the EMIR Refit comes into force and once a year thereafter.
An AIF that determines that its OTC derivatives exceed the clearing threshold must immediately notify the European Securities and Markets Authority (ESMA) and the relevant national regulator and establish clearing arrangements within four months of the notification.
As the above amendments are not expected to be in force in time to apply when the clearing obligation for Category 3 FCs is phased in, from 21 June 2019, ESMA has issued a statement which in essence grants regulatory forbearance for those Category 3 FCs which are expected to trade below the clearing threshold under the EMIR Refit.
Under the EMIR Refit, AIFs categorised as NFC+s whose positions exceed at least one of the clearing thresholds will be subject to the clearing obligation, but only for the derivatives belonging to the asset class for which the clearing threshold has been exceeded.
AIFs that are re-categorised as FCs under the EMIR Refit will be required to exchange margin for any uncleared derivatives. This will be the case even if their OTC derivatives positions do not exceed the clearing threshold. Furthermore, EU AIFs categorised as FCs will need to ensure that they hold appropriate capital to manage any risk not covered by the exchange of collateral.
Third- country AIFs trading with an EU FC or an EU NFC+ may become indirectly subject to the EMIR margin rules.
Although we note that both the European Supervisory Authorities and the UK Financial Conduct Authority have previously clarified that the variation margin rules do not apply to physically settled FX forwards.
Responsibility for reporting will change under the EMIR Refit to the effect that FCs will be “solely responsible and legally liable” for reporting on behalf of both counterparties when they trade with NFC-s. The FC will be responsible for the accuracy of the reported details.
NFCs will be required to provide their FC with information about the OTC derivative trade that the FC cannot reasonably be expected to hold and the NFC will be responsible for ensuring those details are accurate.
The EMIR Refit has clarified that the EU AIF’s manager (regardless of its manager’s location or regulatory status) will be solely responsible and legally liable for reporting the OTC derivative contract where the EU AIF is the principal to the transaction.
These requirements will apply 12 months after the EMIR Refit is published in the Official Journal.
What to do now?
It is important for AIFs to establish how they will be categorised for EMIR Refit purposes. AIFs which are part of a group need to obtain advice on which entities form part of its group. When an AIF is re-categorised as a FC it will need to notify its counterparties of its change in status and determine whether it is subject to the margin rules or exceeds the clearing threshold. If so, it will be required to notify its regulator using the correct form. The FCA is the relevant regulator in the UK.
EU AIFs will need to consider whether any changes will be required to be made to their procedures regarding timely confirmations, portfolio reconciliations and regulator notifications.
Managers of AIFs will need to consider how they will comply with the EMIR reporting requirements.