The amending regulation to the European Market Infrastructure Regulation (also known as EMIR 2.1 or EMIR Refit) will introduce several key changes to the regulation of EU derivatives from next month. On 14 May 2019, the Council of the EU adopted the amended regulation and confirmed that the final text is expected to be signed in the coming weeks, with the amending regulation entering into force 20 days after its publication in the Official Journal of the EU. The EMIR Refit is designed to streamline existing requirements under EMIR and regulators have already advised market participants to take prompt action and review their positions in Over-The-Counter (OTC) derivative contracts in light of the expected changes.
This note specifically focuses on some of the key changes relevant to non-EU counterparties, including:
- the expansion of the definition of financial counterparty (FC);
- the new small FC designation and the practical consequences of this;
- the new exemption from reporting for inter-group trades involving a non-financial counterparty (NFC);
- changes to reporting obligations for smaller non-financial counterparties (NFC-);
- the transfer of reporting responsibilities from alternative investment funds (AIFs) and Undertakings for Collective Investment in Transferable Securities (UCITS) funds to fund managers; and
- the removal of the reporting requirement for historic trades before 12th February 2014 (i.e. backloading).
EMIR, which came into force in 2012, lays down the requirements for the regulation of OTC derivative transactions, central counterparties (CCPs) and trade repositories. Its various requirements have been phased in since this date. Importantly, EMIR introduced the obligation to clear certain OTC derivative contracts through a CCP. Market participants caught by the relevant rules include FCs and NFCs whose gross notional value of OTC derivative positions over a rolling 30 day period exceeds certain clearing thresholds. Other important provisions introduced margin requirements for OTC derivative contracts not subject to a clearing obligation, risk mitigation requirements and mandatory reporting of trades to trade repositories.
The reforms in the EMIR REFIT aim to simplify these requirements, with a view to making regulation of OTC derivatives more proportionate and improving the functioning of the market, particularly for smaller participants. That said, the rule changes also broaden the definition of financial counterparty and will require some entities to re-evaluate their categorization.
New ‘FC’ definition: impact on the classification of AIFs
The EMIR Refit broadens the definition of ‘financial counterparty’ to include any AIF either established in the EU or managed by an Alternative Investment Fund Manager (AIFM) authorized or registered in accordance with the Alternative Investment Fund Managers Directive (AIFMD). The International Swaps and Derivatives Association has highlighted that these changes will also affect the classification of non-EU AIFs that are caught indirectly by the regime. This is because, under EMIR, the relevant obligations are determined as if a non-EU AIF were established in the EU. Once EMIR Refit comes into force, a non-EU AIF trading with EU entities will therefore always be considered as a (third country entity) FC for the purposes of the regime, because were it to be established in the EU, it would be an AIF established in the EU and therefore a FC.
It is noted that certain AIFs will be automatically exempt from the regime. These include AIFs that are set up exclusively for the purpose of serving one or more employee share purchase plans as well as AIFs that are securitization special purpose entities. Moreover, AIFs with limited activity in the OTC derivatives markets may benefit from the newly-introduced exemptions for ‘small financial counterparties’ (see below).
New FC category: Small Financial Counterparties
EMIR REFIT introduces a new category of financial counterparty, so called ‘small financial counterparties’ (FC-) that may be exempt from the clearing obligation where they fall under the relevant clearing threshold for a particular asset class. In effect, EMIR Refit applies the equivalent clearing thresholds which currently apply to NFCs to determine whether FCs will be subject to the mandatory clearing obligation in that particular asset class. However, the calculation methodology for these thresholds does differ between FCs and NFCs as explained below.
The clearing obligation will not apply to a FC if the gross notional value of its OTC derivative positions over a rolling 30 day period does not exceed the relevant clearing threshold, being:
- Credit derivatives. Gross notional value of EUR1 billion.
- Equity derivatives. Gross notional value of EUR1 billion.
- Interest rate derivatives. Gross notional value of EUR3 billion.
- Foreign exchange. Gross notional value of EUR3 billion.
- Commodity derivatives and other OTC derivatives not defined above. Gross notional value of EUR3 billion.
The changes were introduced to address concerns that some smaller market participants had been unable to access viable central clearing solutions in the EU. That said, we expect the new FC- designation to have limited impact on asset managers given that: (i) FCs falling under the threshold will still be subject to other obligations under EMIR, including margin requirements; and (ii) some EU dealers registered in the US as swap dealers will in any event continue to be subject to CFTC clearing obligations.
Calculation of clearing thresholds for FC and NFCs
In its Statement of 28 March 2019, the European Securities and Markets Authority (ESMA) clarified that in order to benefit from this exemption counterparties are required to have calculated their aggregate month-end average position for the previous 12 months as at the date the EMIR REFIT enters into force.
FCs and NFCs must calculate their positions in OTC derivative contracts taking into account all OTC derivative contracts, at a group level. However, positions in relation to UCITS and AIFs shall be calculated at the fund level (or in case of umbrella funds, at the level of the sub-fund), and not at the level of the fund manager.
However, there are certain key differences between FCs and NFCs when it comes to this calculation:
- NFCs shall take into account only non-risk reducing OTC derivatives transactions. On the contrary FCs make their calculations by reference to all OTC derivatives transactions, whether risk-reducing or not.
- A NFC that exceeds the clearing threshold in one asset class will be subject to clearing requirements in respect of that asset class only. It is noted that in that case, the relevant NFC+ will still need to post margin by reference to transactions in all asset classes. FCs however that exceed the clearing threshold in one asset class will be subject to the clearing obligation with regards to all asset classes.
Reporting of intra-group transactions
EMIR Refit exempts certain intra-group transactions from the trade reporting obligation under EMIR, where at least one of the counterparties is a NFC. The justification behind these changes is that intragroup transactions involving NFCs represent a relatively small fraction of all OTC derivative transactions and are used primarily for internal hedging within groups. To benefit from this exemption both parties must be included in the same consolidation, be subject to centralized risk evaluation and the parent undertaking must not be a FC.
Changes to reporting obligations for smaller non-financial counterparties
Financial counterparties will now be responsible for reporting on behalf of both parties where they enter into a trade with a smaller non-financial counterparty (i.e. NFC-). The NFC- will be expected to provide accurate data to the FC to facilitate such reporting. This specific change will apply 12 months after the EMIR Refit comes into force and could impact on any delegated reporting arrangements FCs have in place with NFC- counterparties.
Transfer of reporting responsibilities from AIFs and UCITS funds to fund managers
The EMIR Refit transfers the reporting obligation under EMIR from UCITS and AIFs (i.e. the legal counterparty) to the UCITS management company and AIFM respectively. We would therefore advise fund managers to ensure this transfer of responsibility is reflected in their reporting delegation agreements.
Removal of backloading requirement
This backloading requirement refers to the obligation on entities to report historic trades which were outstanding on or after 16 August 2012 (the date EMIR came into force) and terminated before 12 February 2014 (the EMIR reporting start date). Given the substantial and costly adjustments that reporting entities would need to comply with the backloading requirement and limited volume and value of such data, the changes under the EMIR Refit have now removed this requirement.