Swaps end-users that trade derivatives with counterparties that are established in the European Union (EU) (or that have affiliates established in the EU that trade derivatives) should be aware that they may be subject to the European Market Infrastructure Regulation (EMIR). Similar to Dodd-Frank (DF) in the U.S., EMIR imposes reporting, clearing and risk mitigation obligations on end-users of derivatives; however, an end-user’s EMIR obligations may be different from and potentially more burdensome than its DF obligations. McGuireWoods LLP is providing a series of updates for swaps end-users regarding their potential obligations under EMIR. This update describes an end-user’s clearing obligations under EMIR.
On July 4, 2012, the European Parliament and Council adopted EMIR to provide a framework for addressing the risks related to certain derivative contracts. EMIR requires, among other things, that:
- All derivative contracts be reported to a trade repository.
- OTC derivative contracts be cleared through a central clearing counterparty (CCP), unless an exception or exemption applies.
- Parties to derivative contracts employ certain risk mitigation techniques (RMTs) for uncleared OTC derivative contracts.
EMIR applies to a broad range of financial instruments and may impose obligations on end-users of those financial instruments that are not required by the DF swaps regime in the U.S. Under EMIR, an end-user is typically classified as a nonfinancial counterparty (NFC). Click here for our Swaps End-User Update regarding counterparty classifications under EMIR. If the gross notional value of the OTC derivative contracts for an NFC and the other NFC members of its group exceeds any EMIR clearing threshold, the NFC is considered an NFC+ and must clear all of its OTC derivative contracts that are subject to the clearing requirement through a CCP.
What Are the Clearing Thresholds Under EMIR?
The relevant clearing thresholds are:
- EUR 1 billion in gross notional value for OTC credit derivative contracts.
- EUR 1 billion in gross notional value for OTC equity derivative contracts.
- EUR 3 billion in gross notional value for OTC interest rate derivative contracts.
- EUR 3 billion in gross notional value for OTC foreign exchange derivative contracts.
- EUR 3 billion in gross notional value for OTC commodity derivative contracts and other derivative contracts (combined).
The gross notional value of OTC derivative contracts includes the OTC derivative contracts entered by an NFC and the other NFCs in its group and is calculated on the rolling average position over 30 working days. NFCs are obligated to make their own calculations to determine their clearing status as an NFC+ or an NFC-. If an NFC exceeds the clearing threshold for any category of OTC derivative contract, it must clear all of its OTC derivative contracts, in all categories, that are subject to the clearing requirement (unless an exemption applies). The applicable technical standards for the EMIR clearing thresholds can be found here, and related EMIR Q&As published by the European Securities and Markets Association (ESMA) can be found here. Even if an NFC exceeds the clearing threshold, certain intragroup transactions may be exempt from the clearing requirement.
Do All OTC Derivative Contracts Count Toward the Clearing Thresholds?
In order to calculate whether an NFC exceeds any clearing threshold, an NFC would not include OTC derivative contracts entered by the NFC or other NFCs in its group that are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the NFC or its group. An OTC derivative contact will meet this standard if, by itself or in combination with other derivative contracts, directly or through closely correlated instruments, it meets one of the following criteria:
- It covers the risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the NFC or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal course of its business.
- It covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities of the NFC or its group referred to in category 1 resulting from the fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk.
- It qualifies as a hedging contract pursuant to International Financial Reporting Standards.
NFC end-users may exclude intragroup OTC derivative contracts from the clearing threshold calculation if they meet one of these criteria. However, if two NFC group entities enter into a transaction with each other that does not fall within one of these categories, both sides of the transaction must be counted toward the threshold. The total contribution to the group-level threshold calculation would therefore be twice the notional value of the contract. In addition, OTC contracts cleared on a voluntary basis are included in the calculation of the clearing threshold. When an NFC end-user exceeds any clearing threshold, it becomes an NFC+ and must immediately (on the same day) notify ESMA and the relevant competent authority. An end-user also must notify ESMA and the relevant competent authority “as soon as possible” if it no longer exceeds the clearing threshold. The applicable notice forms can be found on the ESMA web page for EMIR here.
In the next Swaps End-User Update, we will discuss the RMTs that apply to end-users under EMIR.
McGuireWoods’ prior Swap End-User Update regarding the reporting obligations that apply to end-users under EMIR is available here.
A link to the ESMA website for EMIR, which includes a quick guide to EMIR for NFCs, is available here.