Almost two years after draft legislation on over-the-counter (“OTC”) derivatives was proposed by the European Commission and following extensive discussions during the trilogue negotiations between the European bodies, the European Market Infrastructure Regulation (“EMIR”) will come into force on 16 August 2012. As an EU regulation, it has direct effect in EU member states and no national measures are required to implement its requirements.
However, there are a significant number of implementing measures required under EMIR before all of its key requirements become fully operative. Given the extent of the implications for asset managers who use derivatives in their portfolios, parties to OTC derivatives contracts should begin to consider those implications now to assess what changes may be required to their business models.
EMIR seeks to enact in European legislation the G20 commitments made in the wake of the financial crisis which included mandatory clearing of all standardised OTC derivatives contracts, improving transparency in the derivatives markets by requiring the reporting of all OTC derivative contracts to trade repositories and the imposition of new risk mitigation obligations, including new collateral and capital obligations, in respect of those derivatives contracts which are not cleared.
Similar legislation, in the form of Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act"), has been introduced in the USA and a regulatory rule-making process is required before it is fully operational.
The objective of the reporting obligation is to give regulators an understanding of the derivatives market and to assess risks relating to those markets. Reports, which will have to contain details of all derivatives contracts traded (whether OTC or exchange-traded), will have to be made to approved trade repositories, as opposed to regulators themselves, and it will be the trade repositories who will feed information to regulators. The European Securities Market Authority (“ESMA”) will be responsible for the surveillance of trade repositories and for granting / withdrawing their registration.
EMIR provides that the reporting obligation shall apply to derivatives contracts which were entered into before 16 August 2012 and remain outstanding on that date; or are entered into on or after 16 August 2012. ESMA has yet to register any trade repository and it has not finalised the precise reporting template but when these are finalised affected firms will be expected to back-report trades from this August start date. According to ESMA's June 2012 consultation paper on draft technical standards for EMIR, the reporting obligation is expected to come into effect on 1 July 2013, or if no trade repository has been registered for a particular type of derivatives contract on 1 May 2013, 60 days after the registration of such a trade repository in respect of that type of derivatives contract.
The reporting obligation is stated to apply to counterparties and central counterparties. Whether this obligation applies to the investment fund itself or the investment manager will depend on the legal structures in place and these will have to be examined on a case-by-case basis. It may be necessary to review the contractual relationship between the fund and the investment manager to address the reporting requirements under EMIR.
EMIR also requires counterparties to clear all OTC derivatives contracts in a class of OTC derivatives that has been declared subject to the clearing obligation. The relevant classes are to be determined by regulatory technical standards drafted by ESMA and ESMA has suggested that the clearing obligation is unlikely to be applied before the summer of 2013.
Where OTC derivatives contracts are not cleared counterparties will be required to “measure, monitor and mitigate operational risk and counterparty and credit risk”. This must include at least timely confirmation, where available, by electronic means, of the terms of the OTC derivatives contract and “robust, resilient and auditable” processes to reconcile portfolios and manage associated risk. This will involve OTC derivatives contracts being marked-to-market daily and the exchange of collateral or the holding of a proportionate amount of capital.
Although these requirements apply from 16 August, the European Supervisory Authorities (“ESAs”) must draft regulatory and technical standards on risk mitigation techniques for uncleared OTC derivatives before these obligations can be effectively implemented and these standards will need to be approved by the European Commission. The ESAs and the Commission recently agreed to extend the original 20 September 2012 deadline to ensure that the European rules are consistent with the ongoing global development of international standards which are expected to be delivered by the end of 2012.
Significant operational challenges face asset managers in implementing these new requirements. These challenges will in some cases be complicated by overlaps and potential conflicts between EMIR and the Dodd-Frank Act, depending on the residence of the counterparties. Although the operation of EMIR will be phased in, given the extent of the potential implications for asset managers, the EMIR requirements ought to be considered as early as possible.