Summary and implications
There is an ever increasing volume of new legal and regulatory measures coming our way and which potentially affect the real estate and funds sector. This briefing provides a link to a table we have prepared giving an overview (and proposed implementation dates) of some of the main ones.
This briefing also focuses on the European Market Infrastructure Regulation (EMIR) on Over the Counter (OTC) Derivatives and the issues it throws up for the real estate sector. This is especially relevant given the pending vote on the terms of EMIR to be held in the European Parliament on 20 April, which may address some of the real estate sector's concerns.
Click here for the regulatory table.
Many of the new regulatory measures are designed with the financial services and banking industry in mind (such as the Alternative Investment Fund Managers Directive (the AIFM Directive), EMIR, Basel III and Solvency II). Others reflect UK government plans and policies which directly affect the real estate sector (such as Carbon Reduction Commitment Energy Efficiency Scheme, competition issues, localism and the Bribery Act, and which cannot be ignored). Some of the proposals have been implemented, others are agreed and are due to take effect in the future, and others are still being consulted on (for example, EMIR and Solvency II). All actually or potentially also impact on the UK real estate and funds sector.
EMIR on OTC Derivatives
Background and context for real estate
The financial crisis brought derivative contracts, such as credit default swaps, to the forefront of regulatory attention with the near collapse of Bear Stearns, the bail out of AIG and default of Lehman Brothers between March and September 2008. The G20 decided to look at how to regulate and reduce risks to the system due to the use of derivative contracts on an international scale. The European Commission's response is EMIR, which is currently being discussed at European Parliament level with a vote on its terms scheduled for 20 April.
Real estate businesses may not be the most obvious users of derivatives creating systemic risk. However, they frequently enter into interest rate swaps as part of their treasury activities, or when borrowing against their assets to protect themselves against interest rate rises. A 2009 survey estimated that in the UK alone there were around £140bn of loans outstanding with interest rate swaps in place (being 57 per cent of the total). Vigorous lobbying and European Parliament comments on EMIR will hopefully result in real estate businesses being excluded from EMIR or its impact being addressed.
If real estate businesses are caught, the impact is potentially severe.
Context of EMIR – international theme
The international aim was for:
- Standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties;
- OTC derivative contracts to be reported to trade repositories; and
- Non-centrally cleared contracts to be subject to higher capital requirements.
EMIR follows the international theme. It adopts a similar scope of application to the above aims and the Dodd-Frank Act, which was enacted last year in the USA.
Key questions for those in the real estate sector
There are some key questions for real estate businesses to ask, including funds and fund managers, so that they can assess the potential impact of EMIR on them:
- Will I fall within EMIR?
- Do I use derivative contracts, for instance, interest rate swaps or hedges for loans, and are they within EMIR?
- Will those derivative contracts be subject to clearing and reporting?
- If not, will I be subject to risk management and other requirements, such as cash collateral and reporting?
- What about derivative contracts entered into before EMIR comes into force – are they caught?
“Financial” and “non-financial” counterparties
EMIR applies to “financial counterparties” and certain “non-financial counterparties”. The problem for the real estate sector arises because the definition of a “financial counterparty” in EMIR includes, alongside institutions such as insurance companies and banks, alternative investment fund managers (as defined in the AIFM Directive). This potentially brings a whole range of real estate funds, their managers and real estate businesses into the scope of EMIR. Given that some of the detail of the AIFM Directive is still subject to level 2 discussion by the European Securities and Markets Authority (ESMA), uncertainty remains for some real estate sector businesses as to whether or not they are in or out of scope of AIFM and therefore in or out of EMIR.
A real estate business may also be required to clear its OTC derivative contracts as a “non-financial counterparty” if it is very active in this market. The relevant clearing threshold is to be determined by the European Commission, taking into account systemic importance.
There may also be a separate reporting obligation for a “non-financial counterparty” which reaches an information threshold.
The ECON Committee wants MEPs to support amendments to EMIR to take real estate businesses (including funds) out of the scope of a “financial counterparty” on the basis they are fundamentally non-financial and EMIR would create a prohibitively high liquidity burden. If this fails then it is necessary to consider what impact EMIR will have.
OTC derivative contracts – central clearing
EMIR will apply to those OTC derivative contracts which ESMA considers should be centrally cleared through authorised central counterparties (CCPs). Therefore, if a real estate business is a “financial counterparty” (or a clearing “non-financial counterparty”) it will be required to clear trades in those contracts through a CCP. Those trades will need to have “highly liquid” collateral (not property) posted and trades will also need to be reported to trade repositories. There will be detailed conduct of business requirements for CCPs and trade repositories.
ESMA’s approach to determine which OTC derivative contracts are “standardised” and should be part of central clearing is two-fold:
- A “bottom- up” approach: CCPs decide contracts to be cleared, and report details to ESMA; and
- A “top-down” approach: ESMA, together with the European Systemic Risk Board, determine contracts which should be cleared. This is to capture those contracts not yet cleared by a CCP.
CCPs – authorisation and governance
CCPs are to be authorised within the EU or, in the case of third country CCPs, recognised by ESMA, provided certain conditions are met. CCPs will be subject to stringent risk management requirements: for example, robust and transparent governance arrangements, a risk committee and independent expert board members of good repute.
OTC derivative contracts – outside clearing
Different rules apply where OTC derivative contracts are not subject to mandatory clearing by a CCP. In these circumstances, if a real estate business is treated as a “financial counterparty” or a clearing “non-financial counterparty” it will have to put in place risk management techniques for its OTC derivative contracts. The requirements include onerous obligations designed to manage operational and credit risk, including:
- Capital requirements;
- Segregated exchange of collateral;
- Daily marking to market of uncleared derivative positions;
- Increased use of electronic confirmations; and
- Increased transparency requirements (pre-trade and post-trade) and reporting obligations to trade repositories.
In respect of collateral, what is necessary or appropriate for real estate-backed transactions needs to be addressed – arguably, the real estate itself is sufficient.
The treatment of pension schemes
Alongside the real estate sector, there is a separate debate on how pension funds (which are also within the definition of a “financial counterparty”) should be treated under EMIR, such as removing them from the clearing obligation to the extent the posting of liquid collateral would result in an undue burden on its capital.
Impact on real estate
For a real estate sector business which is caught by EMIR:
- Standardised swap activities (determined by ESMA) may need to be cleared through external exchanges, with appropriate liquid collateral (real estate does not currently count) and reporting; and
- It would have to risk manage non-cleared contracts, including marking-to-market on a daily basis, and provide collateral.
Given the potential destabilising impact of EMIR on real estate and debt markets across Europe and the nature of a real estate business, the main focus areas for the real estate industry are:
- A real estate business (including a fund and its manager) should not be treated as a “financial counterparty” under EMIR;
- If caught, issues such as collateral requirements need to be addressed; and
- OTC derivative contracts entered into before EMIR comes into force should be excluded (the European Parliament has put forward proposals for pre-2012 contracts).
Where we are now
The Regulation is yet to be finalised and various drafting amendments have recently been proposed by the European Parliament, with a vote due on 20 April.
EMIR is expected to apply from late 2012. It will have direct national effect once it is adopted in Europe.
You may still wish to lobby or speak to your industry bodies in order to make your own views and any concerns known. Let us know if we can put you in touch. We would also be happy to discuss any of the issues raised in this briefing, or any of those in the attached table.