SUMMARY: KEY CHANGES OF SCOPE FOR ASSET MANAGERS
Key changes to the scope of EMIR which asset managers should be aware of as a result of EMIR REFIT are
- a broadening of the definition of a “financial counterparty” (FC), such that all non-EU funds will be categorised by EU dealers as third-country entity FCs (as opposed to third-country entity NFCs); and
- the introduction of an exemption from the clearing obligation for FCs below a certain threshold (FC-s).
In 2012, the European Market Infrastructure Regulation (EMIR)1 came into force, with the aim of implementing a number of G20 reforms on derivatives transactions in the EU, including central clearing for over-the-counter (OTC) derivatives and reporting of all derivative transactions.
Over the past 18 months, the EU has been debating various amendments to the EMIR regime, many of which are aimed at reducing compliance burdens for smaller and less regulated entities. These reforms are commonly referred to as EMIR REFIT2 or EMIR 2.1 (Note that there is also an EMIR 2.2, which is a separate set of reforms that broadly deals with the regulation of CCPs. EMIR 2.2 is not covered in this Update.)
The text of EMIR REFIT was preliminarily agreed among the European Commission, the European Parliament and the Council of the EU on February 5, 2019. We have set out in this Update some of the major reforms set to affect asset managers both in and outside of the EU.
EMIR REFIT is an amending EU Regulation that will enter into force 20 days following its publication in the Official Journal of the European Union, which is likely to take place early in the second quarter of 2019. The changes to the reporting regime will apply 12 months from the date of entry into force of the Regulation; however, no phase-in period appears to have been agreed with respect to the other reforms covered in this Update.
RE-CATEGORISATION OF FUNDS AS FINANCIAL COUNTERPARTIES
EMIR REFIT will broaden the definition of an FC by providing that any alternative investment fund (AIF) established in the EU is an FC, even if it is not managed by an AIF manager (AIFM) authorised or registered under the AIFMD. The result is that non-EU AIFs will now be classified by EU dealers as third-country entity FCs.
Background: FC or NFC?
Currently, subject to very limited exceptions, entities within the definition of a “financial counterparty” must comply with clearing and bilateral margin requirements under EMIR. By contrast, NFCs below certain thresholds may be exempt from these requirements. With respect to funds, the current definition of an FC includes Undertakings for the Collective Investment in Transferable Securities (UCITS) authorised in accordance with the UCITS Directive as well as AIFs if they are managed by an AIFM authorised or registered under the Alternative Investment Fund Managers Directive (an EU AIFM).3 Under EMIR REFIT, the definition of an FC will be amended to include all AIFs established in the EU, regardless of whether those AIFs are managed by an EU AIFM or not.
Impact on EU funds
Under EMIR REFIT, an EU AIF that is managed by a non-EU AIFM (which therefore is currently classified as an NFC) will need to be reclassified as an FC. This reclassification exercise should not affect too many managers as there are relatively few EU AIFs managed by non-EU AIFMs.
AIFs that are part of an employee share purchase plan, or that are securitisation special purpose entities (i.e., within the meaning of the EU Securitisation Regulation4), are excluded from the definition of an FC. Finally, there should be no effect on UCITS because UCITS already fall within the FC definition.
Impact on non-EU funds
It should be noted at the outset that any fund that is not a UCITS (which by definition must be an EU entity) is an AIF. That means all non-EU funds are AIFs. For example, a U.S. mutual fund is an AIF in the same manner as a Cayman hedge fund or Guernsey private equity fund.
Although non-EU AIFs managed by non-EU AIFMs are not directly within the scope of EMIR, they are frequently asked by EU dealers to confirm what their classification would be if they were established in the EU. This is because EU dealers are required to comply with central clearing and bilateral margin requirements in relation to non-EU entities that would be classified as FCs or NFC+s if they were established in the EU.
Under the current version of EMIR, a divergence of approach has arisen in relation to the classification of non-EU AIFs with non-EU AIFMs, with some in the market taking the approach that non-EU AIFs should be treated as third-country entity FCs (TCE FCs) and others taking the approach that they should be third-country entity NFCs (TCE NFCs).5 EMIR REFIT will put an end to this divergence: Because all EU AIFs will now be classified as FCs regardless of whether their managers are AIFMs authorised under AIFMD, it follows that all non-EU AIFs will be considered to be TCE FCs. This means that EU dealers will now need to comply with more stringent requirements when transacting with non-EU AIFs, including exchanging margin for uncleared OTC derivative transactions and the clearing obligation (subject to the points made below on FC-s).
NEW “FC-” CLASSIFICATION
EMIR REFIT will create a new category of FCs with lower volumes of trading activity in OTC derivatives: “FC-” (i.e., FC minus).
EU FC-s will not be subject to the EMIR clearing obligation, but will still need to comply with EMIR rules on margin exchange and other risk mitigation requirements. EU dealers will not need to comply with the EMIR clearing obligation when facing TCE FC-s, but will need to comply with EMIR rules on margin exchange and other risk mitigation requirements.
What is the effect of being categorised as an FC-?
Importantly, classification as an FC- or a TCE FC- will mean that EMIR-regulated transactions are not subject to the clearing obligation. This exemption is intended to respond to concerns that some smaller market participants are unable to access viable central clearing solutions in the EU, and it follows amendments made to the EMIR Delegated Regulations on clearing that effectively delayed application of the clearing obligation for smaller FCs until a longer-term solution to clearing access could be found. The FC- category will be available to all types of funds that are classified as FCs, including AIFs and UCITS.
How can asset managers determine whether their funds are FC-s?
EMIR REFIT effectively replicates the “clearing thresholds” currently applicable to NFCs, in order to determine whether an FC is an FC+ or an FC-. Thus, if an FC’s aggregate month-end average gross notional value of OTC derivative transactions for the previous 12 months is below the clearing thresholds set out below in each asset class, it will be an FC-.
It should, however, be noted that EMIR REFIT empowers the European Securities and Markets Authority (ESMA) to propose amendments to the above clearing thresholds with respect to FC-s where “necessary.” The clearing thresholds are to be applied at the fund level, provided that the manager can demonstrate that this does not lead to a systematic underestimation of the positions of any fund it manages and that it does not circumvent the clearing obligation.
Likely impact on asset managers This new FC- classification may have a limited impact on asset managers in practice for these reasons: (a) EU dealers registered in the United States as swap dealers may already need to comply with the clearing obligation under the Commodity Futures Trading Commission’s rules in relation to TCE FCs that are classed as U.S. persons. (b) The requirement to exchange margin bilaterally for uncleared OTC derivative transactions will continue to apply to FCs and to EU dealers when facing TCE FC-s. This will likely function as a disincentive to trading in uncleared derivatives in situations where there is a workable clearing solution. In practice, therefore, there will be a question for asset managers as to whether it is worth performing a clearing threshold test against their FC funds to determine whether they are FC+s or FC-s. While asset managers are required to notify ESMA if their EU funds exceed the clearing threshold, EMIR REFIT anticipates that they may also notify ESMA that they have elected simply not to run the calculation (in which case the EU funds will be treated as FC+s).
CHANGES TO REPORTING REGIME
The key development for asset managers in relation to reporting is the shift in responsibility for reporting from AIFs and UCITS to AIFMs and UCITS management committees (ManCos), respectively.
For FCs that are UCITS or AIFs, EMIR REFIT transfers the EMIR reporting obligation from the legal counterparty (i.e., the UCITS or AIF) to the UCITS ManCo and the AIFM, respectively. This approach mirrors the approach taken to reporting under the EU Securities Financing Transactions Regulation (SFTR).6 Fund managers will need to review their reporting delegation agreements to ensure that this transfer of responsibility is reflected in them.
INTERACTION WITH BREXIT On October 22, 2018, the UK government published a set of draft Over the Counter Derivatives, Central Counterparties and Trade Repositories (Amendment, etc., and Transitional Provision) (EU Exit) Regulations. This statutory instrument is intended to implement the provisions of EMIR into UK law from the day after the UK exits the EU (i.e., Brexit) and will replace compliance with the EU-level text of EMIR for UK counterparties. Further to this statutory instrument, the UK government has published the Financial Services (Implementation of Legislation) Bill, which enables the UK to implement certain new pieces of EU legislation into UK law where that EU legislation is adopted no later than two years after Brexit. It therefore seems likely that the UK government will implement laws applicable to UK firms that are similar to those under EMIR REFIT. CONCLUSION In general, the changes that will come into effect under EMIR REFIT contain many positive developments for asset managers and for the buy side generally. However, for AIFs that will need to re-categorise themselves as FCs or TCE FCs, moving to clearing and bilateral margining of OTC derivatives transactions may impose a considerable compliance effort.