Almost three years have passed since the European Market Infrastructure Regulation (EMIR) entered into force on August 16, 2012. EMIR is shortly due its scheduled 2015 review, and still the most publicized obligation under EMIR, that certain counterparties should clear in-scope OTC derivative contracts through an approved central counterparty (CCP), has not yet been finalized. As the European Securities and Markets Authority (ESMA) and the European Commission (the Commission) negotiate the final details of the obligation, the market is preparing to comply and, as part of this process, on June 12, 2015, the International Swaps and Derivatives Association, Inc. (ISDA) published its “Frontloading Additional Termination Event” in order to address frontloading, one of the most criticized aspects of the EMIR clearing obligation. In this Update we set out an overview of the EMIR clearing obligation, an update on the status of the obligation to date, and a discussion of the Frontloading Additional Termination Event. The EMIR clearing obligation: Loud and clear
Under EMIR, the following counterparty pairs are required to clear OTC derivative contracts which the Commission has declared subject to a clearing obligation through an EU1 CCP which has been “authorized” under EMIR, or through a non-EU CCP which has been “recognized” under EMIR:
- two financial counterparties (FCs);
- a FC and a non-financial counterparty (NFC) that exceeds EMIR’s prescribed clearing threshold (NFC+);
- two NFC+s;
- a FC or NFC+ and a third country entity (TCE)2 which would be a FC or NFC+ if it were established in the EU (an Assumed FC and an Assumed NFC+); and
- an Assumed FC/Assumed NFC+ with another Assumed FC/Assumed NFC+, but only in the limited circumstances where either the relevant OTC derivative contract has a “direct, substantial and foreseeable” effect within the EU or imposing the clearing obligation is necessary or appropriate to prevent the evasion of any provision of EMIR.
There is an exemption under the EMIR clearing obligation for intragroup transactions meeting certain criteria and there are also transitional provisions relating to pension funds. Where are we today? Clear and present danger To date, ESMA has issued four consultation papers on the clearing obligation and has proposed that certain interest rate derivatives and index-linked credit derivatives be subject to mandatory clearing. The draft regulatory technical standards (RTS) in relation to the first group of interest rate derivatives proposed by ESMA to be subject to clearing are the most advanced, having been published in July 2014 and having passed through various manifestations. The RTS are currently awaiting endorsement by the Commission after which they will be subject to a non-objection period under the European Parliament and Council, which may last up to six months. The lengthy delay in endorsing the RTS has been caused by disagreement between the Commission and ESMA as to how to resolve certain technicalities relating to the exemption for intragroup transactions. However, Lord Hill, European Commissioner for Financial Stability, Financial Services and Capital Markets Union, stated on May 29, 2015 that the Commission and ESMA have now finalized their discussions and parties may start to become subject to mandatory clearing in April 2016. Once the RTS have passed through the approval process, they will be published in the Official Journal of the EU and will enter into force 20 days later. The phase-in periods set out in the current draft RTS relating to the first group of interest rate derivatives to be subject to mandatory clearing are as follows:
- Category 1 entities (clearing members, for at least one of the interest rate products subject to the clearing obligation, of at least one of the CCPs authorized or recognized to clear at least one of those classes by the date on which the RTS enter into force): six months after the RTS enter into force.
- Category 2 entities (FCs/Assumed FCs or alternative investment funds (AIFs) which are NFC+s/Assumed NFC+s, which do not fall within Category 1 and which belong to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives for the three-month period after the RTS are published, excluding the month of publication, is above €8 billion):12 months after the RTS enter into force.
- Category 3 entities (FCs/Assumed FCs or AIFs which are NFC+s/Assumed NFC+s which do not fall within Categories 1 or 2): 18 months after the RTS enter into force.
- Category 4 entities (NFC+s/Assumed NFC+s which do not fall within Categories 1, 2 or 3): three years after the RTS enter into force.
Helpfully for investment funds, the draft RTS clarify that the €8 billion threshold (used for determining whether a fund falls within Category 2 or Category 3) is determined at the level of the individual fund rather than on the basis of all funds managed by a single investment manager. What is frontloading? As clear as mud EMIR’s much maligned frontloading requirement provides that in-scope OTC derivative contracts entered into after a CCP is authorized to clear such contracts must be cleared as soon as the relevant clearing obligation takes effect, provided the contracts have a certain specified minimum remaining maturity. This means that parties could enter into an OTC derivative contract at a time when ESMA is consulting as to whether such class of derivative should be subject to a clearing obligation or not, or even prior to the consultation paper being issued, and ultimately find themselves having to clear that contract. Understandably, this provision has provoked a great deal of concern due to the uncertainty which it creates in relation to the pricing and terms of derivative contracts.
Fortunately, ESMA’s latest proposals mitigate the impact of the frontloading obligation in two key ways. First, the category of counterparties to whom frontloading applies is limited to FCs and Assumed FCs falling within Categories 1 and 2. Second, the frontloading period has been reduced significantly:
- for Category 1 FCs/Assumed FCs: the period running from two months after the entry into force of the relevant RTS until expiry of the Category 1 phase-in period (i.e. a four-month period); and
- for Category 2 FCs/Assumed FCs: the period running from five months after the entry into force of the relevant RTS until expiry of the Category 2 phase-in period (i.e. a seven-month period).
Category 3 entities and NFC+s/Assumed NFC+s (irrespective of the category into which they fall) are not subject to frontloading. As it is only transactions which affected parties enter into during the frontloading period which are subject to frontloading, these revisions have considerably increased certainty surrounding the application of the frontloading obligation. However, questions remain as to how transactions entered into during the applicable frontloading period will be priced and whether it will be possible to find a clearing member who agrees to clear the transaction upon the clearing obligation entering into effect (e.g. in seven months time) or whether, alternatively, affected trades will simply have to be cleared at inception, thereby negating the benefit of the phase-in period. The Frontloading ATE: Is your conscience clear? ISDA has published a form of amendment to the ISDA Master Agreement, which incorporates a new Additional Termination Event in order to address frontloading (the Frontloading ATE). The Frontloading ATE provides that if a transaction that is required to be cleared under EMIR is not cleared by the relevant clearing deadline (i.e. upon expiry of the relevant phase-in period), it will constitute an Additional Termination Event, with respect to that affected transaction only, for so long as the transaction remains uncleared. This means that if affected parties enter into an in-scope transaction during the frontloading period, and that transaction has the requisite remaining maturity, but has not been cleared by the expiry of the relevant phase-in period, the Frontloading ATE will apply. The form of Frontloading ATE leaves a number of key details to be decided between the parties by choosing from a number of suggested elections:
- Which party will have the right to terminate the transaction(s), or will either party be able to do so? Note that there is not an automatic termination of the affected transaction(s) and counterparties will need to monitor their books of derivatives to ensure they will be in compliance with EMIR upon expiry of the relevant phase-in period and will need to be prepared to exercise their termination rights under the Frontloading ATE if necessary.
- On whose side of the market will the resultant termination amount be calculated? Counterparties may wish to provide that the termination amount is calculated using mid-market prices (e.g. where both parties agree that, rather than clearing the products in question, any uncleared in-scope transactions outstanding at the expiry of the phase-in period should be terminated). However, there may be circumstances where a party will argue that the termination amount should be calculated on its side of the market (e.g. where the other party is required to put in place clearing arrangements and fails to do so by the expiry of the relevant phase-in period).
- If the parties have a 1992 ISDA Master Agreement that specifies “Market Quotation” as the applicable payment measure, do the parties wish to amend the ISDA such that the more subjective “Loss” payment measure will apply to a determination of a termination payment following the occurrence of a Frontloading ATE?
- Where the value of a terminated transaction is determined by reference to the cost or gain of the determining party entering into a replacement transaction, the only replacement transaction available at the time of termination will be a cleared transaction. Therefore, if parties wish to value terminated transactions on an uncleared basis, an express provision to this effect should be included. Pricing of cleared and uncleared transactions may differ significantly and this distinction could alter the termination amount payable between the parties.
The Frontloading ATE is not obligatory. Nonetheless, European dealers may seek to protect themselves from unintended breaches of EMIR by insisting that in-scope transactions with affected parties that are entered into during the frontloading period (i) are cleared from the outset (i.e. ahead of time); (ii) are short dated, such that they will not meet EMIR’s minimum remaining maturity requirements; or (iii) can be terminated if necessary, by way of the Frontloading ATE or otherwise.
In addition to dealers, buyside counterparties that are classified as Category 1 or Category 2 FCs3 may find it helpful to include a provision of this nature in their trading documentation, so as to ensure that they do not fall foul of EMIR, particularly when trading with counterparties who are not directly subject to the obligation themselves (e.g. non-EU banks) and may not be monitoring compliance with this obligation.
What if my transactions are not in-scope? Am I in the clear? Those OTC derivative contracts which do not fall within scope of EMIR’s clearing obligation may still be subject to EMIR’s margin rules in respect of uncleared OTC derivative contracts, a revised draft of which was recently published. It remains to be seen whether the burden imposed on market participants by these rules will result in market participants turning to clearing even in circumstances where clearing is not mandated under EMIR.