Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories ("EMIR") entered into force on 16 August 2012. Most of the obligations that EMIR imposes have, however, been subsequently developed by technical standards. Pursuant to Article 85(1) of EMIR, the European Commission was mandated, by August 2015, to review EMIR and to prepare a general report for submission to the European Parliament and Council.
EMIR was approved with the objective to reducing systemic risk by increasing the safety and efficiency of the OTC derivatives market. On 4 May 2017, the European Commission published a proposal to amend certain provisions of EMIR (the "EMIR Review")24. Although EMIR's prime objective is to reduce systemic risk, the last 5 years have shown that EMIR has imposed onerous and expensive obligations on certain market participants. Taking this into account, the EMIR Review aims to apply EMIR in a more efficient way by reducing certain regulatory requirements.
Germane to the EMIR Review, is the European Commission's proposal published on 13 June 2016 to develop a more robust supervision of central counterparties ("CCPs") (the "CCP Proposal")25. The CCP Proposal is directly linked to the broader EMIR Review in the European Parliament and introduces a more pan-European approach to the supervision of EU CCPs, to ensure further supervisory convergence and accelerate certain procedures. The CCP Proposal aims to ensure closer cooperation between supervisory authorities and central banks responsible for EU currencies. Both the EMIR Review and the CCP Proposal herald a new derivatives regulatory framework shaped not only by the previous crisis but also by the last 5 years of experience since EMIR came into force.
The main aim of the EMIR Review is to ease access to central counterparty clearing and improve transparency. The EMIR Review is particularly focused on small and medium-sized entities that have low volume trading and are nevertheless subject to unduly onerous requirements. However, it also introduces a significant change for securitisation special purpose entities ("SSPEs") since it reclassifies them as financial counterparties. It is envisaged that the EMIR Review, if approved in its current form, will require the European Securities and Markets Authority ("ESMA") to update or develop five technical standards.
Counterparty classification under EMIR is essential since it determines the set of obligations with which an entity will have to comply. Under EMIR, entities are primarily classified as "financial counterparties"26 ("FC") or "non-financial counterparties"27 ("NFC"), in each case established in the European Union ("EU"), or third country entities equivalent to FCs or NFCs. An NFC will be classified as an "NFC+" if the rolling average gross notional position over 30 working days of the OTC derivative contracts it has entered into (including all the OTC derivative contracts entered into by other NFCs within its group) has exceeded any of the following thresholds (with the result that the relevant entity will be classified as an NFC+):
- EUR 1 billion for equity or credit derivatives; or
- EUR 3 billion for interest rate, foreign exchange or commodities derivatives,
(in each case excluding eligible hedging transactions).
The key obligations under EMIR relate to (a) the clearing of OTC derivative contracts; (b) the reporting of OTC derivative contracts and exchange traded derivative contracts; and (c) risk mitigation requirements in respect of OTC derivative contracts not subject to clearing (which includes margin exchange).
An FC and an NFC will each have to comply with the above set of obligations. On the other hand, as long as the NFC does not exceed the above clearing threshold, it is subject to the reduced set of obligations under EMIR (in this case, the entity is referred to as "NFC-").
Summary of the key proposed amendments
SPVs subject to clearing and margin exchange
A material and unexpected28 change included in the EMIR Review is the reclassification of SSPEs as FCs. The immediate consequence of this change is that SSPEs would have to comply with both the clearing obligation, subject to a threshold test, and margin exchange obligation. The EMIR Review, if it goes ahead, would change the definition of "financial counterparty" so that includes:
- "a securitisation special purpose entity as defined in Article 4(1)(66) of Regulation (EU) No 575/2013 of the European Parliament and of the Council ("CRR")"
- "a central securities depository authorised in accordance with Regulation (EU) No 909/2014 of the European Parliament and of the Council"; and
- "an AIF as defined in Article 4(1)(a) of directive 2011/61/EU".
In particular, Article 4(1)(66) of the CRR defines a SSPE as a: "a corporation trust or other entity, other than an institution, organised for carrying out a securitisation or securitisations, the activities of which are limited to those appropriate to accomplishing that objective, the structure of which is intended to isolate the obligations of the SSPE from those of the originator institution, and in which the holders of the beneficial interests have the right to pledge or exchange those interests without restriction."
It is clear that the above definition captures only securitisation vehicles, such that special purpose vehicles which have a nature or purpose that differs from the scope of this definition will remain classified as NFCs29.
This amendment is not qualified by any specific conditions that must be met before SSPEs are considered FCs. Likewise, the EMIR Review does not include any transitional provisions that confirm existing contracts entered into by SSPEs are excluded.
Pursuant to the classification provided by EMIR, SSPEs are currently classified as NFCs. This was also confirmed by ESMA which stated that "securitisation special purpose vehicles do not meet the definition of financial counterparties and should be considered as non-financial counterparties for the purpose of EMIR "30.
The margin requirements set out in Article 11 of EMIR were promulgated pursuant to Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016 (the "Margin Rules").31 Therefore, the Margin Rules left SSPEs who had not exceeded the clearing threshold (i.e. NFC-s) outside the scope of any margin exchange obligation.
- Clearing obligation: By being reclassified as FCs, SSPEs will be subject to the broadest set of obligations under EMIR, which includes clearing of certain OTC derivative contracts. However, SSPEs may be able to benefit from a change that we will discuss more extensively below. If the EMIR Review is approved, FCs with small volume of trading activity will be able to benefit from a new clearing exemption, if the applicable aggregate notional amount is below the relevant clearing threshold. In principle, most SSPEs should be able to benefit from this exemption as typically they are only using OTC derivatives for hedging purposes.
- Margin exchange obligation: Article 10(2) of EMIR established the general framework of entities that are subject to margin exchange, which includes FCs and NFC+s as well as certain third country entities. This was subsequently developed by the Margin Rules.
The Margin RTS entered into force on 4 January 2017. From 4 February 2017, counterparties who each have a group aggregate average notional amount of EUR 3 trillion for non- cleared OTC derivatives have to post both initial margin ("IM") and variation margin ("VM") (with a phase-in for IM then commencing on such date through to 1 September 2020 for EUR 8 billion32). From 1 March 2017, all FC's and NFC+'s within scope became subject to the obligation to post VM in accordance with the Margin Rules33. VM is the minimum level at which counterparties must maintain margin and is based on a daily mark-to-market calculation IM is posted separately to cover potential losses due to a default.
The application of the Margin Rules to SSPEs will cause material issues in the European securitisation market and will restrict the ability of SSPEs to purchase obligations not denominated in the currency of the securitisation notes issued and/or hedge any interest rate risk relating to such notes. In addition, SSPEs will need to consider alternative financing to ensure they are able to post collateral.
For example, SSPEs may be structured so that cash reserves are established to allow for margin payments to be made. This would negatively affect how these entities work. A way to get round this problem may be by structuring these entities with one tranche only outside of the classification as an SSPE.
Alternatively, the originator or a third party liquidity provider could place cash for margining in the SSPE at the time of origination. The SSPE could then post its entire potential margin requirements from day one such that no daily posting is required. Or the SSPE could consider a party to act as an additional liquidity facility provider, specifically to provide margin when needed. However, third party arrangements may pose a number of credit risk issues for the liquidity provider since it will be only be relying on the collateral of the SSPE.
Since SSPEs will have to design alternative arrangements to comply with the Margin Rules, there is reasonable risk that various bespoke structures will begin to be implemented within the securitisation market adding additional layers of complexity and divergence between deals. No single solution will fit every securitisation structure, for each transaction often has unique features. It may, however, be that a common approach develops over time.
In addition, if this measure is approved, it is likely to negatively impact the current regulatory progress towards creation of a European securitisation framework (the "Securitisation Regulation")34. The European Parliament and the Council are currently considering a draft European Commission proposal for a securitisation regulation under which securitisation vehicles could be given exemptions from both the clearing and margin exchange requirements under EMIR, but only if the transactions qualify as "simple, transparent and standardized" securitisations ("STS") (i.e. securitisations meeting certain structural and legal requirements and not issuing any positions which do not meet these requirements). Treatment of non-STS securitisation vehicles will remain dependent on the vehicle falling below the clearing and margin thresholds applicable from time to time.
Currently, there would appear to be an inconsistency between the Securitisation Regulation and the EMIR Review as the former notes that it should not be necessary to apply the margin-exchange obligation to such arrangements since it is market practice that counterparties to securitisation swaps benefit from a senior ranking entitlement and the security package provided to senior creditors.
Potential consequences of the SSPE reclassification
Changes in respect of clearing
Suspension of the clearing obligation
The EMIR Review would introduce a regime for suspension of the clearing obligation, in respect of a particular class of OTC derivative or type of counterparty, a mechanism which EMIR does not currently contemplate. Suspension of the clearing obligation may be effected only in three specific cases:
(i) the criteria that made a specific class of OTC derivative subject to clearing no longer apply;
(ii) a CCP is likely to cease clearing services for such particular class of OTC derivative and no other CCP is able to clear that class of OTC derivative without interruption; or
(iii) to avoid or address a serious threat to the financial stability of the EU.
Summary of the clearing suspension
The fact that the request is not made public may be problematic since the market will not be prepared for such event. The OTC derivative market would benefit from greater transparency in respect of which classes of OTC derivatives or types of counterparty the clearing obligations may be suspended. In addition, a 3 month period, whilst it may provide flexibility to the regulators, in practice it may be disruptive since mandatory clearing of a specific asset class OTC derivative may be subject to continuous suspensions.
Exempting small FCs from clearing
The current classification of FCs and NFCs is fairly simple since it results in that as long as an entity is not listed as being authorised pursuant to a specific piece of European legislation, such entity will be an NFC-.
This approach is relatively straightforward and has the benefit of clarity. However, it is likely that a number of very small FCs with no significant hedging activity have been captured by the FC umbrella. For these types of entities, central clearing is not economically feasible because of the small volume of activity. These entities do not pose any systemic risk and yet are subject to the same regime as a large financial entity.
To benefit from the exemption proposed in the EMIR Review, an FC will have to calculate annually its aggregate month-end average position for the months of March, April and May35. If it exceeds any of the clearing thresholds, it will become subject to clearing for future OTC derivative contracts irrespective of the asset classes for which the relevant clearing threshold has been exceeded.
Please note that, in respect of FCs below the clearing thresholds, the EMIR Review would remove the requirement to clear certain transactions but will maintain the margin exchange obligation.
New calibration of clearing threshold for NFCs
The current Article 10(2) of EMIR mandates that the relevant clearing threshold of a NFC be calculated in respect of "its rolling average position over 30 working days". The EMIR Review suggests that for the purpose of calculating where the relevant threshold has been exceeded, the relevant period would be "the aggregate month-end average position for the months, March, April and May". This will not affect the hedging exemption, i.e. OTC derivative contracts that constitute hedging will not be taken into account for the purposes of the calculation. If finally implemented, counterparties currently classified as NFCs will have to assess whether this new calibration period moves them above the relevant clearing threshold.
NFCs to clear only in respect of a particular type of OTC derivative contract
NFCs are generally corporates that enter into OTC derivatives for the purpose of hedging their exposure to a particular risk. This usually involves interest rate or currency exchange swaps. Their hedging activity is usually confined to market standard instruments and only to the extent that they must hedge a particular risk.
If an NFC exceeds the relevant clearing threshold it will become an NFC+ and therefore will be subject to the clearing as well as margin exchange obligation. EMIR currently does not distinguish between types of OTC derivatives, so once the clearing threshold for interest rate derivatives has been exceeded, such entity would have to clear any other classes of OTC derivatives, subject to mandatory clearing, e.g. foreign exchange and commodity derivatives, etc.
Under the EMIR Review, NFC+s would only have to clear OTC derivative contracts subject to mandatory clearing in respect of the asset classes where they exceed the applicable clearing threshold. This reduces the clearing burden on such NFC+ entities.
However, this will not affect the current margin regime. Once an NFC becomes an NFC+, it must comply with the applicable margin rules in respect of all types of OTC derivatives.
Removal of frontloading
The frontloading requirement is currently laid down in Article 4(1)(b)(ii) of EMIR. Frontloading is the obligation to clear OTC derivative contracts (pertaining to a class of OTC derivatives that has been declared subject to the clearing obligation) entered into or novated on or after notification by a competent authority to ESMA on the authorisation of a CCP but before such clearing obligation takes effect, if they have a remaining maturity higher than the "minimum remaining maturity" determined in the relevant technical standards36. The EMIR Review proposes to remove this obligation and only apply the clearing obligation to those contracts entered into or novated on or after the date from which the clearing obligation takes effect.
Pension scheme arrangements – extension of the exemption
Certain pension scheme arrangements ("PSA") will benefit from a further 3 year (post entry into force) exemption from clearing, extendable by a further 2 years.
Article 85(2) of EMIR mandates the European Commission to develop technical solutions for the transfer by PSAs of non-cash collateral as variation margins. However, no viable solution has been arranged yet which justifies the European Commission's decision to extend the exemption regime. Work on this issue will continue and will involve CCPs, PSAs, clearing members, ESMA and other European regulatory bodies.
A new "Fair, Reasonable and Non-discriminatory" requirement
Small and medium entities have had difficulties in accessing central clearing, either as a client or through indirect client arrangements. The European Commission has concluded that the requirement to facilitate indirect clearing on reasonable commercial terms has not been efficient.
The EMIR Review would therefore impose a stricter set of standards so clearing services will have to be provided and fair, reasonable and non-discriminatory commercial terms. These new measures will be imposed on clearing members in relation their clearing and indirect clearing offered to clients, and will be further elaborated in technical standards by ESMA.
Changes in respect of reporting
Under EMIR small and medium enterprises are subject to the same reporting obligations as that of FCs. In some cases, these requirements may result in disproportionate costs. The EMIR Review is looking at streamlining reporting for those entities that represent a low risk due to their trading volumes. The main drivers behind the proposed changes are to rationalise the reporting process by removing the obligation on NFC-s when facing FCs to report as experience shows that it is disproportionally expensive for NFCs or of little use to regulators. FCs would be responsible for reporting in this case.
The EMIR Review has introduced a change in practical and legal consequences for NFCs, which frequently are less familiar with the reporting obligation and must delegate such obligation to their FC counterparties. Under the EMIR Review, NFC-s would automatically delegate reporting to FC counterparties, with responsibility for report accuracy also falling on the FC.
Although in practice this is already the case (since parties typically enter into a reporting delegation agreement whereby the NFC delegates its reporting obligations to the FC), the liability and responsibility to report and the accuracy thereof remained on the side of the NFC.
Removal of the 'backloading' requirement
Backloading requires reporting of derivatives transaction entered into on or after 16 August 2012 but no longer outstanding on 12 February 2014. The EMIR Review recognises that backloading has resulted in a high reporting failure rate and poor quality of reported data. This measure has been adopted with a view to reducing costs and burdens on counterparties on reporting data that is unlikely to be used.
NFCs will not have to report their intragroup trades
As in the case of backloading, the same rationale applies here. As recent experience suggests, NFCs have low trading volumes which do not justify onerous reporting requirements. Although the "picture" of trading volumes will no longer be fully accurate due to less reporting, this should not affect the monitoring abilities of the regulators.
The EMIR Review will now be discussed and amended by the European Parliament and the Council, with agreement likely in the second half of 2018 at the earliest. The delivery of technical standards is due 9 months after the entry into force of the EMIR Review. It is generally felt that this 9 month period is unlikely to be sufficient for ESMA to consider all the issues and amend the relevant technical standards. Entities will have to consider internally a number of potential changes and how they may impact them since the changes may take effect 20 days after publication in the Official Journal of the European Union.
It is clear that the rationale of the EMIR Review is indeed to rectify requirements imposed by EMIR that recent experience has shown were not necessarily helpful. Most notably, the EMIR Review will alleviate the burden on small and medium sized enterprises which will be subject to a more lenient regime. This will help them in reducing compliance costs.
However, more details and further discussion are required in respect of the proposed suspension of the clearing obligation, which lacks in transparency.
More importantly, the proposal to make SSPEs subject to the Margin Rules is likely to significant structural and commercial issues in the securitisation market and may also hamper the intended goal of transparency.
Summary of the proposed changes