On April 18, 2019, the final text amending the European Market Infrastructure Regulation (EMIR) was adopted by the European Parliament. The update to EMIR is widely referred to as EMIR REFIT and will come into effect on June 17, 2019.
This article provides a broad overview of the main impacts of EMIR REFIT on fund managers and their funds, with a particular focus on U.S. fund managers.
Changes to EMIR Counterparty Categorization
Reclassification of Alternative Investment Funds The most significant change for U.S. fund managers is the reclassification of EU-domiciled alternative investment funds (AIFs). Under the old EMIR classifications, only AIFs managed by a manager (AIFMs) authorized or registered under the Alternative Investment Fund Managers Directive (AIFMD) were classified as financial counterparties (FCs). Under EMIR REFIT, however, any AIF domiciled in the EU, whether or not its manager is an AIFM, is classified as an FC.
The expanded definition of “FC” will bring many more entities into that category, including any private fund, mutual fund or other fund that is not a UCITS. This will prevent those entities from relying on exemptions from certain EMIR requirements available to nonfinancial counterparties (NFCs), as discussed in more detail below.
Revised Clearing Thresholds In order to alleviate some of the impact of this relatively significant recategorization, EMIR REFIT has introduced a new subcategory of financial counterparties with lower OTC derivatives trading volume, labeled FC- (or FC minus). For purposes of this new subcategory, the revised regulations replicate the clearing thresholds currently applicable to distinguish nonfinancial counterparties (as either NFC+ or NFC-). As a result, as long as the FC’s aggregate average month-end notional amount trading volume for the previous 12-month period is below EUR 1 billion (in either credit or equity derivatives) or EUR 3 billion (in any of interest rate, FX, commodity or other derivatives), then the FC will be an FC-. Those thresholds are calculated at the entity level and are subject to adjustments by the European Securities and Markets Authority (ESMA).
Where a fund is part of a group (e.g., a parent-subsidiary relationship), the calculation of clearing thresholds would take into account all covered derivatives entered into across the group. The definition of “group” under EMIR may include structures such as master and feeder funds, in which case derivatives entered into by both the feeder (such as a currency hedge) and the master will be aggregated.
Status of AIFs Going Forward Funds of non-EU managers will fall within two separate categories depending upon whether the fund itself is domiciled in the EU.
1. EU funds with non-EU managers
- Scope: Any EU-domiciled AIF (which includes all private funds) will now be considered an FC. As many managers established outside the EU have established submanagers in the EU or have otherwise registered under AIFMD in connection with their EU funds, the number of entities falling within this bucket will likely be limited.
- Mandatory Clearing Obligation: As currently with NFCs, FCs will be subcategorized based on whether they have derivatives positions in excess of a clearing threshold in any designated product class set forth above. However, unlike for the existing NFC calculation, FCs must include any hedging transactions in the gross notional value.These changes should enable some existing small FCs (e.g., funds with EU managers) to fall out-of-scope of the clearing obligation. However, with the inclusion of hedging transactions in the clearing threshold calculation, current NFCs falling below the threshold cannot necessarily assume they will also fall under the FC clearing threshold. In particular, an NFC- with significant hedging activities may fall in-scope and be required to clear trades.
- Reporting: Given the dual reporting obligations under EMIR, all funds trading with a dealer subject to EMIR currently have a reporting obligation. However, the reclassification of EU AIFs with non-EU managers as FCs does create some additional reporting burden, since the manager of any EU AIF will become directly responsible for the reporting of any FC it manages. This creates, in turn, a direct regulatory obligation at the manager level and therefore introduces liability in the event the manager fails to comply. Managers with EU funds should therefore review their reporting procedures to ensure compliance.
2. Non-EU funds with non-EU managers
- Scope: Although EMIR REFIT expressly includes only EU AIFs as FCs, the new regulations significantly expand the scope and jurisdiction of EMIR. EMIR currently includes the concept of Third Country Entity (TCE), which has effectively enabled many non-EU managers to avoid an FC categorization. Given that EMIR REFIT now treats any EU AIF as an FC, any private fund would be an FC if it were domiciled in the EU. This means that any private fund, irrespective of its domicile and the interpretation made under EMIR as to its application to TCEs in the investment fund context, will be classified as a TCE FC.
- Mandatory Clearing Obligation: Practically speaking, the main impact for a TCE FC will be the application of the mandatory clearing obligation to the extent the TCE FC meets the clearing threshold. As noted above, the inclusion of hedging in the calculation of the clearing threshold will result in some funds’ becoming subject to the clearing requirement under EMIR. However, because broader OTC derivatives clearing mandates are already applicable under other regimes, such as Dodd-Frank in the U.S., the impact of this change is relatively moderate.
- Reporting: Importantly, unlike for their EU counterparts, TCEs are not subject to manager-level reporting requirements, and therefore, non-EU managers that do not have EU-domiciled funds will not be subject to reporting obligations, either at the manager or the EMIR REFIT level from a reporting perspective.
EMIR REFIT has also closed a loophole enabling non-EU AIFs previously categorized as NFC- to remain out-of-scope for the purposes of EU variation margin requirements. However, those funds escaping the EMIR margin requirements were generally in-scope for the purposes of other regimes, such as Dodd-Frank. As a result, it is not expected that this change will substantively alter the current application of variation margin across AIFs or their managers, whether domiciled inside or outside the EU.