Investment funds registered in Europe have been directly subject to the European Markets Infrastructure Regulation (EMIR), Europe’s regulatory reform of its derivative markets, since it came into force in 2013. From 22 July 2014, investment funds registered anywhere else in the world but whose manager is in Europe and authorised under the Alternative Investment Fund Managers Directive (AIFMD) will also be subject to EMIR. The focus of investment managers in Europe for the past twelve months has been on preparing for AIFMD. Attention should also be given to EMIR.
Set forth below are considerations for non-EU investment funds with European managers in preparing to comply with the EMIR obligations. For further information regarding the implementation of EMIR, please refer to Reform of Derivatives Markets in the European Union.
From the date of a European investment manager’s authorisation as an Alternative Investment Fund Manager, or “AIFM” (Authorisation Date), all of the offshore funds that it manages (known as Non-EU Alternative Investment Funds, or “Non-EU AIFs”, under AIFMD) that are counterparties to derivative contracts will also come within the scope of EMIR. Under EMIR, an offshore investment fund with a European-authorised AIFM will be defined as a “Financial Counterparty” and consequently subject to the fullest possible scope of EMIR. Specifically, a Financial Counterparty is expected to ensure that: (i) details of its derivative contracts are reported to a central trade repository; (ii) all derivatives in-scope for clearing are cleared with an approved clearing house (Central Counterparty or “CCP”); and (iii) in respect of those contracts that are not centrally cleared, it complies with the EMIR risk mitigation requirements. Largely, European investment managers will be taking on the responsibility for putting in place the relevant arrangements to deal with these obligations, and many have been updating the investment management agreements with their funds to establish that they have the clear authority to do so.
The EMIR reporting obligation began across Europe on 12 February 2014. Offshore funds with European investment managers were not “in-scope” for reporting at that time. However, once such funds have a manager that is authorised under AIFMD, the fund comes within the scope of EMIR and must begin reporting the details of its derivative transactions.
AIFMs whose funds are counterparties to exchange-traded and over-the-counter derivative transactions will be expected to report (on behalf of their funds) certain information in respect of each derivative transaction. This information is to be reported to an authorised trade repository no later than the working day following the creation of the contract (i.e., on a T+1 basis). The reporting obligation will also apply, in certain circumstances, to the modification or termination of the contract.
We understand that the Financial Conduct Authority in the UK intends to implement the reporting rules for offshore funds from the Authorisation Date in accordance with the following:
- Trades entered into from the Authorisation Date must be reported on a T+1 basis from the date the fund enters into the trade.
- Existing trades that remain open on the Authorisation Date must be reported on a T+1 basis from the Authorisation Date.
- There will not be a requirement to report trades that were entered into before the Authorisation Date but which were closed prior to the Authorisation Date. This provides an exemption for funds from certain aspects of the EMIR obligation to report “historic contracts”.
The reporting of data relating to valuation and collateral will begin in August 2014 and further guidance is expected as to how this will be implemented.
Risk Mitigation Update
The provisions of EMIR relating to risk mitigation began coming into effect in March 2013 (with the introduction of timely confirmation and the requirement for daily marking-to-market or marking-to-model). The rules now also cover portfolio reconciliation, portfolio compression and dispute resolution. From the Authorisation Date, an AIFM will need to ensure that it has operational capacity to carry out these obligations on behalf of its AIF when the AIF enters into derivative contracts that are not cleared through a CCP. The introduction of the final limb of the risk mitigation rules with the approval of the draft regulatory standards on exchange of collateral is expected in due course.
Financial Counterparties are expected to comply with the risk mitigation rules irrespective of where their counterparty is located. For certain of the risk mitigation requirements, compliance requires both parties to exchange data. For example, if a Cayman fund is managed by a London-based AIFM, when that Cayman fund is trading with a U.S. bank, it will need the U.S. counterparty’s co-operation in conducting portfolio reconciliation at the intervals prescribed by EMIR. Consequently, non-E.U. counterparties are being asked to comply with certain aspects of the EMIR rules even though they are not themselves directly subject to such rules. Broadly, non-E.U. counterparties have been willing to do so, often as a quid pro quofor the Financial Counterparty’s assistance in helping the non-E.U. counterparty comply with its own regulatory obligations.
There is no certainty as to when the clearing obligation will come into force in Europe. The most recent guidance from ESMA is that the entry into force of the Regulatory Technical Standards (RTS) on the clearing obligation is expected sometime between November 2014 and June 2015. There could also be a phased-in implementation of the provisions of the RTS, which may further extend the start date for clearing derivative contracts.
Retrospective Clearing: Frontloading
In addition to the requirement to clear certain OTC derivative transactions on a prospective basis, Financial Counterparties will be required to clear certain existing transactions retrospectively. This has been termed “frontloading”.
CCPs are being authorised under EMIR to act as clearing houses for the new regime, in anticipation of the clearing obligation commencing in Europe. CCPs apply for authorisation to clear certain classes of derivative contracts.
From the date a CCP has been authorised to clear a defined class of derivative contract, all derivative contracts of such a class that are subsequently entered into will have to be “front-loaded” into the clearing house on the date the clearing obligation comes into force. Consequently, chief operating officers and counsel at European AIFMs will need to consider the following:
- Has a CCP been authorised to clear the class of derivative contracts that I am entering into on behalf of my AIFs?
- If so, do I have adequate records and processes in place to keep track of all the contracts of the clearable class that I have entered into from the date of the relevant CCP's authorisation until such time as the clearing obligation is actually in force?
- On the date the clearing obligation comes into force, do I have the necessary documentation in place with the clearing houses that have been authorised to clear my open trades in order to meet the “frontloading” obligation?
For example, NASDAQ OMX was authorised to clear certain classes of derivative contracts on 18 March 2014, and so for unsettled derivative contracts of that type, the frontloading requirement potentially applies to contracts entered into after 18 March 2014 and still existing at the date of application of the clearing obligation. Consequently, there may be different frontloading periods for different derivative classes, depending on when a CCP becomes authorised to clear the type of derivative contract in question.
There is uncertainty as to how this “frontloading” will work in practice and this has caused widespread industry concern, particularly in relation to the potential impact on pricing structures. ESMA wrote to the European Commission on 8 May 2014 identifying industry concerns and proposing two potential solutions to this issue. The EC’s response and the final form RTS are awaited. We will follow up on how the rules are being put into effect and the impact they are having on the industry.