Part 1 appeared in the September 2013 issue of FundsTalk, which can be found at http://www.kramerlevin.com/ or by contacting one of the authors or editors.
The European derivatives regulatory reforms originally adopted in the summer of 2012 and commonly referred to as EMIR are closer to full implementation with the entry into force of technical standards published by the European Securities and Markets Authority (“ESMA”) and the recent September 15th effective date for certain risk mitigation requirements.
This article provides an overview of the main obligations imposed by the regulations on buy-side market participants. In Part 1 of this article we discussed the scope and application of EMIR and addressed trade reporting and recordkeeping. Part 2 will focus on clearing and risk mitigation requirements for non-cleared derivatives and EMIR’s cross-border application.
Derivatives Contracts Subject to Mandatory Clearing
Derivatives contracts that a clearinghouse has been authorized or recognized to clear and that ESMA has determined should be cleared will be subject to the mandatory clearing requirement under EMIR. Additionally, while the mandatory clearing obligation under EMIR will not apply to exchange-traded contracts, proposed revisions to the Markets in Financial Instruments Directive (the so-called MiFID II) include a mandatory clearing requirement for those contracts.
Mandatory Clearing Determination Process
In determining whether a derivatives contract should be subject to the clearing obligation, ESMA can follow one of two approaches:
- A “bottom-up” approach, where national regulators notify ESMA of any authorized existing clearing services for derivatives contracts in their jurisdictions (essentially upon the initiative of the relevant clearinghouse), following which ESMA is required to make a mandatoryclearing determination within six months based on a number of factors; or
- A “top-down” approach, where ESMA can mandate clearing with respect to certain derivatives contracts even though no clearinghouse is offering the contract for clearing.
EMIR requires national authorities to notify ESMA of any existing clearing requirements for derivatives contracts in their jurisdictions so that ESMA can assess which products should be cleared.
ESMA will establish and maintain a public register of derivatives contracts subject to mandatory clearing on its website indicating the date when the clearing obligation will become effective for such contracts and any phase-in by categories of counterparties.
Mandatory Clearing for Historical Swaps?
Trades entered into before EMIR’s entry into force (August 16, 2012) are not subject to the mandatory clearing requirement and counterparties can keep them purely OTC. Trades entered into after a national regulator has notified ESMA of any authorized existing clearing services but before a mandatory clearing determination becomes effective with respect to such trades, may need to be cleared under the so-called “frontloading” principle. This will likely pose a number of pricing and collateral issues for counterparties and ESMA may need to adjust its approach in that respect.
Counterparties Subject to Mandatory Clearing
The clearing obligation applies to transactions between two entities that are either financial counterparties or non- financial counterparties exceeding the clearing threshold (see box on page 5) (an “NFC+”).
Transactions between a financial counterparty, an NFC+ or a non-EU jurisdiction entity (a “Third-Country Entity”) that would be subject to the clearing obligation if it were established in the EU will be subject to the clearing obligation.
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As a result, non-European mutual funds and private funds trading with European dealers will likely be subject to the mandatory clearing requirement under EMIR because they will qualify as alternative investment funds under the AIFMD.
When does a non-financial counterparty become obligated to clear?
A non-financial counterparty becomes an NFC+ when the rolling average of its derivatives contracts positions (gross notional value), exclusive of derivatives contracts related to hedging, exceeds the applicable clearing threshold during any 30 working day period.
Once these conditions are satisfied, an NFC+ is required to notify ESMA and its local regulator that it has exceeded the clearing threshold. Similarly, when an NFC+ moves below the clearing threshold, it will no longer be required to comply with mandatory clearing once it has notified its local regulator that it does not exceed the clearing threshold.
Before clearing obligations can be implemented, ESMA must first designate contracts subject to mandatory clearing, and draft standards for approval by the European Commission, European Parliament and Council. In that respect, in July 2013 ESMA published a discussion paper in which it sought market participants’ views on proposed standards implementing the clearing obligation.
Risk Mitigation Obligation
Non-cleared Derivatives Contracts
Financial and non-financial counterparties entering into derivatives contracts not cleared by a clearinghouse or exchange-traded are required to ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational and counterparty credit risks.
Market participants are required to timely confirm (by electronic means where available) the terms of their non-cleared derivatives contracts and develop processes in order to reconcile portfolios, manage associated risk, quickly identify and resolve disputes between parties, and monitor the value of outstanding contracts. Financial counterparties are also required to hold appropriate and proportionate amounts of capital to manage the risks not covered by an exchange of margin.
With respect to risk mitigation requirements, EMIR is broader in scope than Dodd-Frank because some risk mitigation rules (for instance with respect to confirmations, reconciliation, compression and dispute resolution) apply to all market participants and requirements to carry out daily valuations and exchange collateral apply to all financial counterparties and NFC+. Under Dodd-Frank, business conduct rules and similar risk mitigation requirements are mainly imposed on dealers and major swap participants and other market participants are only indirectly impacted.
In early September, ESMA determined that Dodd-Frank rules on timely confirmation, portfolio reconciliation and portfolio compression (but not dispute resolution) were equivalent to EU technical standards. Once the European Commission approves ESMA’s submissions, market participants may choose to comply with either Dodd- Frank or EMIR risk mitigation techniques in that respect.
As of September 15th, all of EMIR’s risk mitigation techniques became effective and EU entities were required to ensure that they have procedures in place to achieve portfolio reconciliation and compression, as well as procedures for dispute resolution. To aid market participants in meeting these requirements, ISDA developed the 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol as well as the ISDA March DF Protocol Extension Agreement for market participants who have adhered to the ISDA March 2013 DF Protocol.
EMIR mandates that a transaction between two Third Country Entities that would be subject to clearing and risk mitigation techniques if the Third Country Entities were established in the EU will be subject to such requirements to the extent that the transaction has a direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent the evasion of any provision of EMIR.
EMIR tasks ESMA with clarifying these principles and in July 2013 ESMA published a consultation paper on draft regulatory technical standards seeking public input.
ESMA is proposing that clearing and risk mitigation requirements, but not the reporting obligation, apply to transactions between two Third Country Entities when rules in those counterparties’ jurisdictions have not been determined to be equivalent to EMIR and either: (a) one of the counterparties is guaranteed (above certain thresholds) by an EU financial counterparty; or (b) both counterparties execute the transaction via their EU branches.
Also, in order to implement the anti-evasion principles of EMIR, the consultation paper would treat any “artificial” transaction as being structured to avoid EMIR’s application. A transaction is artificial where it lacks commercial substance or relevant economic justification in itself and ESMA specified certain criteria that would guide their determination.
This past month, the European Commission extended the deadline for ESMA to draft related technical standards until November 15, 2013 so that ESMA could fully analyze and take into account the results of its public consultation.
EU member states are required to provide penalties relating to the infringement of regulatory requirements under EMIR, as well as take all measures necessary to ensure that EMIR is implemented in their jurisdiction. Penalties must be effective, proportionate and dissuasive, and include at least administrative fines. In certain instances, local regulators may disclose every penalty imposed on financial counterparties and, where appropriate, non-financial counterparties for certain infringements.
Infringement of EMIR’s rules, however, will not affect the validity of a derivatives contract or the parties’ ability to enforce the provisions of a derivatives contract, nor will a party to a derivatives contract be entitled to any compensation as a result of its counterparty’s infringement of EMIR.
Market participants will need to take a number of actions to adjust to the new regulatory environment. Those actions include implementing procedures to ensure compliance with reporting and recordkeeping obligations (see Part 1 of this article), checking which products ESMA determines are required to be cleared, and when the clearing mandate will begin, and implementing risk mitigation procedures, including in certain instances adhering to protocol agreements.
Market participants will need to open reporting lines with trade repositories or enter into agreements with third- party service providers, counterparties or clearinghouses to satisfy their reporting obligations. Those required to clear will need to set up clearing capabilities with one or more clearinghouses and negotiate applicable clearing documentation with clearing brokers. Also, market participants should understand how clearing will impact their funding needs, business operations, and relationships with trading counterparties, prime brokers and custodians.
Non-financial counterparties will need to monitor their use of derivatives contracts in light of the clearing threshold and make appropriate notifications to their regulators when they pass the threshold.
Market participants, especially those established in non- EU jurisdictions, should pay careful attention to final technical standards setting forth EMIR’s extraterritorial reach and determine whether some of EMIR’s requirements apply to them and if substituted compliance with another regime (such as Dodd-Frank) is sufficient to discharge their obligations under EMIR.