Swaps end-users that trade with counterparties who are established in the European Union (EU) (or who have affiliates established in the EU) and that trade derivatives should be aware that they may be subject to the European Market Infrastructure Regulation (EMIR). Similar to Dodd-Frank (DF) in the U.S., EMIR imposes reporting, clearing and risk mitigation obligations on end-users of derivatives; however, an end-user’s EMIR obligations may be different from and potentially more burdensome than its DF obligations. McGuireWoods LLP is providing a series of updates for swaps end-users regarding their potential obligations under EMIR. This update describes how end-users of swaps are classified under EMIR and how that classification affects an end-user’s obligations under EMIR.
On July 4, 2012, the European Parliament and Council adopted EMIR to provide a framework for addressing the risks related to certain derivative contracts. EMIR requires, among other things, that:
- All derivative contracts be reported to a trade repository (TR),
- OTC derivative contracts be cleared through a central clearing counterparty (CCP), unless an exception or exemption applies, and
- Parties to derivative contracts employ certain risk mitigation techniques (RMTs) for uncleared OTC derivative contracts.
EMIR applies to a broad range of financial instruments and may impose obligations on end-users of those financial instruments that are not required by the DF swaps regime in the U.S.
EMIR applies to derivative contracts and OTC derivative contracts traded by financial counterparties (FCs) and nonfinancial counterparties (NFCs). EMIR defines “OTC derivative” or “OTC derivative contract” to mean a derivative contract that is not executed on a regulated market. OTC derivative contracts include many OTC equity and credit derivatives not included in the definition of “swap” for DF purposes. OTC derivatives within scope for EMIR (but not currently for DF) include single-name and narrow-based basket share options, forwards and swaps as well as single-name and narrow-based basket credit default swaps. Similar to those under DF, spot transactions are not OTC derivatives or OTC derivative contracts under EMIR.
Under EMIR an entity is either a financial counterparty or a nonfinancial counterparty. FCs are entities established in the EU that are financial in nature, such as credit institutions, investment firms, insurance/reinsurance companies, pension funds and hedge funds. NFCs are entities established in the EU that do not meet the definition of an FC. A counterparty’s obligations under EMIR will depend on whether it is classified as an FC or an NFC, as well as on the gross notional amount and purpose of an NFC’s OTC derivative contracts. An NFC with a gross notional amount of OTC derivatives contracts above a clearing threshold is an NFC+. An NFC with a gross notional amount of OTC derivatives contracts below each of the applicable clearing thresholds is an NFC-. An NFC+ is subject to EMIR clearing obligations and additional RMTs. An NFC- is not subject to EMIR clearing obligations and additional RMTs. Given the importance of knowing a counterparty’s clearing status for compliance with EMIR obligations, dealers often require counterparties to make representations and agreements regarding their classification under EMIR.
The ISDA 2013 EMIR NFC Representation Protocol (the “EMIR NFC Protocol”) facilitates compliance with EMIR’s clearing obligations and additional RMTs by enabling counterparties to amend their ISDA Master Agreements to represent their status under EMIR. The first part of the EMIR NFC Protocol allows a counterparty to represent that it is an NFC or an entity established outside the EU that would constitute an NFC if it were established within the EU. The second part of the EMIR NFC Protocol allows a counterparty to represent that it is an NFC- below the clearing threshold (not an NFC+) and therefore is subject to less burdensome EMIR obligations and RMTs.
In the next Swaps End-User Update, we will discuss an end-user’s reporting obligations under EMIR.
A link to the European Securities and Markets Authority website for EMIR, which includes a quick guide to EMIR for NFCs, is available here.