This note sets out the application of EMIR and EMIR Refit to Alternative Investment Funds.
EMIR & EMIR REFIT
Regulation (Eu) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories ("EMIR") entered into force in August 2012 with the aim of addressing the systemic risk posed to the financial system by over-the counter (OTC) derivative contracts. Such OTC transactions lack transparency given that they are privately negotiated, with relevant information on them generally only available to the parties involved.
EMIR therefore sought to reduce that systemic risk by imposing requirements on several elements in the OTC derivative trade ecosystem including:
- the central clearing of standardised OTC derivative contracts;
- margin requirements and operational risk mitigation requirements for OTC derivative contracts that are not centrally cleared; and
- reporting obligations for derivative contracts,
with a view to increasing the transparency of the OTC derivatives market and reducing the counterparty credit risk and the operational risk associated with OTC derivatives.
EMIR applied to AIFs to the extent that an alternative investment fund managed by AIFMs authorised or registered in accordance with Directive 2011/61/EU was defined as a financial counterparty for the purposes of EMIR.
Under the European Commission's 2016 Regulatory Fitness and Performance programme, EMIR's requirements were assessed to determine whether they may be simplified and eliminate requirements where the cost of compliance was disproportionate. The result is the new Regulation (EU) 2019/834 ("EMIR Refit") which directly amends certain existing EMIR provisions. EMIR Refit came into force on 17 June 2019.
EMIR Refit – Application to AIFs
Under EMIR Refit, the scope of the definition of financial counterparty is widened (in respect of AIFs) to include:
"an alternative investment fund (AIF), as defined in point (a) of Article 4(1) of Directive 2011/61/EU, which is either established in the Union or managed by an alternative investment fund manager (AIFM) authorised or registered in accordance with that Directive".
There is a carve out that specifically excludes AIFs that are (i) set up exclusively for the purposes of serving one or more employee share purchase plans or (ii) that are securitisation special purpose entities from the definition of financial counterparty.
AIF Obligations Under EMIR
The relevance of the definition of "financial counterparty" is that AIFs caught by the definition are subject the EMIR rules on clearing OTC derivative contracts, reporting on derivative transactions and risk-mitigation techniques for OTC derivative contracts.
Reporting Obligations: Given the increased scope of the AIF
definition under the EMIR Refit, it is now the AIF's manager
rather than the AIF itself that is subject to and liable for the
reporting obligation reporting each OTC derivative trade. AIFMs now
have 12 months to implement this change.
Clearing obligations: All AIFs caught by the increased financial counterparty scope are now subject to the EMIR clearing obligations (subject to exceeding the clearing threshold (see below)).
Risk mitigation obligations: Under the risk mitigation requirements, AIFs that now come under the financial counterparty definition must implement risk-mitigation procedures, exercising due diligence, that appropriate to measure, monitor and mitigate operational risk and counterparty credit risk. In respect of the obligation to exchange margin, EU AIFs that fall within the new financial counterparty definition are subject to the requirements to exchange variation margin and potentially initial margin.
Small FC & Clearing Threshold
As part of the cost reduction aims behind the EMIR Refit, the concept of small financial counterparty (Small FC) has been introduced. The rationale being that the volume of a Small FCs activity in OTC derivatives markets is too low to create a significant systemic risk for the financial system and central clearing creates disproportionate costs. Small FC's are therefore exempted from the central clearing obligation but remain subject to reporting and risk mitigations obligations.
A Small FC is a financial counterparty who's clearing thresholds are below EUR 1 billion in gross notional value in respect of credit derivatives and equity derivatives, and below EUR 3 in gross notional value in respect of interest rate derivatives, FX derivatives and commodity derivative contracts and others (these are reviewed on a regular basis following public consultation). Where a financial counterparty's position in any one class exceeds the clearing threshold for that particular class, the clearing obligation shall apply to all of that financial counterparty's derivative OTC transactions.
Action Points for AIFs
In light of the amended financial counterparty definition, and particularly as it applies to AIFs, fund managers should reassess the AIFs that they manage to confirm their status under this new definition. If applicable, the AIF manager shall notify ESMA that they fall into the new financial counterparty meaning, and whether they qualify as a Small FC. Any on-going representations and warranties made by an AIF in an OTC derivative context should be revisited to ensure that it remains accurate.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.