The European Markets Infrastructure Regulation1 (EMIR) introduces requirements aimed at improving transparency and the reduction of risks associated with the derivatives market. EMIR also establishes organisational, conduct of business and prudential standards for central counterparties (CCPs) and trade repositories (TRs).
This Client Alert sets out a basic introduction to the key requirements under EMIR with particular emphasis on those that apply to OTC derivatives. Please click here for an EMIR project planning primer, setting out:
- a bullet point summary of the main obligations under EMIR;
- key milestones; and
- a timeline of suggested actions to help market participants prioritise tasks in preparation for compliance.
On 27 July 2012, the final text of EMIR was published in the Official Journal of the European Union. It came into force on 16 August 2012.
EMIR requires the European Securities and Markets Authority (ESMA) to draft "regulatory technical standards" (RTS) to flesh out and implement its main obligations.
The first batch of RTSs came into force on 15 March 2013 (with many requirements under them subject to phased implementation).
Two further consultations, one on RTS concerning extra-territoriality and anti-avoidance and the other on issues related to the mandatory clearing requirement are currently awaited.
Application of EMIR
Most of the requirements on market participants under EMIR apply to OTC derivatives (i.e. derivatives not executed on a regulated market or certain equivalent non-EEA markets). The reporting requirement and the requirements on central CCPs (e.g. with regard to margin and eligible collateral) also apply to exchange-traded derivatives (ETD).
It imposes three main categories of obligation on market participants:
- risk mitigation; and
- transaction reporting.
The Clearing Obligation
Who is caught?
Broadly, counterparties are required to clear OTC derivatives (other than exempt intra-group trades2) and are entered into between:
- two financial counterparties (FCs);3
- an FC and a non-financial counterparty which exceeds the clearing threshold (NFC+);4
- two NFC+s;
- an FC or NFC+, on the one hand, and, on the other, a non-EEA entity which would be an FC or NFC+ if were established in the EEA (TC+); and
- two TC+s, provided the contract is of a type that has a "direct, substantial and foreseeable effect within the Union" or where such an obligation is necessary or appropriate to prevent the evasion of EMIR.5
Whether or not a non-financial counterparty (NFC) is subject to the clearing obligation depends on whether its OTC derivatives volumes are over the relevant clearing threshold.
The clearing threshold applies per asset class6, but once an NFC is over the threshold for a particular asset class, the clearing obligation applies to all its OTC derivatives and not just those related to that particular asset class. Similarly, once one NFC in a group is over the threshold, all the NFCs in the group will be over the threshold too.
In determining whether or not the clearing threshold is exceeded, a non-financial counterparty must take account of all OTC derivatives entered into by itself or any other "non-financial entities" in its group which are not for hedging or treasuring financing purposes. The clearing thresholds are calculated by reference to "gross notional value" (i.e. meaning that trades cannot be netted to reduce the overall position).
Calculation of the gross notional value involves assessing (a) what is a derivative; (b) which derivatives are OTC; (c) how to calculate the "notional" amount for each relevant type of derivative; (d) what the relevant "non-financial entities" are in the firm's "group" and (e) what may be excluded as a hedge or treasury financing activity. Each of these questions turns on specific EU law definitions and approaches.
Which contracts will be caught?
When a CCP obtains authorisation, ESMA will assess the classes of OTC derivative cleared by that CCP for eligibility to be subject to mandatory clearing.
Although the first authorisations of CCPs7 may be this year, latest indications are that the first clearing obligation could enter into force mid-2014 at the earliest.
When it comes into force, the clearing obligation will apply to OTC derivatives entered into (a) on and from that date and (b) outstanding on that date and entered into since the date on which ESMA was notified of the CCP's authorisation (otherwise known as "frontloading")8.
The Risk Mitigation Obligation
FCs and NFCs that enter into OTC Derivative Contracts which are not cleared by a CCP need to comply with risk mitigation obligations. The precise nature of the relevant obligations depends on how a party is classified under EMIR.
General risk mitigation requirements for all counterparties
FCs, NFC+s and NFCs need to comply with a high-level risk mitigation obligation to ensure they have "appropriate procedures and arrangements in place to measure, monitor and mitigate operational risk and counterparty credit risk".
These must include at least:-
- Timely confirmation. The timely confirmation, where possible by electronic means, of all the terms of OTC derivatives. The timelines vary by product and eventually confirmation will need to be by T+1 for FCs/NFC+s and T+2 for NFCs9.
- Portfolio reconciliation. Portfolio reconciliation is the process by which the counterparties must confirm that their records of the terms of the trade are the same
- For FC and NFC+:
- each business day where the parties have more than 500 outstanding OTC derivative contracts with each other;
- once per week where the counterparties have between 51 and 499 outstanding OTC derivative contracts with each other; and
- once per quarter where the counterparties have less than 50 outstanding OTC derivative contracts with each other.
- For NFC:
- once per quarter where the counterparties have more than 100 outstanding OTC derivative contracts with each other; and
- once per year where the counterparties have 100 or less outstanding OTC derivative contracts with each other.
- Portfolio compression. Portfolio compression
involves parties netting trades to maintain the same risk profile
but reducing the number of contracts and therefore the gross
- Only FCs and NFCs with more than 500 outstanding OTC derivative contracts with a counterparty need consider whether or not to carry out portfolio compression.
- NFCs may find that carrying out portfolio compression could help reduce the number of trades to be taken into account in calculating against the clearing threshold.
- Dispute Resolution. Parties are required to have detailed procedures and processes to identify and resolve disputes not resolved within 5 business days. FCs must also report disputes with a value over EUR 15 million outstanding for at least 15 business days.
Additional requirements only for FCs and NFC+
FCs and NFC+ must comply with all the above and also with requirements to conduct daily mark to market (or "mark to model") valuations and to "exchange of appropriately segregated collateral" on uncleared OTC derivatives
Margin for Uncleared OTC Derivatives
Draft RTS on what is considered to be "appropriate" collateral are expected in late 2013 at the earliest10. At present it appears it may involve initial and variation margin requirements.
- Variation margin is collateral calculated, broadly to reflect the net exposure of an in-the-money party to the out-of-the-money party. Variation margin is routinely calculated on a daily basis and payments, reflecting the size of the net exposure, are made between them daily. As the exposure levels vary with market fluctuations, so the variation margin position will change.
- Initial margin (like the "Independent Amount" under the Credit Support Annex to the ISDA Master Agreement) is designed to provide a buffer over and above that set by the level of variation margin. In a close-out situation, the market may have moved since the previous variation margin calculation and the market may move again before all collateral may be realised. Initial margin is collateral designed to provide a sufficient buffer to address that risk.
The forthcoming RTS may provide that initial margin would need to be held on a gross rather than net basis and that, in some circumstances, it may need to be held in a segregated account and not by way of a title-transfer collateral arrangement. If so this would require a redocumentation of many existing credit support arrangements under standard market documentation.
Counterparties are required to report any derivative contract (not just OTC derivatives) that they have concluded, modified or terminated to a trade repository registered or recognised by ESMA by the close of the following day.
Each report must include "counterparty data" and "common data" in over 60 data fields in a prescribed format. "Common data" must be agreed between the counterparties.
FCs and NFCs must also provide daily reports on mark to market valuations of positions and on collateral value.
"Backloading" and Phase-in
The reporting obligation will apply to derivative contracts entered into:
- before 16 August 2012 and which were outstanding at that date (this is known as "backloading"); and
- on or after 16 August 2012.
As such, counterparties will need to ensure that the data they hold about these trades is maintained in a way which will enable them to comply with the reporting obligation when it (retrospectively) takes effect.
There will be a phase-in period for contracts entered into before the reporting obligation begins which will provide for a longer time period for these historic trades to be reported.
The reporting obligations for credit and interest rate derivative contracts are expected to come into force earlier than those for other classes of derivatives. However, this timetable is dependent on a TR being authorised and this has led to slippage. Latest estimates of reporting go-live dates are set out in Appendix 2. The reporting obligations for other derivative contracts are expected to come into force no earlier than Q1 2014.
Reliance on others
A party may rely on its counterparty – or on a third party – to report for it. But the reporting obligation applies to all counterparties and there is no obligation on FCs to report on behalf of their clients.
If a counterparty appoints a reporting entity, that counterparty remains responsible for any incorrect reporting. While EMIR and the RTS do not set out any potential sanctions dealing with this point, ESMA has previously stated that:
- it expects counterparties to select such third parties carefully to ensure they are providing accurate and timely information to TRs;
- the third parties need to guarantee protection of the data and compliance with the reporting obligation in the same way the counterparty appointing them is required to do so; and
- it may request the competent authority of a counterparty to take action in relation to the use of a third party reporting entity which is not able to ensure that counterparties duly comply with their reporting obligations under EMIR and such action could include requiring counterparties to stop using a third party which repeatedly provides incorrect or delayed data to a TR.
In addition, the counterparties and (if relevant) any appointed reporting entities need to agree a report's contents before reporting it and the counterparties must ensure that details of their derivative contracts need to be reported without "duplication". It seems likely that counterparties will need to find a mutually-agreed reporting solution which enables them to make or procure a single agreed report.
Timely Confirmation Deadlines
|Credit and Interest Rates|
|FC and NFC+||NFC|
|Up to 28 Feb 2014: T+2||Up to 31 Aug 2013: T+5|
|Up to 28 Feb 2014: T+2||1 Sept 2013 to 31 Aug 2014: T+3|
|1 Sept 2014 onwards: T+2|
|Other Derivatives (including commodities|
|FC and NFC+||NFC|
|Up to 31 Aug 2013: T+3||Up to 31 Aug 2013: T+7|
|1 Sept 2013 to 31 Aug 2014: T+2||1 Sept 2013 to 31 Aug 2014: T+4|
|1 Sept 2014 onwards: T+1||1 Sept 2014 onwards: T+2|
Reporting Obligation Go-live Dates and Backloading of Existing Trades
|Entered into on/ after 16 August 2012 - outstanding on reporting go live date||Outstanding on 16 August 2012 - outstanding on reporting go live date11||Outstanding on or entered into on/ after 16 August 2012 - expired prior to reporting go live date12|
|IR & Credit||earliest 23rd Sept 201313||earliest mid-Q4 2013||earliest 23rd Sept 2016|
|All other derivative classes||1st Jan 201414||earliest April 2014||earliest 1st Jan 2017|
|Collateral & M2M15||6 months after relevant reporting go live date (180 days)|
1. Regulation (EU) No 648/2012
2. The definition of an intra-group trade is very complex and will not catch every intra-group transaction. Procedural requirements must be met before the exemption can be relied on. A key issue is that intra-group trades with non-EU entities will not be eligible for the exemption unless those entities are subject to equivalent regulation in their home jurisdiction. (Equivalence advice is due from ESMA on the USA and Japan on 15 June 2013 and on Switzerland, Hong Kong, Canada, Australia and Korea on 15 Sept 2013). N.B. Although EMIR is intended to extend to the EEA, at the time of this alert it has not been adopted by EEA Joint Committee Decision. Once this occurs, the equivalence requirement will only apply to non-EEA entities.
3. "Financial counterparty" is defined (article 2(8), EMIR) to include a host of different types of entity, including: investment firms authorised under MiFID; Credit institutions authorised under BCD (i.e. EU deposit-taking banks); insurance/assurance/reinsurance firms authorised under their respective EU directives; UCITS and UCITS management companies; certain occupational pension schemes; and alternative investment funds (whether they are established in the EU or not) if they are managed by an alternative investment fund manager authorised or registered under AIFMD.
4.A non-financial counterparty is a person established in the EEA which is not a financial counterparty.
5.Consultation is due in Q3 2013. ESMA is due to deliver draft RTS to the Commission by 25 Sept 2013.
6. The relevant classes and threshold amounts are: (i) credit derivatives (€ 1 bn); (ii) equity derivatives (€ 1 bn); (iii) interest rates derivatives (IR) (€ 3 bn); (iv) foreign exchange derivatives (€ 3 bn); and (v) commodities derivatives and other OTC derivatives not included in the other classes (€ 3 bn). N.B. ESMA has stated in its Q&As dated 20 March 2013 that cross-currency swaps and swaptions should be classified as within the IR class.
7. Existing CCPs must submit application for authorisation by 15 September 2013. The first authorisations could be granted from Q4 2013.
8. ESMA is expected to consult on this during Q3 2013.
9. The Commission has confirmed that the timely confirmation provisions "do not introduce hard deadlines to be complied with case-by-case". An FC, NFC+ or NFC is not required to ensure the deadlines are always met. The requirement is to have adequate procedures in place.
10. Timing is dependent on the timing and outcome of the BCBS IOSCO recommendations following its two-stage consultation on Margin requirements for non-centrally cleared derivatives.
11. 90 days after relevant reporting go live date.
12. 3 years after relevant reporting go live date.
13. Latest timeline from ESMA's website notes the earliest date for IR and credit derivative reporting as 23 September 2013. However, it also mentions that the first TR authorisation unlikely to take place before August, with the reporting obligation starting 90 days later (i.e. mid-Q4 2013).
14. If TR registered by 1 Oct 2013; otherwise 90 days after TR registration.
15. Only applicable to FC and NFC+.
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.