What is the aim of this regulatory activity?
EMIR is an acronym that stands for European Market Infrastructure Regulation. EMIR legislation is based on an agreement of the G20 leaders made in Pittsburgh in September 2009. As a result of this agreement all standardised OTC derivates contracts must be cleared via central counterparties until the end of 2012. It is the objective of the draft legislation to minimise the systemic risks in connection with OTC derivatives trading. In other words, it should be avoided that the default of huge market participants (such as the insolvency of Lehman Brothers in September 2008) causes a domino effect on capital markets. The legislation is to be implemented by a regulation on OTC derivates transactions, central counterparties and trade depositories (the EU Derivatives Regulation). Currently, miscellaneous draft proposals have been presented by the European Commission, the European Parliament and the Council of the European Union. As these European institutions have not yet come to an agreement in relation to the exact obligations to be complied with by the market participants, only the core principles of the European Derivatives Regulation will be outlined in this briefing. The US equivalent to EMIR is Title VII of the Dodd-Frank-Act which has not entered into force yet.
Unlike other laws enacted as a reaction to the financial crisis, EMIR addresses not only the banking and financial services sector but also companies in the real economy.
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Future obligations of companies in the real economy
The EU Derivatives Regulation imposes several regulatory obligations in relation to OTC derivatives contracts. OTC derivatives contracts are bilateral contracts such as options, swaps and forwards which are traded “over the counter”, i.e. not on a regulated market. Underlyings of OTC derivatives contracts can be, inter alia, credit risks, commodities, currencies and interest rates. These contracts are frequently documented by using standardised master agreements, mostly aiming to hedge risks.
Reporting obligation
The EU Derivatives Regulation requires companies in the real economy as well as credit institutions and financial services institutions to report the entering into OTC derivatives contracts to a trade repository. Such report has to include at least the counterparty and the underlying of the derivatives contract as well as the face value of the contract. The reporting obligation will apply irrespective of the exceeding of any thresholds.
Clearing obligation
More importantly, the OTC Derivatives Regulation provides for the introduction of a clearing obligation in relation to standardised OTC derivatives contracts. Such derivatives contracts will in principle have to be cleared via central counterparties. The central counterparty is an entity which is subject to strict regulations and will be interposed between the counterparties of a derivatives contract. Hence, the central counterparty will act as a purchaser to any seller and as a seller to any purchaser. One of the most important tasks of the central counterparties will be to assess the margin which has to be posted by either party to hedge the risk which is inherent in any derivatives contract.
The EU Derivatives Regulation, however, provides a number of exceptions in relation to the clearing obligation. Derivatives contracts within an affiliated group are in principle not subject to a clearing obligation. Corporates outside the financial sector (i.e. companies in the real economy) will be exempt from the clearing obligation if the volume of the OTC derivatives trades does not exceed a certain threshold over a predefined period of time. The relevant threshold remains to be determined by the newly established European Securities and Markets Authority (ESMA). One additional exemption for companies in the real economy is that OTC derivatives contracts that are objectively measurable as reducing risks directly related to the commercial or treasury financing activity should not be taken into account when determining the volume of OTC derivatives trades. This exemption will, for instance, apply to interest hedges or hedging activities of aviation companies against the volatility of kerosene prices.
Risk Management
Both, financial institutions and companies in the real economy that enter into OTC derivatives contracts not cleared by a central counterparty will have to apply risk mitigation techniques. Risk mitigation techniques within the meaning of EMIR are, inter alia, the measuring of the risk which is inherent to the contract, the timely confirmation of the terms of the contract and the posting of collateral.
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What is the status of the legislation and when will EMIR enter into force?
The most recent draft legislation is dated October 2011 and has been presented by the Council of the European Union. The legislation process is currently undergoing discussions between the Council, the Parliament and the Commission which will lead to the final text of the European Derivatives Regulation. Furthermore, it is intended to conduct public consultations in which the market participants will have the opportunity to submit their views in respect of particular questions in relation to the European Derivatives Regulation. The results of this public consultation will be implemented in technical standards drafted by ESMA. These technical standards will further refine the regulatory obligations of the market participants under EMIR. The technical standards will define OTC derivatives categories, which may be considered as standardised and are therefore subject to the clearing obligation. Furthermore, the technical standards will determine the threshold which is relevant for the question whether or not corporates outside the financial sector will be exempt from the clearing obligation.
EMIR is expected to enter into force by the end of 2012. Because of the ongoing controversial discussions in relation to this piece of legislation, a delay in the implementation process is not unlikely. The EU Derivatives Regulation does not require an act of implementation on the national level. It will directly be applicable in any member state of the European Union.
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Preparation in relation to EMIR and support by Norton Rose
The regulation of OTC derivatives trading by the introduction of EMIR will substantially change current market practice. This will particularly affect companies in the real economy which have not yet been exposed to banking and financial services regulation. Although EMIR will not enter into force until the end of this year, a number of our clients have already started to evaluate the risks and opportunities involved. The key challenges will be the set-up of internal processes in relation to the compliance with the reporting and clearing obligations and also the implementation of risk mitigation techniques. In particular, companies in the real economy will have to link themselves to a central counterparty and should bear in mind that only highly liquid financial instruments and cash meet the margin requirements of EMIR.
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