What is this?
The European Market Infrastructure Regulation (EMIR) is the new European regulation on over-the-counter (OTC) derivatives, central counterparties and trade repositories. It will implement the Group of Twenty (G20) commitment to have all standardised OTC derivatives cleared through a central counterparty in the European Union (EU) by the end of 2012 and is part of the worldwide effort to reduce counterparty and operational risk in the OTC derivatives market, which was identified as a contributing factor to the financial crisis.
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Who does it apply to?
It is relevant to, and this briefing is designed for, anyone who trades derivatives, whether on an exchange or otherwise, whether regulated or not and whether within the EU or outside. EMIR is also relevant to central counterparties and trade repositories or those who wish to become such entities. However this note is designed primarily for those that trade derivatives including potential clearing members and their clients.
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Where have we got to?
EMIR is in the final stages of the European legislative process. The European Commission (Commission), the European Parliament and the Council of the EU are discussing the few issues on which they have not yet been able to reach agreement but the industry hopes they will be able to do so within the next few weeks because, if the intention is for the regulation to take effect in line with the G20 commitment, time is tight.
Being a regulation, EMIR does not need to be implemented in the member states. However, several important details have been delegated to the Commission to determine so there is a significant amount of work to be completed once the regulation has been adopted. The European Securities and Markets Authority (ESMA) is required to submit draft regulatory standards to the Commission by the end of June for this purpose.
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What will it mean?
EMIR will impose three new requirements on those who trade derivatives:
- To clear OTC derivatives that have been declared subject to the clearing obligation through a central counterparty (CCP)
- To put in place certain risk management procedures for OTC derivatives transactions that are not cleared
- To report derivatives to a trade repository
There are also some important provisions relating to client clearing that will be of interest to both clearing members and clients.
In real terms, it could mean:
- Becoming a member of a clearing house or a client of a clearing member
- Having to provide sufficiently liquid margin for previously uncollateralised obligations
- Extra legal resource to put in place arrangements with clearers and custodians
- Adapting systems to incorporate risk management and reporting mechanisms
Who does it apply to?
All three obligations apply to financial counterparties. The clearing and risk management obligations apply to certain non-financial counterparties (which we refer to as “in-scope non-financial counterparties”) but the reporting obligation applies to all of them.
- A financial counterparty is any investment firm, credit institution, insurance or reinsurance undertaking, UCITS or UCITS manager, institution for occupational retirement provision or alternative investment fund managed by an alternative investment fund manager.
- A non-financial undertaking is any other undertaking established in the EU.
- An in-scope non-financial counterparty in relation to a particular class of derivative, is a non-financial counterparty whose position has exceeded the threshold set for that class of derivatives by the Commission. In calculating its positions, the non-financial counterparty must include all OTC derivatives entered into by itself and any other non-financial entities within its group which are not directly related to the commercial or treasury financing activity of the counterparty or of the group. The thresholds and tests for determining whether derivatives are so objectively measurable will be determined by the Commission and it seems unlikely that they will have been determined before late 2012 given that ESMA is only required to develop drafts by 30 June this year. Once set, the thresholds will be reviewed periodically.
What does derivatives mean in this context?
Derivatives has the same meaning as in the Markets in Financial Instruments Directive (MiFID) for these purposes and therefore includes:
- Financial derivatives settled physically or in cash
- Commodity derivatives that must or may be cash settled
- Physically settled commodity derivatives that are traded on a regulated market or a multilateral trading facility
- Physically settled commodity derivatives that have characteristics of other derivative financial instruments
OTC derivatives are those that are not executed on a regulated market or an equivalent market outside the EU. A regulated market is a European market which is regulated as such under MiFID.
However, the clearing obligation does not apply to all OTC derivatives as explained further below. In addition, it has been recognised that the predominant risk for some classes of derivatives such as foreign exchange is settlement risk and that CCP clearing may not be the optimal way of mitigating such risk.
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What is the clearing obligation?
Counterparties will be required to clear all OTC derivatives of a class which has been declared subject to the clearing obligation that are concluded between:
- Two financial counterparties
- A financial counterparty and an in-scope non-financial counterparty
- Two in-scope non-financial counterparties
- A financial counterparty or an in-scope non-financial counterparty and a third country entity that would be subject to the clearing obligation if it were established in the EU.
It may also apply to a derivative concluded between two third country entities that would be subject to the clearing obligation if they were established in the EU, provided that the contract has a direct, substantial and foreseeable effect within the EU or where such obligation is necessary or appropriate to prevent the evasion of EMIR. Power has been delegated to the Commission to specify which contracts would be considered to have such effect or be necessary or appropriate for such purposes.
Which derivatives must be cleared?
The Commission will decide which classes of OTC derivatives must be cleared and ESMA will keep a register which will show, in relation to each class, which CCPs are permitted to clear the derivatives and the date from which the derivatives must be cleared. There are two ways in which a derivative may be added to the list:
Bottom up: This is where a competent authority authorises, or ESMA recognises, a CCP to clear a class of OTC derivatives. In this case, the competent authority will notify ESMA, which will, having conducted a public consultation and consulted the European Systemic Risk Board and any appropriate third country competent authorities, determine whether that class of derivatives should be subject to the clearing obligation, the date from which the obligation should take effect and the categories of counterparty to which the obligation applies, and the minimum remaining maturity of any OTC contracts that are required to be cleared even though they were entered into before the clearing obligation took effect. ESMA must take into consideration various criteria including the degree of standardisation, volume and liquidity of the relevant class of derivatives and the availability of fair, reliable and generally accepted price information. ESMA may also take into consideration the inter-connectedness between counterparties using the relevant class of derivatives and the anticipated impact of counterparty credit risk and the impact on competition within the EU.
Top down: This is where ESMA identifies on its own initiative, having undertaken the same consultations and taken into consideration the same criteria, classes of derivatives that should be subject to the clearing obligation and notifies the Commission. The Commission may ask ESMA to publish a call for the development of proposals for the clearing of any such class of derivatives.
Are there any exemptions?
Certain intra-group transactions do not have to be cleared. Intra-group transaction has a different meaning for financial and non-financial counterparties but the basic requirements are that they are entered into with another counterparty which is part of the same group where the counterparties are included in the same consolidation on a full basis, are subject to appropriate centralised risk procedures and are established in the EU or third country which the Commission has found to impose equivalent obligations. In relation to a financial counterparty, the counterparty must also be a financial counterparty or one of certain other types of entities. It is likely that the exemptions will be subject to authorisation of their application by the relevant competent authorities.
There is also a transitional provision which means that the clearing obligation will not apply to OTC derivatives that are objectively measurable as reducing risks directly related to the financial solvency of certain defined pension scheme arrangements for three years after the entry into force of EMIR. This will be the subject of a review but may be extended twice for a total period of a further three years if the Commission considers that technical solutions for the transfer of non-cash collateral as variation margin have not been made and the adverse effect of CCP clearing derivatives on the retirement benefits of future pensioners remains unchanged.
The clearing obligation applies to derivatives that are entered into or novated on or after the date from which the clearing obligation takes effect or an earlier date to be determined by the Commission. This means that clearing members and clients will have to submit not only new OTC derivatives but also those that exist at the time the clearing obligation takes effect.
A non-financial counterparty will be permitted a grace period from when it comes within scope to clear all relevant future contracts.
Where can OTC derivatives be cleared?
OTC derivatives must be cleared through a central counterparty that has been authorised or recognised to clear the relevant class of derivatives pursuant to EMIR as listed in the register to be maintained by ESMA. EMIR sets out the process by which CCPs established in the EU will be authorised and those established in a third country will be recognised.
Beneficial treatment of exposures to a CCP for credit risk capitalisation purposes will continue but on a more limited basis. Under changes proposed by the Basel Committee on Banking Supervision (BCBS), margin posted to a CCP which complies with the Committee on Payment and Settlement Systems - International Organisation of Securities Commissions International Principles for Financial Market Infrastructures (a qualifying CCP) in such a way that it is bankruptcy remote from the CCP will receive a risk weighting of 0 per cent, whereas collateral posted to such a CCP will otherwise be risk weighted at 2 per cent. If the CCP does not qualify under the Principles, the clearing member will have to capitalise its margin as under the bilateral framework, which would mean a risk weighing of at least 20 per cent for a CCP which is a bank and 100 per cent for a CCP which is a corporate financial institution.
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What is the risk management obligation?
Both financial and non-financial counterparties that enter into an OTC derivative that is not cleared by a CCP must have appropriate procedures and arrangements to measure, monitor and mitigate the operational and credit risk arising from such contracts. Such procedures and arrangements depend on the nature of the counterparties and the detail behind several of them is not yet known as it has been delegated to the Commission to determine.
- All financial and non-financial counterparties must include at least the timely confirmation of OTC derivatives, by electronic means where possible, and processes to reconcile portfolios, manage associated risk, identify disputes early and try to resolve them and to monitor the value of outstanding contracts.
- Financial and in-scope non-financial counterparties are also required to mark to market the value of outstanding contracts on a daily basis or, where market conditions prevent marking to market, mark them to model.
- In addition, financial counterparties and in-scope financial counterparties are required to exchange collateral in an amount to be specified by the Commission on a timely, accurate and appropriate basis. If the other counterparty so requests, any collateral received must be recorded separately in their accounts. Where the risk management procedures of the counterparties are adequately sound, robust and consistent with the level of complexity of the derivative and there is no current or foreseen practical or legal impediment to the prompt transfer of own funds or repayment of liabilities between the counterparties, intra-group transactions are exempt from this obligation. However, this exemption is subject to approval by the relevant competent authorities.
- Finally, financial counterparties must hold a proportionate amount of capital (again, to be specified by the Commission) to manage the risks not covered by appropriate exchange of collateral.
As with the clearing obligation, these obligations will apply to derivatives concluded between third country entities that would be subject to the clearing obligation if they were established in the EU, provided that the contract has a direct, substantial and foreseeable effect within the EU or where such obligation is necessary or appropriate to prevent the evasion of EMIR.
The transitional provision for OTC derivatives used in pension scheme arrangements does not apply to the risk management obligation and the risk management models used for collateralisation of such derivatives must be as robust as those used for central clearing.
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What is the reporting obligation?
The details of any derivative contract concluded, modified or terminated must be reported to a trade repository no later than the working day following such conclusion, modification or termination. This obligation applies to both financial and non-financial counterparties and to all derivatives, regardless of whether they are concluded OTC or are subject to the clearing obligation. The reporting obligation may be delegated but counterparties must ensure that derivatives are reported without duplication. ESMA will keep a list of trade repositories which may be used for this purpose. If a trade repository is not available, the details must be reported to ESMA. The obligation applies to both derivatives which were entered into on or after the date of entry into force of EMIR and those which were entered into before but which are still outstanding on such date.
The form and content of the reports has not yet been determined though they will include at least the parties to, and main characteristics of, the contract. ESMA has been tasked with producing a draft for the Commission by the end of June this year.
It is proposed that compliance with this obligation should also satisfy the obligation on investment firms to report their transactions under MiFID as it will be amended pursuant to the MiFID review.
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Those subject to the clearing obligation will either need to become a clearing member of the CCPs which clear the relevant derivatives or a client of such a clearing member. To date, the CCP clearing model has not been required to provide much protection to clients, with CCPs not being required to recognise all client positions and clients having to take credit risk on clearing members where any amount returned by the CCP has been lost in the clearing member’s insolvency estate. EMIR includes some provisions which are intended to improve this.
A CCP will be required to offer both:
Omnibus client segregation: where the CCP keeps separate records and accounts enabling the clearing member to distinguish the assets and positions of the clearing member from the assets and positions held for the account of its clients.
Individual client segregation: where the CCP keeps separate records and accounts enabling the clearing member to distinguish the assets and positions held for the account of each client from those held for the account of each other client.
CCPs must also offer further levels of segregation on request so clients may be able to require CCPs to hold more than one account in their name. These obligations then filter down to the clearing member, which must inform its clients of the cost and level of protection conferred by each option, which must be offered on reasonable commercial terms. Where a client chooses individual segregation, the clearing member is required to post to the CCP any margin in excess of that required by the CCP. This, combined with the fact that the new porting obligation described below may necessitate gross margining by the CCP, could make client clearing a less profitable activity for clearing members that are used to taking a cut on client margin that the CCP has called net across all clients.
CCPs are still permitted to take margin on either a title transfer or security interest basis but they must make clear any right of use relating to both the margin and default fund contributions. Clients should also be clear what segregation means. CCPs will satisfy their obligations if they record assets and positions on separate accounts in their records and accounts, do not net positions recorded on different accounts and the assets covering positions recorded in one account are not exposed to losses relating to positions recorded on another account.
CCPs must commit to transferring client positions and assets on the default of a clearing member to another clearing member designated by the client, on the client’s request and without the consent of the defaulting clearing member. This is the case in relation to both omnibus and individually segregated accounts, though in the former case, the clearing member is designated by all the clients. The new clearing member is only required to accept the positions and assets if it has previously committed to do so though it seems unlikely that any clearing members will bind themselves to accept unknown liabilities potentially years in advance, at least not without carve outs. If the transfer has not taken place within a period pre-defined by the CCP, the CCP may take steps to manage its risk relating to those positions in the normal way as permitted by its rules, including liquidating the positions and assets.
The position should be improved even if porting does not take place because collateral distinguished as relating to segregated clients may only be used to cover the positions held for their account and any balance owed by the CCP after completion of its default management procedures must be returned to these clients where they are known by the CCP or, if they are not, to the clearing member for their account.
Clients will also be able to benefit from the preferential capital requirements applicable to margin posted in respect of derivatives cleared through a qualifying CCP if certain segregation and continuity requirements are met. These are that:
- whichever of the CCP and/or the clearing member has control of the assets and collateral posted by the client, identifies and segregates the client's positions and assets from those of the CCP and the clearing member so that they are bankruptcy remote from the clearing member; and
- the relevant laws, regulations, rules and contractual arrangements ensure that the client’s contracts with the defaulting clearing member will be adopted by another clearing member. Where the client is not protected from loss in the event of a joint default of both the clearing member and other clients but meets all other requirements for segregation and continuity, the BCBS has suggested a risk weight of 4 per cent. Otherwise, the client must capitalise its exposure to the clearing member as a normal bilateral trade.
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International overlap / conflict
The cross border nature of derivatives trading and the extra-territorial application of some of the provisions of EMIR and that of the other legislative initiatives which are implementing the G20 commitment around the world make it particularly important to be clear about what happens in the event of a counterparty being subject to a similar or conflicting obligation under more than on piece of legislation. EMIR requires the Commission to prepare reports on the international application of the three obligations specifically with regard to potential duplicative or conflicting requirements and make recommendations, which may include the negotiation of international agreements with the relevant third countries. Before such agreements are in place, the Commission may adopt, in relation to any third country, an implementing act declaring its arrangements to be equivalent to the EMIR obligations, which will imply that the EMIR obligations are satisfied in relation to a transaction if at least one of the counterparties is established in the third country.
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Other G20 commitment mandatory trading
The G20 commitment also required standardised OTC derivatives to be traded on an exchange or other electronic platform. This obligation will be included in the new Markets in Financial Instruments Regulation. It is not the subject of this briefing but it is worth noting that the scope of counterparties and transactions to which it is proposed to apply is the same as under EMIR, and the process for determining which derivatives are subject to the obligation piggy backs off the process for determining whether a class of derivatives should be declared subject to the clearing obligation.
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