On 27 September 2012, the European Securities and Markets Authority (ESMA) published its draft technical standards in the European Market Infrastructure Regulation (EMIR). The technical standards supplement the level one text of EMIR that came into force on 16 August 2012.
The Technical Standards
The technical standards delineate the practical application of EMIR, and set out how market participants will be affected. The standards are divided broadly into three main categories:
Over-the-counter (OTC) derivatives, including clearing obligations, risk mitigation techniques and access to trading venues
Requirements for central counterparties
Trade repositories, and the content and format of information that is to be reported by counterparties to trade repositories.
There are also a number of provisions that are dealt with in the technical standards. These include the clearing and reporting obligations for financial and non-financial counterparties (NFCs) trading OTC derivative contracts.
Pursuant to EMIR, all financial counterparties, and NFCs in certain circumstances, will be required to clear all their OTC trades. NFCs will be required to clear trades when they cross one of the prescribed thresholds set out in the technical standards. The thresholds vary depending on the asset class that is the subject of the trade:
For credit and equity derivative contracts, the proposed threshold is €1 billion in gross notional value of the OTC derivative contract.
For interest rate, foreign exchange and commodity or other derivative contracts, the threshold is €3 billion in gross notional value.
When the clearing thresholds for an asset class are reached, the counterparty is considered to have exceeded the threshold and is subject to the requirements prescribed by EMIR for all classes of OTC derivative contracts, not only those for which the relevant threshold has been exceeded. The clearing obligation will then apply to all OTC derivative contracts concluded after the clearing threshold was exceeded.
Counterparties should note that these thresholds may be revised once further data on counterparties’ trading activities becomes available. The thresholds will be reviewed on a regular basis to ensure they continue to be suitable for the relevant derivative markets. Counterparties should therefore monitor regularly any changes to these thresholds, to ensure they know if their trading activities are brought within the scope of EMIR in the event that the thresholds are lowered in the future.
It should be noted that trades that are objectively measurable as reducing risks related directly to the commercial activity of the NFC, (i.e., trades undertaken for hedging purposes) will not count towards the prescribed threshold. An example of a trade undertaken for hedging purposes is one that reduces potential change in the value of the counterparty’s assets. In addition, when the accounting treatment of the derivative contract is that of a hedging contract pursuant to the International Financial Reporting Standards (such as an OTC derivative relating to employee benefits), it will be considered as a trade that reduces risk. Speculation and investment will not come within the hedging definition. Proxy hedging, i.e., hedging undertaken when an instrument needed to carry out a direct hedge is not available will, however, come within the definition of hedging.
All counterparties (whether financial or non-financial) will be required to report details of all their trades to a registered trade repository. It was thought previously that counterparties subject to the reporting requirements under the Markets in Financial Instruments Directive (MiFID) and/or the regulation on the wholesale energy market integrity and transparency (REMIT) would not be subject to a double reporting obligation; i.e., a transaction report submitted under one piece of legislation would satisfy any other reporting obligations that may arise under other pieces of legislation. ESMA states in the technical standards, however, that since the reporting obligations prescribed by EMIR are more extensive than those of MiFID and REMIT, it will not be possible to align reporting obligations. ESMA does, however, also note that it will continue working towards creating a single reporting mechanism across EMIR, MiFID and REMIT.
The type of information that is to be reported includes the parties to the contract, the beneficiary of the rights and obligations arising from the contract, and the main details of the contract. A counterparty’s Legal Entity Identifier (LEI) should be used, where such a code is available. In the absence of an LEI, a counterparty’s Business Identifier Code should be used.
Market participants support the development of a unique product identifier that could be adopted when specifying the details of a particular contract. Until such a code is developed, counterparties should use the International Securities Identification Number, the Alternative Instrument Identifier or the Classification of Financial Instruments Code to identify the product that is the subject of the trade.
One of the issues not covered by these technical standards is the extra-territorial application of EMIR. Guidance on this is expected to be published over the coming months, although no precise publication date has been set. Such guidance is expected to confirm exactly how the phrase “contracts with a direct substantial or foreseeable effect in the European Union” will be defined.
Only contracts that have a “direct substantial or foreseeable effect in the European Union” are due to come within the scope of EMIR. It has been suggested that trades undertaken by EU-based counterparties outside the European Union will have such an effect, as will trades undertaken in the European Union by non-EU based counterparties, but this still needs to be confirmed. The territorial reach of EMIR is expected to mirror that of MiFID, which is currently also undergoing substantial revision.
The European Commission has three months from the date of publication of the technical standards to decide whether to endorse them or to request that amendments are made. As a result, the definitive text of the technical standards will likely not be published until the end of December 2012.
Market participants should confirm now that they have the correct systems in place, to ensure that they are able to comply with the obligations set out in the technical standards. Similarly, trading activities should be reviewed to assess whether any changes will have to be made to existing practices.