Update on the European Market Infrastructure Regulation

by Morgan Lewis
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With the imminent trade reporting obligation under EMIR, affected entities should review the new requirements as well as the status of other EMIR obligations.

On 12 February 2014, the trade reporting obligation under the European Market Infrastructure Regulation (EMIR) will take effect throughout the EU, marking the next step in the phased commencement of the various obligations under EMIR. This LawFlash will summarise the current implementation status of EMIR obligations and will provide an update on the new trade reporting obligation and the steps that both US and other non-EU entities should be taking.

EMIR—Europe’s regulation on over-the-counter (OTC) derivatives, central counterparties, and trade repositories—came into force on 16 August 2012 as part of the G20’s commitment to reduce counterparty and operational risk and enhance transparency in the OTC market.

EMIR sets out the framework for the introduction of the following:

  • Central clearing of certain derivatives transactions
  • Risk mitigation techniques for uncleared OTC trades
  • Trade reporting of OTC derivatives and exchange-traded derivatives to authorised trade repositories

Although EMIR came into force in 2012, the regulation’s set of obligations takes effect on a phased basis. As a regulation, EMIR takes direct effect throughout the EU without any requirement for specific implementation by the member states.

The requirements apply to a wide range of financial and non-financial counterparties to derivative contracts. “Derivative contracts” are defined by reference to the definition of “derivatives” under the Markets in Financial Instruments Directive (MiFID), which includes options, interest rate swaps, credit default swaps, and forward rate agreements relating to underlying instruments such as securities, currencies, interest rates, commodities, emissions allowances, and weather derivatives. However, there remains a lack of clarity with respect to each member state’s interpretation regarding which foreign exchange (FX) contracts are considered financial instruments under MiFID. (As MiFID is a directive, each member state must implement the directive in its national law as it sees fit.) Therefore, whether an FX contract constitutes a “derivative” for purposes of, and is subject to, EMIR, may vary from member state to member state as there is no consistent pan-EU understanding as to which FX contracts are considered financial instruments under MiFID.

Lobbyists have asked the European Securities and Markets Authority (ESMA) to provide guidance that clarifies which FX contracts it considers to be outside EMIR’s scope, and the lobbyists have referred to guidance from the US Department of the Treasury that exempts certain FX swaps and forwards from the mandatory derivatives requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank). We understand that the Alternative Investment Management Association (AIMA) is lobbying ESMA to issue guidance that “FX swaps and forwards should be considered outside the scope of EMIR.” This uncertainty makes it particularly difficult for non-financial counterparties (NFCs)—whether EU NFCs or non-EU deemed NFCs—to determine whether they are NFCs as referred to in article 10 of EMIR (i.e., NFCs+) by virtue of exceeding the prescribed levels of FX derivatives activity.

Who is impacted?

EMIR applies to and distinguishes between “financial counterparties” (FCs) and NFCs. An FC is an EU-based investment firm, bank, insurer, UCITS fund, or pension fund or an alternative investment fund (irrespective of location) managed by an Alternative Investment Fund Managers Directive–authorised manager. An NFC is an EU entity other than an FC. EMIR further distinguishes between NFCs+ and NFCs-. An NFC becomes an NFC+ if it takes positions in OTC derivatives that exceed any relevant clearing threshold. The thresholds are set out below.

OTC credit derivatives

€1 billion in gross notional value

OTC equity derivatives

€1 billion in gross notional value

OTC interest rate derivatives

€3 billion in gross notional value

OTC FX derivatives

€3 billion in gross notional value

Other OTC derivatives (including commodities)

€3 billion in gross notional value

EMIR also applies to a third-country counterparty (TCC) that would be subject to the clearing obligation if it were established in the EU. Such a TCC will be subject to the clearing obligation if it enters into either of the following types of trade:

  • A trade with an FC or an NFC+
  • A trade with another TCC if
    • the contract has a direct, substantial, and foreseeable effect within the EU; or
    • the obligation is necessary or appropriate to prevent the evasion of any provisions of EMIR.

Similarly, the risk mitigation techniques under EMIR apply to TCCs that would be subject to those obligations if they were established in the EU, provided the contract has such effect or the obligation is as described above.

On 15 November 2013, ESMA issued draft regulatory technical standards elaborating on these provisions, clarifying that OTC derivative contracts entered into by two counterparties established in one or more non-EU countries, for which a decision on equivalence of the jurisdiction’s regulatory regime has not been adopted by the European Commission (EC), will be subject to EMIR where one of the following conditions is met:

  • One of the two non-EU counterparties to the OTC derivative contract is guaranteed by an EU FC for a total gross notional amount of at least €8 billion and for an amount of at least 5% of the OTC derivatives exposures of the EU FC guarantor
  • The two non-EU counterparties execute their transactions via their EU branches and would qualify as FCs if established in the EU

To date, ESMA has delivered advice to the EC on the equivalence of the legal and supervisory frameworks of Australia, Canada, Hong Kong, India, Japan, Singapore, South Korea, Switzerland, and the United States. The EC is currently considering that advice and whether to issue any formal determinations of equivalence.

The draft standards also specify cases of transactions aimed at evading EMIR’s regulatory requirements, which would be the case for derivatives contracts or arrangements concluded without any business substance or economic justification and in a way to circumvent the clearing obligation and risk mitigation provisions.

In the context of a derivative between an EU and a non-EU counterparty, EMIR provides for the applicable regime in the country of the non-EU counterparty to trump EMIR, provided that the EC has determined that the regime is equivalent to EMIR.

What are the obligations under EMIR, and which ones have already taken effect?

Obligation

Applies to

Key dates

Recordkeeping of any derivative contract and any modification

FCs, NFCs+, and NFCs-

Took effect on 16 August 2012

NFC+ notification to its local regulator

NFCs+

Took effect on 15 March 2013

Risk mitigation: Timely confirmation

FCs, NFCs+, and NFCs-, irrespective of the counterparty; TCCs*

Took effect on 15 March 2013

Risk mitigation: Daily valuation

FCs and NFCs+, irrespective of the counterparty; TCCs*

Took effect on 15 March 2013

Risk mitigation: Portfolio reconciliation, portfolio compression, and dispute resolution mechanisms

FCs, NFCs+, and NFCs-, irrespective of the counterparty's location; TCCs*

Took effect on 15 September 2013

Reporting to registered trade repositories of all derivative contracts (whether OTC or exchange-traded, cleared or non-cleared) that were outstanding on 16 August 2012 or entered into on or after that date

FCs, NFCs+, and NFCs-, irrespective of the counterparty's location (reporting may be delegated to an EU or non-EU person but responsibility may not be)

Will take effect on 12 February 2014

Clearing obligation

FCs, NFCs+, and TCCs*

  • First CCP authorisations and commencement of front-loading period expected early 2014
  • First clearing obligations expected to take effect second half of 2014

Risk mitigation: Margining

FCs and NFCs+

Expected second half of 2014

Risk mitigation: Capital

FCs

Dates unknown

* Timing is uncertain for extraterritorial clearing and risk mitigation obligations.

In August 2013, ESMA proposed that reporting of OTC derivatives and exchange-traded derivatives should begin on 1 January 2014 and 1 January 2015, respectively. However, the EC has overridden ESMA and announced in early November 2013 that the reporting start date for all derivative asset classes will be 12 February 2014. ESMA recently approved the registrations of the following trade repositories (TRs) under EMIR: CME Trade Repository Ltd. (UK); DTCC Derivatives Repository Ltd. (UK); ICE Trade Vault Europe Ltd. (UK); Krakow Deposit Papierów Wartosciowych S.A. (Poland); Regis-TR S.A. (Luxembourg); and UnaVista Ltd (UK). The registration of these TRs means that they can be used by counterparties to fulfil their trade reporting obligations under EMIR. The proliferation of rival services has led to concerns among regulators that data may be fragmented between repositories and jurisdictions.

Reporting obligations under EMIR apply to both counterparties to a derivative contract but generally do not apply to the non-EU counterparty in the case of a transaction between an EU and a non-EU counterparty. In the case of counterparties that are alternative investment funds (AIFs), EU-based AIFs will be subject to the reporting obligation from the outset, irrespective of the location of their managers in or outside the EU. Non-EU AIFs, on the other hand, will only become subject to the obligation when their managers becomes authorised under the Alternative Investment Fund Managers Directive. For new transactions, the report must be made no later than the working day following execution, modification, or termination of the contract. Contracts that were in effect on or after 16 August 2013 must be reported retrospectively in accordance with significantly longer timeframes. However, the non-EU counterparty may be subject to other reporting requirements in its own jurisdiction. Furthermore, the EU counterparty to such a transaction may delegate the EMIR reporting requirement to the non-EU counterparty. EMIR does not provide relief from reporting for transactions between affiliated entities, as is available in the United States under Dodd-Frank.

EU counterparties (with help from their asset managers, where applicable) have not had long to put arrangements in place to enable them to report details of concluded, modified, or terminated derivative contracts to an EU registered TR. They will also need to obtain a prelegal entity identifier code from a prelocal operating unit (e.g., the London Stock Exchange) and have arrangements in place to generate a unique trade identifier code for each derivative transaction.

NFCs face particular challenges in complying with EMIR. They likely will find it challenging to meet their obligations on portfolio reconciliation, dispute resolution, and portfolio compression when trading with non-EU firms that may not be aware of EMIR. It is understood, however, that NFCs have made a good start in planning for trade reporting, identifying EMIR TRs, and/or exploring the option of delegating reporting to their counterparty or a service provider. However, NFCs may need to develop their own reporting systems in order to report internal intragroup back-to-back derivative transactions.

The UK Financial Conduct Authority (FCA) recently reviewed challenges for market compliance by FCs with the timely confirmation and risk mitigation requirements. Their findings included the following:

  • FCs using electronic platforms for all eligible trades found that electronic confirmation helped them to comply with the timely confirmation time frames.
  • A certain proportion of OTC derivatives would remain confirmed on paper due to their bespoke nature.
  • Products for which no standardised industry documentation is available pose a challenge to timely confirmation.
  • FCs are reviewing their operational processes to ensure compliance with the timely confirmation and bilateral risk mitigation requirements.
  • FCs are working on including intragroup trades in their timely confirmation and risk mitigation processes, as required by EMIR.

FCA also reviewed how NFCs are defining their hedging activity and monitoring their status against the clearing threshold, finding that NFCs are accurately classifying hedging and nonhedging transactions (the former do not count towards the threshold). However, some NFCs are unaware that all OTC transactions entered into by group non-financial entities (whether EU or non-EU) must be included in the threshold calculation.[1]


[1]. An article on EMIR was also published in the December 2013 issue of FX-MM, titled ‘Ready or not, EMIR I come . . .’ The article can be accessed via the Morgan Lewis website here.

 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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