Reform of the Derivative Markets in the European Union

by Dechert LLP

The phased-in implementation of the European Market Infrastructure Regulation1(EMIR), the European Union’s wide-ranging reform of its derivative markets, is due to continue throughout 2014. Risk mitigation rules were implemented first, followed most recently by the reporting obligation. At some point in the next 12 months, market participants must contend with EMIR’s clearing obligation. This article sets out the central provisions of EMIR as they affect buy-side clients, and describes the various approaches in the market to ensure compliance with the rules.

Risk Mitigation Obligation

EMIR risk mitigation obligations began coming into effect in March 2013, with requirements for timely confirmation and daily marking-to-market or marking-to-model. Since 15 September 2013, all Financial Counterparties (FCs) and Non-Financial Counterparties (NFCs) have been required to apply various risk management techniques to OTC derivatives that are not cleared through a clearing house or central counterparty (CCP). These measures include: (i) portfolio reconciliation; (ii) dispute resolution; (iii) portfolio compression; (iv) timely confirmation; and (v) daily valuation. FCs include MiFID investment firms, EU credit institutions, UCITS funds and non-UCITS funds managed by managers which are authorised or registered under the AIFM Directive. NFCs are parties established in the EU that are not FCs.

Some counterparties have opted to adhere to the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol (Protocol), which creates a framework to comply with certain aspects of the risk mitigation obligations. Buy-side clients that do not want to adhere to the Protocol have instead entered into bilateral agreements with their dealers, which incorporate the Protocol’s terms by reference.

Under the Protocol, counterparties must elect to be either a “Portfolio Data Sending Entity” or “Portfolio Data Receiving Entity”. Most buy-side clients have elected to be receiving parties. A receiving party receives data from the dealer (a sending party), which it must confirm or dispute within five business days. If the receiving party fails to do so, it will be deemed to have accepted the portfolio data. Consequently, there is a benefit in being a sending party, as no such negative affirmation provision process applies. Where both parties are sending parties, they exchange data and then reconcile any discrepancies.

Non-EU counterparties are affected. Because the portfolio reconciliation and dispute resolution risk mitigation provisions require both parties to co-operate, EU counterparties often ask their non-EU counterparts to either adhere to the Protocol or incorporate the terms in a bilateral agreement as a precondition for trading with them.

The Protocol does not cover the timely confirmation and daily valuation risk mitigation obligations, and parties have had to review their internal processes to comply with the rules. Additional requirements relating to the exchange and maintenance of collateral and to capital requirements are due to be introduced in 2014-2015, although these rules will only apply to FCs.

Reporting Obligation

Since 12 February 2014, all European counterparties to both OTC and exchange-traded derivative contracts have had to report certain information to a trade repository no later than the working day following the conclusion, modification or termination of a derivative contract. In addition, certain historic transactions must be reported.

In order to comply with the reporting obligation, many buy-side counterparties have delegated to their dealer (or a third-party service provider) under an EMIR Reporting Delegation Agreement. Buy-side counterparties have chosen this route because they lack additional internal operational resources to comply or simply because delegation can be more convenient.

Buy-side clients have also struggled with the distinction between FX “forwards” (which are to be reported) and “spot” transactions (which are out of scope). To complicate matters, different Member States have adopted different definitions. For example, the FCA in the UK considers FX transactions with a settlement period up to seven days, or entered into for commercial purposes, to be a “spot” transaction. Other Member States take a narrower view and assume that FX transactions with a settlement period of more than two days should be reported. As a consequence, ESMA has asked the European Commission as a matter of urgency to clarify the definition of a derivative to ensure the uniform application of EMIR across all Member States.

The reporting of data relating to valuation and collateral will begin in August 2014, and we await further guidance as to how this is to be implemented.

Clearing Obligation

EMIR imposes an obligation to clear an OTC derivative contract when:

    • there is a CCP that has been authorised to clear the contract; and
    • the transaction is of a class subject to the clearing obligation.

In order to access the CCP, counterparties must become either a clearing member of the CCP or a client of a clearing member. Dealers typically will be clearing members, and the buy-side counterparty is likely to be a client of the clearing member. The International Swaps and Derivatives Association, Inc. (ISDA) and the Futures and Options Association have proposed a standard clearing agreement that will govern the terms on which the clearing member will stand between the CCP and the buy-side counterparty for the purposes of clearing the derivative contract. It will supplement the ISDA Master Agreement to accommodate a clearing arrangement between the buy-side counterparty and the clearing member.

Entities Subject to the Clearing Obligation

The clearing obligation applies to FCs, and to NFCs that have crossed the “clearing threshold” (NFC+). An NFC+ is subject to the clearing obligation where the 30-day rolling average of its positions exceeds the relevant clearing thresholds set by ESMA.2 In addition, once the relevant regulatory technical standards (RTS) are approved, the clearing obligation could potentially apply to third country entities outside the EU whose contracts have a “direct, substantial and foreseeable effect within the Union” or where imposing the obligation is necessary to “prevent the evasion of any provision of EMIR”.

What OTC Derivatives Need to be Cleared?

ESMA will take into account the level of contractual and operational standardisation of contracts, the volume and liquidity of the relevant class of OTC derivative contract, as well as the availability of fair, reliable and generally accepted pricing information in the relevant class of OTC derivative contract. Once these have been identified, ESMA will establish, maintain and keep up to date a Public Register showing the derivative types that need to be cleared. As previously noted, OTC derivative contracts that are not cleared must instead comply with the risk mitigation obligations

What is the Start Date for Clearing?

The clearing obligation will commence in stages, once the relevant contracts have been identified as derivatives subject to the clearing obligation and a CCP has been authorised to clear each contract type. The first CCP has now been authorised. Provided ESMA submits the draft RTS in the next month, which the European Commission, European Parliament and Council swiftly endorse, it is possible that the clearing obligation will begin sometime in the autumn to early winter of 2014. It is anticipated that ESMA will shortly provide further guidance with a more definitive timeframe.

*The authors would like to thank Nicolas Kokkinos for his contributions to this article.


1. The European Market Infrastructure Regulation (EU) 648/2012 of the European Parliament and Council on over-the-counter derivatives, central counterparties and trade repositories was adopted on 4 July 2012.

2. ESMA’s clearing thresholds (in gross notional value) are: €1 billion for contracts involving credit or equity derivatives; and €3 billion for contracts involving interest rate, foreign exchange, commodity or other derivatives.


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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