The New EU Derivatives Rules Go Live: Implications for Counterparties

The EU Regulation on OTC Derivatives, Central Counterparties and Trade Repositories (also known as the European Market Infrastructure Regulation, or EMIR)¹ is now effective. Final rules went live on March 15, 2013, clarifying the clearing, reporting, and risk mitigation obligations for EU-regulated investment firms, hedge funds, and other financial counterparties (FCs), as well as for non-financial counterparties (NFCs) established in the European Union. EMIR requires over-the-counter (OTC) derivative contracts to be cleared by central counterparties (CCPs) and reported to trade repositories. The new rules apply to all EU firms, even when they are transacting with third country counterparties.

Many of the requirements will be phased in over time, and some entities and transactions are exempt from certain obligations. For example, NFCs whose positions in OTC derivative contracts (excluding those entered into for hedging purposes) exceed a specified clearing threshold do not need to comply with the clearing requirements and certain other provisions.

Some details of the regulation still need to be finalized, such as the extent to which EMIR will apply to transactions outside the European Union. However, counterparties should take action now to ensure that they understand their obligations and are prepared to comply.

The following table provides an overview of which requirements apply to which categories of counterparties.

Transaction Reporting

All counterparties — including FCs and NFCs — must report details of every derivatives contract to an authorized trade repository. This applies to both exchange-traded and OTC derivatives contracts and includes intragroup transactions. Details of the contract, including parties and commercial terms, and any modification or termination must be reported by the end of the next working day. In addition, FCs and NFCs above the clearing threshold must report the value of posted collateral (on a transaction or portfolio basis) and the mark-to-market or mark-to-model valuation of the contract.

The reporting obligation falls on both parties to every contract, although the obligation can be delegated. For example, CCPs may be willing to report transactions that are centrally cleared, and brokers and dealers may agree to report on behalf of their NFC clients. However, the party to the contract remains primarily responsible for the reporting obligation. Counterparties should therefore confirm in advance that the relevant CCP or other party is willing to perform this task.

To be eligible, the trade repository must be established in the European Union and registered with the European Securities and Markets Authority (ESMA). ESMA may also recognize third country trade repositories, but only if the European Commission has determined that they are subject to equivalent regulation and supervision. Examples of EU trade repositories include REGIS-TR, a Luxembourg-based joint venture of Iberclear and Clearstream. The London Stock Exchange Group and the U.S. Depository Trust & Clearing Corporation and IntercontinentalExchange have also applied to ESMA to operate trade repositories.

In order to avoid duplication with the transaction reporting requirements under the EU Markets in Financial Instruments Directive (MiFID),² the Commission has proposed that reports made to trade repositories in accordance with EMIR should satisfy these obligations.³ Reporting requirements under EMIR and the EU Regulation on Wholesale Energy Market Integrity and Transparency (REMIT)⁴ have also been aligned.

Implementation Schedule

As shown in the following table, the reporting start date depends upon the type of derivative contract and when a trade repository has been registered for the class of contract. In all cases, if no trade repository has been registered by July 1, 2015, contracts must be reported to ESMA from that date until a trade repository is registered.

This schedule only applies to derivative contracts outstanding at the time of the relevant reporting start date. Contracts that were outstanding on August 16, 2012 (the date that EMIR entered into force), or executed on or after that date, but which are no longer outstanding on the reporting start date must be reported within three years of the reporting start date.

Clearing

CCPs remove counterparty risk by standing between the parties to a derivative contract and guaranteeing the performance of their obligations. ESMA will determine which classes of OTC derivative contracts must be centrally cleared by a CCP under EMIR. The contracts may already be cleared by a CCP authorized by the competent authority of a Member State (the “bottom-up” approach), or ESMA may decide to require clearing for a class of OTC derivatives for which no CCP has been authorized (the “top-down” approach). A list of those classes of derivatives that must be cleared will be made available on ESMA’s website.

In making this determination, ESMA will take into consideration the standardization and liquidity of the contracts and the availability of pricing information. Once a class of OTC derivative contracts has been declared to be subject to the clearing requirement, all newly executed contracts of that class must be cleared. In addition, all contracts entered into after ESMA begins its assessment of a class under the bottom-up approach will need to be cleared once mandatory clearing takes effect with respect to that class.

CCPs must be authorized in order to clear OTC derivative contracts under EMIR. ESMA will work with home country regulators and a “college” of other competent authorities and central banks in order to determine which CCPs should be authorized. Although the Commission has not yet approved ESMA’s draft technical standard on the functioning of these colleges, this is not expected to delay the timing of the clearing obligation or the authorization of CCPs under EMIR. ⁵

ESMA should begin assessing contracts under the bottom-up approach in the next few months, with the first clearing obligations likely to commence in 2014. Contracts will be considered under the top-down approach on an ongoing basis. Pursuant to a last-minute compromise agreed between the Commission and the European Parliament in February 2013, the clearing obligations for NFCs will be phased in over a three-year period from the time that specific classes of OTC derivatives are declared to be subject to mandatory clearing.⁶

As not all market participants with clearing obligations are members of CCPs, some counterparties will need to become clients of, or establish indirect clearing arrangements with, a clearing member. Counterparties should take action now to ensure that all necessary arrangements are in place.

Clearing Threshold

Only FCs and NFCs above the clearing threshold are subject to the clearing requirements; NFCs with positions in OTC derivative contracts below the threshold are exempt. The level of the threshold varies depending on the type of contract, as set forth in the following table.

The calculation must include all OTC derivative contracts entered into by the NFC or any other NFC within the same group, including affiliates outside the European Union. Contracts entered into for hedging purposes will be excluded from the calculation if they 1) cover risks of the NFC or group arising in the normal course of its business, 2) cover indirect risks, or 3) qualify as a hedging contract under International Financial Reporting Standards.

NFCs must notify ESMA and the relevant competent authority immediately if they exceed any of the thresholds. Once the rolling average position in any category exceeds the threshold for over 30 business days, the NFC will become subject to the clearing obligation and must clear all future OTC derivative contracts (including those from other categories) within four months. The clearing obligation will cease if the rolling average position subsequently falls below the threshold for a 30-day period.

Risk Mitigation Techniques

OTC derivative contracts that are not required to be centrally cleared are subject to additional requirements, in order to mitigate the risks that would otherwise be addressed through clearing. All counterparties, including FCs and NFCs, must employ the following risk mitigation techniques:

• timely confirmation;

• portfolio reconciliation;

• portfolio compression; and

• dispute resolution.

The requirement for timely confirmation will be implemented according to the schedule described below. The other obligations will enter into force on September 15, 2013.

In addition, FCs and NFCs above the clearing threshold must mark-to-market the value of outstanding contracts on a daily basis. If this is not possible due to market conditions, then marking-to-model is permissible. Market conditions that prevent marking-to-market will be deemed to occur when 1) the market is inactive or 2) the range of reasonable fair value estimates is significant and the probabilities of the various estimates cannot reasonably be assessed.

FCs and NFCs above the clearing threshold must also have procedures in place for the segregated exchange of initial and variation margin. In the case of FCs, this applies to all contracts entered into on or after August 16, 2012, while for NFCs it only applies to contracts entered into on or after the date when the clearing threshold is exceeded. FCs are also required to hold an appropriate amount of capital.

Timely Confirmation

Derivative contracts not cleared by a CCP must be confirmed, by electronic means if possible, within one or more business days after execution, according to the following schedule. The timing varies depending on the type of contract and the nature of the counterparty.

Portfolio Reconciliation

Before entering into an OTC derivative contract, FCs and NFCs must agree with the counterparty how their portfolios will be reconciled. The reconciliation may be carried out by the counterparties or delegated to a third party, and should include key trade terms identifying each contract as well as the mark-to-market or mark-to-model valuation required by EMIR.

The timing of the reconciliation will vary depending on the type of counterparty and the number of OTC derivative contracts that the counterparties have outstanding with each other during the relevant time period, as set forth in the following table.

Portfolio Compression

FCs and NFCs with 500 or more non-centrally cleared OTC derivative contracts outstanding with any counterparty must have procedures in place at least twice a year to 1) analyze the possibility of conducting a portfolio compression exercise to reduce counterparty risk and 2) engage in such an exercise.

Notably, the requirement is to analyze whether a portfolio compression exercise is possible and not necessarily to engage in such an exercise. However, the FC or NFC must provide a “reasonable and valid explanation” to the relevant competent authority if it concludes that a portfolio compression exercise is not appropriate.

Dispute Resolution

When concluding OTC derivatives contracts with each other, FCs and NFCs must have procedures and processes in place to:

• identify, record, and monitor disputes relating to the recognition or valuation of the contract or the exchange of collateral; and

• resolve disputes in a timely manner, with a specific process for disputes that are not resolved within five days.

FCs must also report to the relevant competent authority any disputes between counterparties that 1) relate to an OTC derivative contract, its valuation, or the exchange of collateral with an amount or value exceeding €15 million and 2) remain outstanding for 15 business days or more.

Margin Requirements

Final proposals by ESMA, the European Banking Authority, and the European Insurance and Occupational Pensions Authority (together, the European Supervisory Authorities, or ESAs) for draft rules on margin requirements for uncleared OTC derivative contracts have been delayed pending the development of international standards by the Basel Committee on Banking Supervision (BCBS) and the Board of the International Organization of Securities Commissions (IOSCO). A second consultation on the topic by BCBS and IOSCO, including a near-final policy framework, closed on March 15, 2013, and a final framework should be published soon⁷ (see WSLR, March 2013, page 20).

It is likely that initial margin will be more widely required than is currently the case. In addition, two-way initial margin will need to be segregated.

Capital Requirements

Whereas in the United States, the Commodity Exchange Act, as amended by the Dodd-Frank Wall Street Reform and Consumer Protection Act, includes capital requirements for both swap dealers and major swap participants, EMIR only requires FCs to hold sufficient capital to manage the risk not covered by collateral exchanged with respect to uncleared OTC derivative contracts. NFCs are exempt from this requirement.

In a March 2012 consultation paper, ESMA and the other ESAs concluded that no additional capital requirements were required for banks and other prudentially regulated firms beyond the existing capital regimes. The ESAs also believed that it would be inappropriate to impose capital requirements on non-prudentially regulated firms such as hedge funds and undertakings for collective investments in transferable securities (UCITS) and their managers. According to the ESAs, these entities should cover their risk through the exchange of collateral.⁸

The EU Capital Requirements Regulation was proposed by the Commission in July 2011 together with a new EU Capital Requirements Directive as part of a legislative package known as “CRD IV.”⁹ The proposals are intended to implement Basel III in the European Union and to replace the existing capital requirements directives. Among other things, the regulation would require banks to hold more capital against uncleared OTC derivative contracts. However, agreement on CRD IV has proven difficult, and implementation is not likely until 2014.

Intragroup Exemptions

Intragroup transactions are exempt from the clearing requirements, provided they meet the criteria set forth in EMIR and the relevant competent authorities are notified at least 30 calendar days in advance. A transaction with another party will be deemed to be intragroup if:

• both parties are 1) included in the same consolidation on a full basis and 2) subject to appropriate centralized risk evaluation, measurement, and control procedures; and

• the counterparty is established in the European Union or the Commission has determined that it is subject to equivalent supervision.

For FCs, the other counterparty must also be subject to appropriate prudential requirements. FC transactions will also be considered intragroup if both counterparties are subject to the same institutional protection scheme or affiliated to the same central body.

Intragroup transactions will also be exempt from the margin requirements for uncleared trades, provided they meet various criteria, including:

• the risk management procedures of the counterparties are adequately sound, robust, and consistent with the level of complexity of the derivative transaction; 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.

Pension Scheme Transitional Arrangements

Trades entered into by pension scheme arrangements may be exempt from the clearing obligation until August 2015, provided that the OTC derivative contracts are objectively measurable as reducing investment risks directly relating to the financial solvency of the pension scheme arrangement. This transitional provision also applies to entities established for the purpose of providing compensation to members of pension scheme arrangements in case of a default. However, these transactions will still be subject to the risk mitigation requirements for uncleared contracts.

For certain pension scheme arrangements, this exemption will only be available if the relevant competent authority is satisfied, after consultation with ESMA, that the entity would have difficulties in meeting the variation margin requirements.

Extraterritorial Application

The clearing and risk mitigation requirements of EMIR apply to third country entities that would be subject to the obligations if they were established in the European Union, provided that the contract has a direct, substantial, and foreseeable effect in the European Union or the obligation is necessary to prevent evasion of EMIR. The regulation calls on ESMA to propose technical standards clarifying these provisions, but this has not yet happened. ESMA has been working with U.S. and other third country regulators to ensure that their regulatory frameworks are consistent and do not disrupt the global OTC derivatives market or create opportunities for regulatory arbitrage¹⁰ (see Special Report by Jonathan D. Gupta, Legal Analyst with Bloomberg Law, New York, and Christopher Bernard, Legal Analyst with Bloomberg Law, London, at WSLR, September 2012, page 38). These discussions are ongoing.

Trading Requirements

The roll-out of the new rules brings the European Union one step closer towards achieving the G-20’s goal, stated in September 2009, of requiring all standardized OTC derivative contracts to be cleared through CCPs and reported to trade repositories, although the G-20’s deadline of end-2012 has been missed.¹¹ It also brings the European Union into line with the United States, where clearing and reporting requirements are already in place.

The G-20 also declared that standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms by the end of 2012. In the European Union, the trading requirement is contained within the wider proposals to overhaul MiFID. These proposals, which were first published by the Commission in October 2011, have become mired in negotiations between the European Parliament and the Council, and are not expected to be agreed until late 2013 at the earliest.¹²

Christopher Bernard is a Legal Analyst with Bloomberg Law, London.