EMIR Margin Rules – ESAs submit formal opinion rejecting Commission's draft 

Summary

The European Supervisory Authorities ("ESAs") have published a revised draft of the Margin Rules under EMIR which regulate the exchange of initial and variation margin for non-cleared OTC derivatives.

The revised draft differs in various respects from the European Commission's draft published in August. As a result, the precise scope of the rules, and the start date for implementation, remains unclear and depends on the Commission's response. If the Commission accepts the latest changes, the rules can be expected to come into force at the end of 2016 with the first collateral exchange requirements applying one month after that. If the Commission does not agree with the latest changes, then implementation may be further delayed.

Background

In August, we reported that the European Commission had written to the ESAs, stating its intention to endorse with amendments the draft Regulatory Technical Standards which set out the rules on exchange of collateral for non-cleared OTC derivatives required by Article 11 of EMIR (the "Margin Rules"), published by the ESAs on 8 March 2016 (the "ESAs' draft RTS"). The Commission's amendments included revised phase-in dates for the application of the initial and variation margin requirements and these were explained in our 3 August 2016 briefing. The ESAs had six weeks from publication of the Commission's draft in which to amend the draft RTS and re-submit it in the form of a formal opinion to the Commission. On 8 September, the final day of the six-week period, the ESAs re-submitted their draft RTS in the form of an opinion to the Commission (the "ESAs' Opinion").

The ESAs' Opinion takes issue with certain of the points raised in the Commission's draft, and also makes some less substantive (although mostly, in our view, helpful) drafting changes.

This briefing sets out below the main points which are still at issue. It is now for the European Commission to respond to the ESAs' Opinion. Whether it accept or rejects the proposed changes will affect the timetable for implementation, which we also consider below.

Relaxation of concentration limits for pension schemes

The Margin Rules contain concentration limits in Article 8(2) which apply to collateral in the form of certain government or public-sector securities, or cash, in excess of EUR 1 billion. The Commission's draft had relaxed this requirement where the collateral is collected from a pension scheme, instead including a more general requirement to manage concentration risk.

The ESAs have rejected the inclusion of this provision for pension schemes. As a result, pension funds and certain of their counterparties will need to comply with the stricter concentration limits for amounts over EUR 1 billion. Instead, the ESAs' Opinion proposes that pension schemes are required to comply with less onerous requirements for frequency of initial margin calculation than other counterparties. Provided that a pension scheme has, in the preceding three months, not collected initial margin of EUR 800 million or more from any individual counterparty, the scheme may calculate its initial margin requirement only once every three months, rather than the business day following the triggers applicable to other counterparties for initial margin calculation (e.g. the execution of a new contract within the netting set). This provision does not appear to remove the obligation of the pension scheme's counterparty to calculate initial margin more frequently, therefore, as drafted, the pension scheme may still be required to post initial margin on a more frequent basis.

Exemption for covered bond issuers

The Margin Rules contain an exemption in Article 29 from the requirement to collect margin where the counterparty is a covered bond issuer. This is subject to various conditions which, as revised by the Commission, included the condition that the swap counterparty ranks at least pari passu with the bondholders except on default of the swap counterparty, or waives the pari passu ranking.

The ESAs have rejected the additional italicised wording, on the basis that allowing the exemption in those circumstances would have the effect of permitting derivatives counterparties to rank after bondholders, which is not the purpose of the exemption. The reason that covered bond issuers are given preferential treatment is that the obligation to post variation margin by the issuer would not be permitted by the terms of the transaction as it would result in the swap counterparty having additional claims ranking senior to the bondholders which would not have been taken into account in the cashflows supporting the bonds. Similar considerations would apply to the swap counterparty's ability to withdraw initial margin posted. Swap counterparties do however retain the ability to receive back previously posted variation margin from the issuer (which may be required to be posted by the swap counterparty in order to obtain the required rating on the bonds).

Non-centrally cleared derivatives concluded by central counterparties as part of their default management procedures

The ESAs also recommend that the Commission provides clarification that CCP default management trades are not intended to be covered by the Margin Rules (Recital 4). The ESAs' draft RTS had provided this clarification, but it was removed by the Commission's draft.

As hedging of the positions of a defaulted member is governed by CCP default management procedures under the RTS made under EMIR on Central Counterparties (EU No 153/2013), the ESAs take the view that these transactions should not be subject to the Margin Rules.

Application of the RTS to transactions concluded with third-country counterparties

The ESAs' draft RTS had included a provision which stated that where a counterparty established in the EU (i.e. in scope) enters into an OTC derivative contract with a counterparty established in a third country that would be subject to the rules if it were established in the EU, initial and variation margin should be exchanged between the counterparties in compliance with the Margin Rules, rather than just collected by the in-scope counterparty. This provision was deleted from the Commission's draft.

The ESAs have requested that this provision be re-instated in Article 2, to provide necessary clarity that in-scope EU counterparties will be required to post margin to third-country counterparties if the derivative contract is within scope of the RTS. Note that if a third country has equivalent margin rules, an equivalence decision under EMIR would mean that compliance with two, possibly differing, sets of margin rules can be avoided.

Calculation of the notional amount threshold for non-netting jurisdictions

The Commission's draft had approved the inclusion of a notional amount threshold in Article 30 under which no margin was required to be posted to or collected from counterparties in non-netting jurisdictions (i.e. jurisdictions in which a legal review indicates the netting and segregation arrangements may not always be enforceable). However, the Commission changed the way that counterparties should assess whether the threshold has been reached.

The Commission's threshold would be reached where the aggregate notional amount of outstanding OTC derivative contracts of the EU Counterparty's group concluded after the entry into force of the RTS for which no margin has been collected from counterparties in a non-netting jurisdiction is 2.5% or more of the total aggregate notional of the group's outstanding OTC derivative contracts (excluding intragroup contracts).

However, the ESAs take the view that the numerator of the ratio should not be limited to contracts entered after the date the RTS come into force, but should include all contracts outstanding with counterparties in non-netting jurisdictions for which no margin has been collected. The ESAs argue that this more conservative approach is in line with the way other thresholds are applied under the rules.

Delayed application to intragroup transactions

The position taken by the ESAs with regard to the delayed application of the rules to intragroup transactions is somewhat unclear. The ESAs' draft RTS had included a provision delaying the application of both initial and variation margin requirements for intragroup contracts where an equivalence decision was needed. The margin rules were to apply on the later of 60 days after the equivalence decision was obtained, and three years after the RTS came into force (the "equivalence grace period"). The Commission, however, restricted the equivalence grace period to apply only to initial margin. The ESAs appear now to have accepted that the equivalence grace period only applies to the initial margin requirements and not to the variation margin requirements.

The Commission had also deleted a provision (Article 36(7)) which appeared to provide that intragroup contracts would be required to comply with both the initial and variation margin rules from a date six months after entry into force of the RTS. Our view was that the Commission's deletion of this provision was correct, as it removed an apparent conflict with the three-year equivalence grace period. However, the ESAs have reinstated the provision in Article 36(7), leading to renewed ambiguity in the rules as to when the margin requirements will start to apply to intragroup contracts. Our view is that the reinstated Article 36(7), which requires compliance from six months after the in-force date, should be clarified so as to apply in relation to initial margin to a limited set of intragroup contracts which do not benefit from the equivalence grace period and otherwise to apply only in respect of variation margin.

We do note, however, that where an equivalence decision is made, the counterparties will now have to exchange initial margin from a date which falls four months after the decision on equivalence, rather than the 60 days suggested by the Commission, which makes it possible, though with little room for delay, for parties to seek and obtain intragroup approvals following the decision on equivalence.

Drafting points and clarifications

As well as the areas of apparent disagreement with the Commission outlined above, the ESAs have made some further drafting changes which are mostly clarifications rather than substantive changes from previous drafts. The following are noteworthy:

• Article 2(5): The risk-management procedures requiring exchange of margin will apply throughout the life of all OTC contracts that were subject to the Margin Rules at their inception date (this provision had apparently been deleted from the Commission's draft and is reinstated).
• Article 3: The ESAs clarify that a counterparty's trading documentation may comprise a netting agreement and an exchange of collateral agreement, and that the netting agreement is part of the legal review (previously only an "exchange of collateral" agreement was required, despite frequent references to netting sets).
• Article 11: The Commission's draft had removed the requirement in the ESAs' draft RTS that initial margin should be exchanged without offsetting between the parties. This provision has been restored in the ESAs' Opinion, thereby requiring payment of initial margin on a gross basis. 
• Article 8(2): Concentration limits applying to initial margin in the form of government and public sector securities and cash (outlined in our March 2016 briefing) are to be calculated for the excess of initial margin over EUR 1 billion - in previous drafts it was not entirely clear whether the limits apply to the excess or, if over EUR 1 billion, the whole amount.
• Article 12: Previous drafts have provided that, in respect of derivative contracts not subject to initial margin requirements, where collection of variation margin is not collected within the same business day as calculation, it may be collected within two business days if an advance amount of variation margin calculated in the same manner as initial margin under the rules has been collected covering the margin period of risk. This has now been clarified so that the two-day period is available if an advance amount of collateral has been collected which is calculated in the same manner as initial margin under the rules. This appears to mean that the two-day period is available if, effectively, the initial margin requirements are applied voluntarily. However, unlike the case for initial margin, if no method is available for segregation of this advance amount, it may be offset between the parties. The draft also appears to provide in Article 12(3) that such collateral must comply with the other requirements for initial margin although the drafting is not entirely clear.
• Article 19(1): The ESAs have added a requirement in the collateral management provisions that where initial margin is held with the collateral provider, "the securities are maintained in insolvency-remote custody accounts". We assume this simply means that securities posted as initial margin must be held with a third-party custodian and be subject to a charge or other legally binding arrangement (such as, for example a declaration of trust) that ringfences the assets on insolvency in favour of the collateral taker. This would reflect the approach taken in Article 19(3), rather than imposing a requirement to remove the collateral entirely from the insolvent estate of the chargor. The reference to "securities" here implies that this provision does not apply to cash.
• Article 19(5): The ESAs have reinstated the requirement that where non-cash collateral is held with the collecting party or a third-party custodian, the posting party must be given the option to have the collateral individually segregated, i.e. segregated from collateral posted by other counterparties. The Commission had included the ability for the posting counterparty to request such individual segregation, but had not indicated that the collecting party must comply with the request. Although the draft on this point refers to "non-cash collateral" we assume that, as only initial margin is required to be segregated, the option to have individual segregation of collateral also applies only to initial margin.
• Article 28: The threshold based on amount of initial margin has been slightly changed, so that where initial margin required to be collected from a counterparty is less than EUR 50 million (at a group level) or EUR 10 million (where both parties are in the same group), the collecting party can reduce the initial margin collected by up to EUR 50 million. The previous draft only provided for a binary option here, i.e. either to collect the initial margin due in total or not to collect it at all.

How does this all affect timing?

As the ESAs have submitted a draft RTS that is not consistent with the Commission’s amendments, under the Regulations establishing the ESAs the Commission may either:

• adopt the RTS, either in the form submitted by the ESAs, or with the amendments it considers relevant; or
• reject it.

If the Commission adopts the RTS and accepts the ESAs' Opinion, so that the adopted version is the same as that submitted with the ESAs' Opinion, the European Parliament and the Council have one month from the date of notification in which to object.

The European Parliament or the Council can extend that period by one month, twice (i.e. the scrutiny period may be a total of three months, including the initial month).

If the Commission rejects the ESAs' amendments and adopts its own version of the RTS, the European Parliament and the Council have three months from the date of notification in which to object, and they may extend this period by a further three months.

Following expiry of the European Parliament and Council scrutiny period, if neither the European Parliament nor the Council has objected to the adopted version, the RTS will be published in the Official Journal of the European Union and will enter into force twenty days later.

If the Commission does not reject the amendments proposed by the ESAs, the Margin Rules could still come into force at the end of 2016, in which case the first exchange requirements would commence one month later. However, it appears more likely that the Commission may reject some of the changes made by the ESAs. In that event, the Margin Rules would be likely to come into force in the first quarter of 2017, with the first exchange of collateral commencing one month later.