EMIR Margin Rules adopted by European Commission

On 4 October, the European Commission (finally) adopted the delegated act under EMIR which sets out regulatory technical standards (the "RTS") including the rules for exchange of initial and variation margin for non-cleared OTC derivatives (the "Margin Rules").

In July, the Commission had suggested revisions to the original draft RTS submitted by the European Supervisory Authorities ("ESAs") in March 2016.
In September 2016 the ESAs submitted, in the form of a formal opinion (the "ESAs' Opinion"), an amended draft rejecting several of the Commission's proposed amendments to the March draft.

In its adopted version, the Commission has accepted most of the changes made in the ESAs' Opinion, but there are still some differences in substance. Strictly, this means that Parliament and the Council have the full scrutiny period available to consider the RTS – i.e. three months, plus a possible extension by a further three months. This could result in a delay to the expected implementation dates for the first requirements to exchange initial and variation margin. However our understanding is that the full scrutiny periods available will not be used and that the timing will remain broadly as expected in our September briefing (see "Next Steps" below).

Changes made by the Commission which are worthy of note include the following:

Grandfathering of existing contracts

Previous drafts of the RTS have failed to include a substantive grandfathering clause, and the market has had to rely instead on a reference in the non-operative Recitals to the RTS, stating that the requirements would only apply to transactions entered into after the relevant phase-in dates.

The adopted RTS now contain, in Article 35, a substantive clause allowing counterparties to continue to apply their existing risk management procedures to derivative contracts entered into between 16 August 2012 and the relevant application date of the Margin Rules to them under the adopted RTS. This fills the gap between contracts entered into before the entry into force of EMIR, which are grandfathered by Article 11(3) of EMIR itself, and the application of the relevant rule on the relevant phase-in date.

The Commission has also deleted a provision which stated that the Margin Rules would apply for the life of all contracts which are subject to the rules at their inception. 

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

The ESAs had recommended that the Commission clarify that CCP default management trades are not intended to be covered by the Margin Rules. 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, the ESAs took the view that these transactions should not be subject to the Margin Rules.

In the adopted version, the Commission has included a provision (Article 23) which allows counterparties not to collect margin from EEA CCPs which are authorised as credit institutions. It is not clear what treatment should be applied to such trades entered into by CCPs which are not authorised as credit institutions.

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

The ESAs' draft RTS in March 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 in July.

The provision was re-instated in the ESAs' Opinion in September, 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. However, the Commission has again deleted the substantive provision to this effect, but has kept the provision in Recital 7, perhaps relying on the fact that at various points the RTS refer to the requirement for "exchange" of collateral rather than just "collection" of collateral, but the deletion means the issue is not free from doubt.

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.

Concentration limits for pension scheme counterparties

The Commission and the ESAs appear still to be in disagreement about the application of concentration limits to counterparties that are occupational pension schemes.

The Margin Rules contain (among others) concentration limits which apply to initial margin in the form of certain government or public-sector securities, or cash, in excess of EUR 1 billion. The Commission's previous 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 then rejected that approach for pension schemes and in the September draft provided for pension funds to comply with the concentration limits for amounts of collateral over EUR 1 billion. As a concession, the ESAs' Opinion proposed that pension schemes should be required to comply with less onerous requirements for frequency of initial margin calculation than other counterparties.

The Commission has however stuck to its guns and has reverted to a provision imposing the lesser requirement that a counterparty transacting with a pension scheme must establish procedures to manage concentration risk with respect to collateral collected from pension schemes as initial margin which consists of certain categories of sovereign and public-sector debt.

The Commission has also kept the ESAs' Opinion proposal that pension schemes are required to comply with less onerous requirements for frequency of initial margin calculation than other counterparties.

However, as the counterparty will still have to calculate initial margin on the usual basis (including every time a new contract is added to the netting set and at least every ten days), the pension scheme may still be required to post initial margin on a more frequent basis.

Concentration limits for certain collateral

The 50% concentration limit applying to initial margin in the form of cash and/or government and public-sector securities from a single issuer or issuers domiciled in the same country was expressed in the ESAs' Opinion to apply only to the excess of initial margin over EUR 1 billion. There has been a drafting change here which in our view introduces some ambiguity, although we are of the view that the 50% limit still applies only to the excess initial margin over EUR 1 billion rather than the full amount.

Furthermore, the ESAs' drafts included provision that a 50% limit would apply to the risk exposure from a single third-party custodian holding initial margin in cash. This has been changed so that the effect appears to be that this does not operate as a separate concentration limit from the 50% applying to securities of a single issuer, but rather is taken into account in applying that limit. This appears to mean, for example, that if collateral is posted in the form of bonds issued by Country A and cash which is held by ABC Bank in Country A, that collateral in aggregate can only form 50% of the total initial margin over EUR 1 billion.

Delayed application to intragroup transactions

The transitional provisions relating to intragroup transactions have not been particularly clear in any draft of the RTS so far, but this situation has improved somewhat in the adopted version.

A maximum three-year grace period now applies during which initial margin does not need to be transferred under an intragroup contract where one of the group counterparties is in a third country awaiting an equivalence decision. Subject to the three-year backstop if no equivalence decision is forthcoming, the initial margin requirements will only begin to apply to such contracts (assuming they meet the conditions for being an intragroup contract) either four months after the equivalence decision is obtained - which leaves time to apply for approval to use the intragroup exemption once equivalence is obtained - or the date the initial margin requirements would apply to the counterparties according to the phase-in schedule, whichever is later .

Otherwise, contracts entered into between members of the same group will be required to comply with both the initial and variation margin rules from a date six months after entry into force of the RTS, or the date the initial and variation margin requirements would apply according to the normal phase-in schedule, whichever is later.

Timing of posting/collecting

The adopted version makes a change to the language relating to when initial and variation margin must be posted. The ESAs' Opinion draft had required that margin be collected within the same business day of calculation (subject to limited derogations). The adopted version instead requires that the posting counterparty must provide margin within the time limit. No explanation as to what is intended here is given, although this appears to give the obligation to the posting, rather than the collecting, party (although the latter will nonetheless be required to have compliant risk management procedures in place ensuring this happens). The changed language could also be seen as implying that the provision can be complied with if, for example, an irrevocable instruction to deliver book entry securities is given within the time limit, even though the settlement cycle would end after the deadline. We understand that this may mean further drafting changes to the published ISDA margin documentation.

How does this affect timing?

As the Commission has adopted the RTS in a form which differs from the draft submitted by the ESAs, the European Parliament and the Council have a scrutiny period of three months during which they can object (although they can extend this period for a further three months).

Our understanding, however, is that Parliament and the Council are unlikely to object to the enactment of the RTS and will not want unnecessarily to delay the coming into force of the Margin Rules. The expectation appears to be that the European Parliament and the Council are likely to confirm their non-objection before the full three months expires. On that basis, the Margin Rules could still come into force at or before the end of 2016 and the first collateral exchange requirements would apply one month later - i.e. in mid to late January 2017.

This timing is however subject to change and cannot be confirmed until Parliament and the Council formally indicate their positions.