EMIR Review - Commission publishes draft of proposed regulation

Proposed Regulation and highlights

The European Commission has published its proposal to amend the European Market Infrastructure Regulation – the landmark post-crisis reform in the EU which introduced mandatory clearing, margining, and trade reporting for OTC derivative transactions. The proposal reflects the Commission's intention to simplify and streamline these regulatory requirements in a number of respects, particularly for smaller derivatives market participants. The principal changes proposed by the Commission are set out in the box below.

Background to Proposed Regulation

In November 2016, the European Commission submitted its report (the "EMIR review") to the European Parliament and the Council under Article 85 of Regulation 648/2012 EU ("EMIR"). Our briefing from last November is available here.

The Commission indicated in November that it would be publishing a legislative proposal and an impact statement during 2017. It has now published that impact statement accompanied by a draft amending regulation (the "Draft Regulation").

The specific Commission proposals set out in the Draft Regulation are discussed below.

Financial Counterparties ("FCs") and Non-Financial Counterparties ("NFCs"), and application of clearing thresholds to FCs

The EMIR review noted that some small financial counterparties subject to clearing requirements undertake such limited activity in OTC derivatives that it is not commercially viable for them to establish clearing solutions. These counterparties face significant challenges principally as a result of leverage ratio requirements anticipated by clearing members under the Capital Requirements Regulation 575/2013 ("CRR"). The Commission is proposing that smaller financial counterparties should not be subject to the clearing obligation.

The Draft Regulation therefore applies the clearing thresholds, which currently only apply to NFCs, to FCs. This effectively creates two new categories of counterparty: FC+s and FC-s, in addition to NFC+s and NFC-s.

Mandatory clearing will therefore apply to transactions between the following:

• two FC+s;
• an FC+ and an NFC+;
• two NFC+s
• an FC+ or NFC+ and an entity established in a Third Country that would be an FC+ or NFC+ if it were established in the Union; and
• two Third-Country entities which would be FC+s or NFC+s if established in the Union, if the contract has a “direct, substantial and foreseeable effect within the Union”.

There was some discussion in the EMIR review that any reclassification of counterparties and change to application of the clearing thresholds would involve the removal of the hedging exemption. The Draft Regulation provides that contracts which are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of an NFC will continue not to count toward the clearing thresholds in respect of that NFC. However under the Draft Regulation the hedging exemption does not apply to the calculation of the notional amount of transactions to establish whether an FC is an FC+ or FC-. The Commission has previously stated that hedging activity is not relevant in considering the systemic importance of NFCs, as entities that hedge are generally not highly leveraged and hold underlying offsetting positions. However this approach has not been applied to FCs. 

Furthermore, an FC must also count toward the clearing threshold the notional amount of all OTC derivative contracts entered into by that FC or any entity in the group to which it belongs, regardless of FC or NFC status. In contrast, an NFC only need include contracts entered by the NFC or other NFCs within its group. The Draft Regulation does not clarify with respect to UCITS and AIFs that the clearing threshold is to be calculated at the fund level and this appears to remain a matter for the respective regulatory technical standards.

The effect of these changes on the various opt-outs available to counterparties under the regulatory technical standards made under Article 11(15) of EMIR (the "Margin Rules") is not clear. Currently, for example, counterparties can opt out of collecting collateral from NFC-s. There is no indication as to whether this would be extended to the new category of FC-. On the one hand, those entities' derivative trading volumes should not pose any greater systemic risk than NFC-s. On the other, the change has been brought in in order to overcome obstacles to clearing faced by small FCs, with no mention made of obstacles to margining in the explanatory text. Note that the European Supervisory Authorities ("ESAs") would be required to submit new regulatory technical standards on risk-mitigation techniques for non-cleared OTC derivatives (see below) which may deal with this question.

Additionally, the period for calculation of notional amounts of OTC derivatives outstanding for the purpose of exceeding the clearing thresholds has changed from the current rolling 30-day period to the aggregate month-end average for the months March, April and May of each year, and if that figure exceeds the clearing thresholds, mandatory clearing applies and contracts must be cleared within four months of the date that the clearing obligation applies. This means that the calculation period for assessing NFC+ or NFC- (or FC+ or FC-) status is aligned with that used under the Margin Rules made under Article 11(3) of EMIR.

FC category widened – securitisation vehicles, CSDs, AIFs and large commodities firms

The Draft Regulation brings the following into the definition of FC:

• central securities depositories ("CSDs")
• securitisation special purpose entities ("SSPEs")
• AIFs and UCITS (rather than their EU-authorised managers)
• investment firms falling within Directive 2014/65/EU ("MiFID II"), rather than just those within Directive 2004/39/EC ("MiFID I")

This last change is intended to catch those large non-financial commodities traders who will be reclassified as investment firms from January 2018 under the "ancillary activity test" in MiFID II.

The change of focus on AIFs and UCITS rather than their EU-authorised managers may also affect the way in which the status of non-EU funds under EMIR is analysed.

SSPEs for this purpose are defined by reference to the definition of SSPE in CRR, which requires that:

• the SSPE is organised for carrying out a securitisation or securitisations;
• its activities are limited to those appropriate to accomplishing that objective;
• it is structured with the intention of isolating the obligations of the SSPE from those of the originator institution; and
• the holders of the beneficial interests in the SSPE have the right to pledge or exchange those interests without restriction.

The reference to "securitisation" transactions here is to securitisation as defined in CRR, and not to the definition of securitisation used for the purpose of reporting to the European Central Bank under the ECB's regulation on Financial Vehicle Corporations (ECB/2013/40). The effect of this is that the vehicle will only be caught by the definition of an FC if it is involved in a securitisation transaction in which credit risk is tranched. Repackaging vehicles issuing a single tranche of debt should therefore remain NFCs on the basis of this definition.

Although SSPEs will be FCs, they will still not be subject to mandatory clearing unless they carry out large volumes of derivatives trading and qualify as an FC+. As SSPEs typically enter into swaps with banks who will be FC+s in the proposal and would already be required to clear in-scope contracts with an SSPE which is currently an NFC+, the impact of this change to the status of SSPEs may not appear to be significant. However, note that the differences in the treatment of the calculation of the clearing thresholds between FCs and NFCs will have the effect that FCs exceed the thresholds more easily. The most significant of these for SSPEs is the hedging exemption, which will apply to NFCs but will not apply to FCs. Securitisation vehicles will generally enter OTC derivative contracts in order to hedge interest rate and currency mismatches between the underlying assets and the liabilities issued. Until now, this would generally mean that these swaps would not count toward the notional amount, but this will now change. Furthermore, any SSPE which is consolidated with the originator for accounting purposes may fall within the "group" test in EMIR and be required to count toward the threshold all OTC derivatives contracts entered by any group company, whereas currently, as an NFC, it would only be required to count contracts entered by other NFCs in the group. Multi-issuance vehicles in particular may be in danger of breaching the thresholds as a result.

The European Parliament and the Council are currently considering a draft Commission proposal for a securitisation regulation under which securitisation vehicles could be given exemptions from both the clearing and margin exchange requirements under EMIR, but only if the transactions qualify as "simple, transparent and standardised" ("STS") securitisations (i.e. securitisations meeting certain structural and legal requirements and not issuing any positions which do not meet these requirements). Treatment of non-STS securitisation vehicles will remain dependent on the vehicle falling below the clearing and margin thresholds applicable from time to time.

Removal of frontloading requirement

Although not required to clear trades until the date the clearing obligation in respect of that class of derivative is effective (the “clearing effective date”), under EMIR clearing members and other high-volume users of derivatives are currently required to clear trades entered into during a prescribed period prior to the clearing effective date applicable to them. This is known as “frontloading".

The Draft Regulation removes the provision in Article 4(1)(b)(ii) of EMIR which gave effect to the frontloading requirement by including contracts with certain minimum outstanding maturities at the clearing effective date. If this change is enacted, mandatory clearing will only apply to contracts entered into or novated on or after the date the clearing obligation takes effect.

Mandatory clearing of all classes once one threshold exceeded for FCs but not NFCs

The Draft Regulation clarifies that where an FC exceeds one of the clearing thresholds for one class of OTC derivatives to which clearing applies, then it must clear all classes of derivative to which mandatory clearing applies, and not just contracts within the class for which the threshold has been exceeded. In contrast, it is made explicit that an NFC will only have to clear OTC derivatives within the class or classes for which the threshold has been exceeded.

Review of risk management (margin) procedures under Article 11 with possible requirement for supervisory approval

The Draft Regulation proposes that within nine months of its coming into force the ESAs are to submit common draft regulatory technical standards specifying the risk-management procedures, including the levels and type of collateral and segregation arrangements referred to in Article 11(3) of EMIR. These RTS are also to include related supervisory procedures to ensure initial and ongoing validation of those risk-management procedures.

This would appear to mean that there will be a new set of Margin RTS replacing the current version, as well as introducing new supervisory powers. In addition the ESAs may impose a requirement for "a priori supervisory approval of the risk-management procedures that require the timely, accurate and appropriately segregated exchange of collateral". This would be a change from the current margin requirements, under which, for example, initial margin models do not require supervisory sign-off.

Where counterparties have been exchanging margin on the basis of the current RTS, and a new version requires supervisory approval of risk management procedures and, potentially, initial margin models, it is not clear how transactions conducted in accordance with the existing rules will be treated.

Suspension of Clearing Obligation

The European Securities and Markets Authority ("ESMA") and the European Systemic Risk Board had previously highlighted the absence of a mechanism under EMIR for the clearing obligation to be suspended where necessary to react quickly to dramatic changes in market conditions. 

The Commission agreed that this was a weakness in the current regime and a mechanism for suspending a clearing obligation was included as part of the draft proposals on CCP Recovery and Resolution which was published on 22 November 2016. This proposal would include a new Article 6a to EMIR, which allows the competent authority of a clearing member to request that the Commission temporarily suspend the clearing obligation in respect of a class of derivatives cleared by the CCP in resolution where there is a threat to financial stability. Such a suspension would take effect within 48 hours of the request, and could last for an initial period of up to three months, plus a further period or periods not exceeding three months from the end of the initial suspension.

The Commission has now also included in the Draft Regulation a separate mechanism for suspension of a clearing obligation for other purposes besides CCP resolution. The new Article 6b would allow ESMA to request suspension of clearing in the following circumstances:

• the class of derivative no longer meets the criteria for clearing such as standardised terms, volume, liquidity and transparent pricing set out in Article 5(4) of EMIR;
• the only CCP clearing that class is likely to cease doing so and no other will be able to do so without interruption; or

• to avoid a serious threat to financial stability in the EU.

Following ESMA's request the Commission has 48 hours to make its decision, and the suspension will be for an initial three-month period which can be extended in further three-month blocks to a total suspension period of 12 months. Note there is less flexibility here to suspend the clearing obligation for shorter periods than in the case of CCP Resolution, and the rationale for this difference is not clear.

Trade reporting, removal of backloading and exemption for intragroup contracts with NFCs

In the EMIR review, the Commission recommended streamlining reporting requirements in certain areas to promote transparency and improve the functioning of trade repositories.

The current obligation in Article 9 of EMIR to report transactions existing prior to the start of the application of the reporting obligation (so-called "backloading") requires the reporting of derivative contracts entered into before 16 August 2012 (i.e. the date on which EMIR came into force) and which were outstanding as of that date, and derivative contracts entered into on or after 16 August 2012.

The Commission proposes removing the backloading requirement by an amendment in the Draft Regulation to the effect that the reporting obligation only applies to derivative contracts entered into:

• before 12 February 2014 and remain outstanding on that date; or
• on or after 12 February 2014.

Furthermore, the Draft Regulation proposes that the reporting obligation will not apply to intragroup contracts where one of the counterparties is an NFC. 

Participants in the consultation preceding the EMIR review had argued that the trade reporting obligation should only require single counterparty reporting, rather than requiring both counterparties to report data on the same transaction. They argued that reports by both counterparties are frequently not accurately matched within trade repositories and that requirements could be simplified significantly without losing crucial data.

The Draft Regulation does not propose single-sided reporting, however it does provide that:

• CCPs are responsible for reporting the details of derivative contracts that are not OTC derivative contracts (i.e. exchange-traded derivatives) on behalf of both counterparties;
• financial counterparties are responsible for reporting on behalf of both counterparties the details of OTC derivative contracts concluded with an NFC- (but not an FC-);
• the management company of a UCITS is responsible for reporting the details of OTC derivative contracts to which that UCITS is a counterparty; 
• the manager of an AIF is responsible for reporting the details of OTC derivative contracts to which that AIF is a counterparty;
• counterparties and CCPs must ensure that the details of their derivative contracts are reported accurately and without duplication; and
• counterparties and CCPs subject to the reporting obligation may delegate that reporting obligation.

In each case the reporting counterparty specified above is responsible for the accuracy of the trade report. The counterparty for whom the data is reported is permitted access to that data under Article 81 of EMIR.

ESMA would also be required to submit, within nine months of entry into force of the Draft Regulation, new ITS on the standards and format of data reports, and the dates by which reports must be made.

Transparency of CCP initial margins

ESMA (in its EMIR Report No.2) recommended that as clearing members have difficulty in predicting margin calls, more information from CCPs should be provided to clearing members on how CCPs assess margin requirements, in order to make it easier for clearing participants to anticipate big margin changes ahead of changes in positions, parameters or prices.

The Draft Regulation would amend EMIR to oblige CCPs to provide a "simulation tool" enabling members to determine the gross amount of initial margin that would be required by the CCP on clearing of a new transaction, and also to give clearing members information on the initial margin model it uses.

Segregation and Portability

The ESAs had advised that the requirements of Article 39 of EMIR on segregation and portability may be in conflict with national insolvency law, and there is no express provision to determine the precedence of these EMIR provisions in the event of default of a clearing member.

The Draft Regulation now includes a provision stating that where the requirements of Article 39(9) are satisfied, the assets and positions recorded in those accounts will not be considered part of the insolvency estate of the CCP or clearing member. Paragraph 9 of Article 39 provides that the requirement to distinguish assets and positions with a CCP in accounts (using either omnibus client segregation or individual client segregation) is satisfied where:

(a) the assets and positions are recorded in separate accounts;

(b) the netting of positions recorded on different accounts is prevented; and

(c) the assets covering the positions recorded in an account are not exposed to losses connected to positions recorded in another account.

By way of example, a clearing member may have its own account with the CCP and its omnibus client account, or other client accounts. Under English law, these client accounts would usually be trust accounts and, being subject to a trust, in the event of the insolvency of the clearing member they would not form part of the clearing member's estate. However this may not be the case in all jurisdictions – and it could be that where there is no protection by virtue of a trust, the accounts could form part of the insolvent estate of the clearing member. This provision attempts to ring-fence the client account from the other accounts of the clearing member provided there is no ability to net between the accounts.

The provision also applies to protect assets and positions in accounts with the CCP in the event of CCP insolvency, but no further detail is given with regard to how this is to be effected.

Pension scheme arrangements

Occupational pension schemes ("PSAs" in the Draft Regulation) are currently exempt from clearing under EMIR but the exemption is due to expire on 16 August 2017. This exemption can be extended by a Commission delegated act for only one further year.

PSAs generally minimise their cash holdings in preference for higher-yielding investments such as securities in order to generate returns for pensioners. However, as CCPs do not accept non-cash assets for variation margin, if required to clear their derivative contracts, PSAs would need to borrow cash or sell or repo assets in order to meet CCP margin calls.

The costs of central clearing would therefore reduce retirement incomes if PSAs were required to clear their derivatives and meet variation margin calls in cash.

The Commission has opted not to make the exemption permanent at this stage. Instead, the Draft Regulation amends the transitional provision in Article 89 of EMIR so as to exempt PSAs from clearing for three years after that date the Draft Regulation comes into force. Within two years of the Draft Regulation coming into force, the Commission must prepare a report on whether technical solutions to the transfer of cash and non-cash variation margin by PSAs have been found, the volume of PSA trading, and cost differential for PSAs of fulfilling the clearing requirement in the context of other legal requirements such as margining for uncleared derivatives, and calculation of the leverage ratio. The Commission can then extend the exemption in Article 89 once for a further two years if it concludes that no viable solution has been found following this report.

"Fair and Reasonable" client clearing

A new provision would require that clearing members and clients who provide clearing services, whether directly or indirectly, must provide those services on fair and reasonable commercial terms. The Commission may adopt a delegated act setting out the terms which will be considered to be fair and reasonable.

It is not clear what the reason is behind this requirement, or the impact it is expected to have. No guidance is currently given as to what it meant by "fair" or "reasonable", and there is no indication as to whether a breach of the requirement would be actionable by the client. These details appear to have been postponed until any delegated act is published.

Further EMIR review in three years

Within 30 months of its coming into force, the Draft Regulation requires the Commission to prepare a report, a report on the participation of PSAs in central clearing and the impact of those solutions (following the earlier report on that specific subject above), as well as on the impact of the regulation on the level of clearing by NFCs and FCs and the appropriateness of the clearing thresholds, the improvement in quality of data reporting, and the accessibility of clearing.

The Draft Regulation then amends Article 85 of EMIR, to the effect that the Commission will be required to submit to Parliament and the Council a further review of EMIR within three years of its coming into force. Also, various authorities granted to the Commission to produce delegated acts under EMIR have been extended indefinitely.

Trade Repositories and access to data in third countries

A new Article 76a would give authorities in third countries that have trade repositories direct access to the data held in Union trade repositories where the Commission has adopted an implementing act in respect of that third country. The implementing act would confirm that the trade repositories in that third country are duly authorised, there is effective supervision and enforcement, there are guarantees of professional secrecy and there is a legal obligation on those trade repositories to give direct and immediate access to the data to the relevant Union authorities.

ESMA would be required to submit draft regulatory technical standards on the procedures for reconciliation and transfer of data between trade repositories, and information to be published under Article 81(1) and (3) (i.e. the information to be published by trade repositories to relevant supervisors) within nine months of the date the Draft Regulation comes into force. Note that these RTS are required to ensure that the identities of the parties to individual contracts will remain confidential.

Transitional provisions

The Draft Regulation will come into force on the twentieth day following its publication in the Official Journal, except that the following requirements relating to:

• the new Article 4a under which FCs become subject to clearing thresholds, and their calculation of notional amounts of OTC derivatives and date of application of the clearing obligation;
• the changes to Article 10 for calculation of notional amounts of OTC derivatives entered by NFCs (i.e. by reference to aggregate averages in March, April and May of each year) and the date of application of the clearing obligation;
• the requirements for CCPs to provide clearing members with information on Initial Margin; and
• the provision giving preference to CCP segregation arrangements over local insolvency law,

will take effect six months later.

There are also some additional requirements which come into effect six months or 18 months after the Draft Regulation comes into force, however at this stage it is difficult to identify those provisions as the references appear to be incorrect. We assume they will be corrected in the next version of the Draft Regulation.