Focus on EMIR - the clearing obligation comes into effect

 

Background

Regulation (EU) No. 648/2012 of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (also known as the European Market Infrastructure Regulation ("EMIR")) entered into force on 16 August 2012. For implementation purposes, the general provisions of EMIR must be supplemented by detailed level 2 regulations known as technical standards, which are drafted by the European Securities and Markets Authority ("ESMA"), adopted by the European Commission (the "Commission") and approved by the Council of the European Union and the European Parliament. The technical standards can take the form of regulatory technical standards ("RTS") or implementing technical standards.

Article 4 (Clearing obligation) of EMIR contains a general clearing obligation (the "General Clearing Obligation") which can be translated into specific clearing obligations affecting certain classes of derivatives by following a procedure set out in Article 5 (Clearing obligation procedure) of EMIR. In March 2014, ESMA commenced this process for the first time by confirming NASDAQ OMX Clearing as the first central counterparty ("CCP") authorised to clear interest rate derivatives under EMIR. The ensuing consultation process culminated in the publication on 1 December 2015 of RTS documenting EMIR's first clearing obligation in the Official Journal of the European Union (the "OJ") as Commission Delegated Regulation (EU) 2015/2205 of August 6 2015 (the "G4 IRS Clearing RTS").

The G4 IRS Clearing RTS will enter into force on 21 December 2015, twenty days after its publication in the OJ, and will implement the General Clearing Obligation in respect of certain classes of interest rate derivatives that CCPs have been authorised to clear (the "G4 IRS Clearing Obligation"). The G4 IRS Clearing Obligation will come into effect for different counterparty types on different dates, calculated by reference to the date of entry into force of the G4 IRS Clearing RTS (see 'When will the obligation apply?' below), so its publication in the OJ has started the clock ticking for phased-in implementation. This briefing gives an overview of the G4 IRS Clearing RTS and highlights certain elements of the G4 IRS Clearing Obligation of which market participants should be aware.

Affected classes of derivatives

The classes of interest rate OTC derivatives which are subject to the G4 IRS Clearing Obligation (the "G4 IRS Classes") are set out in an annex to the G4 IRS Clearing RTS. They are:

• basis swaps denominated in EUR, GBP, JPY or USD with a maturity of 28 days to 50 years;
• fixed–to-float interest rate swaps denominated in EUR, GBP, JPY or USD with a maturity of 28 days to 30 years (for JPY) or 50 years (for EUR, GBP and USD);
• forward rate agreements denominated in EUR, GBP or USD with a maturity of three days to three years; and
• overnight index swaps denominated in EUR, GBP or USD with a maturity of seven days to seven years.

The G4 IRS Clearing RTS also specifies for each of the G4 IRS Classes that they cover transactions with constant or variable notional amounts but not transactions with optionality. Each authorised CCP also has detailed criteria as to the characteristics of the transactions that such CCP will accept for clearing and, on the basis that the G4 Clearing RTS are not intended to subject to the mandatory clearing obligation transactions that are not currently cleared by an authorised CCP, these criteria will also need to be assessed in order to determine whether a transaction is subject to mandatory clearing. In addition, an authorised CCP may not necessarily clear all maturities and notional types of a G4 IRS Class.

Affected counterparties under EMIR

EMIR establishes to which OTC derivatives contracts the General Clearing Obligation applies; namely, those entered into between:

(i) two financial counterparties (which includes financial institutions such as banks, insurers, investment firms and certain alternative investment funds);

(ii) one financial counterparty and one non-financial counterparty whose aggregate group notional amount of outstanding derivatives (excluding hedging transactions) exceeds a pre-determined threshold (Euros 3 billion for interest rate derivatives) (each such non-financial counterparty an "NFC+");

(iii) two NFC+s;

(iv) one financial counterparty or NFC+ and one counterparty which is established in a non-European Union ("EU") country but which would be subject to the General Clearing Obligation if it were established in the EU; and

(v) two entities established in one or more non-EU countries that would be subject to the General Clearing Obligation if they were established in the EU, where such contract has a direct, substantial and foreseeable effect within the EU, or where necessary or appropriate to prevent the evasion of any provisions of the G4 IRS Clearing RTS.

Direct, substantial and foreseeable effect within the EU

Guidance on (v) above has been provided through additional RTS on transactions between two third-country counterparties (the "Third Country RTS"). The Third Country RTS specify that contracts between two non-EU entities will be deemed to have a direct, substantial and foreseeable effect within the EU if they are between EU branches of financial counterparty equivalents or at least one counterparty benefits from a guarantee given by an EU entity which:

• covers all or part of that non-EU entity's liability arising from an aggregate notional amount of OTC derivatives of at least Euro 8 billion; and
•  is for an amount at least equal to 5% of the guarantor's then current OTC derivatives exposure.

As regards the evasion of EMIR, the Third Country RTS provide that an OTC derivative contract will be caught if the way in which the contract has been concluded is considered, when viewed as a whole, to have as its primary purpose the avoidance of the application of any provision of EMIR.

Categories of affected counterparties

The G4 IRS Clearing RTS establish when the G4 IRS Clearing Obligation will take effect and for this purpose it divides affected counterparties into four categories, which are set out below.

Category 1 counterparties are counterparties which are clearing members of an authorised CCP that clears at least one of the classes of derivative specified in the G4 IRS Clearing RTS.

Category 2 counterparties are financial counterparties and alternative investment funds which are not clearing members and whose aggregate group monthly average of outstanding gross notional amount exceeds EUR 8 billion.

Category 3 counterparties are financial counterparties and alternative investment funds which do not fall within category 1 or 2.

Category 4 counterparties are NFC+s which do not fall within categories 1, 2 or 3.

When will the obligation apply?

The General Clearing Obligation only applies to contracts entered into or novated on or after the date on which the specific clearing obligation takes effect. For the G4 IRS Clearing Obligation, the effective date will vary depending on the categories of the contract counterparties as follows:

counterparty category	date of application of G4 IRS Clearing obligation
Category 1	21 June 2016
Category 2	21 December 2016
Category 3	21 June 2017
Category 4	21 December 2018

 

Where a contract is entered into between counterparties in different categories, the longer phase-in period applies, thus ensuring that each counterparty type has sufficient time to achieve compliance with the regime. Different phase-in periods apply to intragroup transactions where one counterparty is a non-EU entity, subject to certain conditions.

Frontloading

Counterparties in categories 1 or 2 are also required to clear transactions with the specified minimum remaining maturities (as at the date on which the G4 IRS Clearing Obligation takes effect) and which are entered into from 21 February 2016 and 21 May 2016 respectively once the applicable phase-in period has ended (the "Frontloading Requirement"). Due to the complications of clearing transactions that have been priced on an OTC basis, category 1 and category 2 counterparties may decide to treat the relevant Frontloading Requirement start date as the date from which they will regard clearing as mandatory for G4 IRS Classes with the applicable remaining maturity.

For category 1 counterparties, the minimum remaining maturities referred to above are:

• 50 years for G4 IRS Classes which are basis swaps or fixed-to-float interest rate swaps entered into or novated before 21 February 2016;
• 3 years for G4 IRS Classes which are forward rate agreements or overnight index swaps entered into or novated before 21 February 2016; and
• 6 months for all G4 IRS Classes entered into or novated on or after 21 February 2016.

For category 2 counterparties, the minimum remaining maturities referred to above are, as at the date on which the G4 IRS Clearing Obligation takes effect:

• 50 years for G4 IRS Classes which are basis swaps or fixed-to-float interest rate swaps entered into or novated before 21 May 2016;
• 3 years for G4 IRS Classes which are forward rate agreements or overnight index swaps entered into or novated before 21 May 2016; and
• 6 months for all G4 IRS Classes entered into or novated on or after 21 May 2016.

The Frontloading Requirement will not apply to category 3 or category 4 entities.

Exemptions

Covered bonds

The G4 IRS Clearing RTS also contain an exemption from the G4 IRS Clearing Obligation for contracts which would otherwise be caught where such contracts are concluded with covered bond issuers or with cover pools for covered bonds for the purpose of hedging interest rate or currency mismatches on the cover pool relating to the covered bond and certain other conditions specified in article 1(2) of the G4 IRS Clearing RTS are met.

Intragroup transactions

EMIR contains an exemption from the General Clearing Obligation for intragroup transactions (the "Intragroup Exemption"), where certain conditions are met. One such condition requires that each EU entity intending to use the Intragroup Exemption must notify its competent authority (in the UK, the Financial Conduct Authority (the "FCA")), in writing, of its intent no less than thirty calendar days prior to such use. The relevant competent authority must then consider whether the transactions in question meet specified criteria set out in Article 3 of EMIR and may object to the use of the Intragroup Exemption if they do not. Notifications to the FCA can be effected via its EMIR portal.

With the first implementation date of the G4 IRS Clearing Obligation now imminent, the FCA has advised that it is accepting notifications for the Intragroup Exemption for transactions between two entities which are both established in the UK. The FCA has also advised that it is able to accept applications for transactions between a UK entity and an entity elsewhere in the EU, but firms should check whether the other relevant competent authority whose approval is also required is accepting notifications before notifying the FCA. We understand that the FCA will only accept notifications in respect of transactions between a UK counterparty and a third country entity once the first RTS on mandatory clearing comes into force (i.e. from 21 December 2015).

Pension scheme arrangements

Under transitional provisions set out in EMIR, certain pension scheme arrangements are exempt for a period of three years from the General Clearing Obligation when they enter into OTC derivatives contracts for genuine hedging purposes. These transitional provisions were originally due to expire in August 2015 but have been extended for an additional two years to August 2017.

Note that derivative transactions entered into by such pension scheme arrangements will, as non-cleared trades, be subject to other requirements under EMIR, such as the risk mitigation requirements set out in Article 11 of EMIR.

Extraterritorial effect and equivalence decisions

As mentioned in 'Affected counterparties under EMIR' above, although EMIR is a piece of European legislation, it can nevertheless apply in certain circumstances to non-EU entities. In order to avoid conflict with similar rules in non-EU countries, potentially duplicating compliance requirements, contracts which are subject to the G4 IRS Clearing Obligation must be cleared through either (i) a CCP which is authorised and established in the EU or (ii) a CCP which is recognised by ESMA and established in a non-EU jurisdiction in respect of which ESMA has issued an equivalence decision.

To date, equivalence decisions have been issued in respect of Australia, Canada, Hong Kong, Japan, Mexico, Singapore, South Africa, South Korea and Switzerland ¹. One notable omission from this list is the United States, which the Commission has not yet found to have equivalent regulatory standards as regards clearing. As it stands, according to ESMA's public register of CCPs authorised to clear the G4 IRS Classes, only two non-EU CCPs (JSCC of Japan and OTC HK of Hong Kong) are authorised. Market participants will no doubt be focused on whether anything changes in this regard between now and the time the G4 IRS Clearing Obligation (or, for that matter, the Frontloading Requirement) takes effect.

For regulated entities which are subject to minimum capital requirements, the lack of an equivalence decision may also have an impact from a capital perspective, as trades which are not cleared through CCPs in 'equivalent' jurisdictions are subject to more onerous capital requirements under the Capital requirement Regulation (Regulation (EU) No 575/2013) ("CRR"). CRR is largely already in force, but the legislation provides a transitional period for the authorisation and recognition of CCPs, during which firms may treat exposures to a CCP which has not yet been authorised or recognised by ESMA as exposures to a CCP which has been so authorised or recognised (i.e. the otherwise higher capital requirements will not apply). The transitional period was originally extended from 15 June 2015 to 15 December 2015 and has just been extended again to 15 June 2016 - just six days before the G4 IRS Clearing Obligation takes effect for category 1 counterparties. This may further increase pressure on the Commission to issue equivalence decisions in respect of other key jurisdictions, such as the United States in order that ESMA can authorise CCPs from those jurisdictions.

The next classes subject to clearing

The next clearing obligations to be implemented are expected to cover (i) certain European untranched index credit default swaps and (ii) interest rate swaps denominated in NOK, PLN and SEK. ESMA submitted draft RTS (the "Draft RTS") to the Commission in October and November 2015 respectively. The Commission has three months to review and, if no amendments are proposed, adopt the Draft RTS, after which the text will be reviewed by the European Parliament and the Council of the EU. The Draft RTS uses the same counterparty categorisation system as the G4 IRS Clearing RTS. The effective start date of the obligations will depend on the time taken by the Commission, Parliament and Council to review the draft, but at this stage it appears likely that the earliest implementation date (i.e. that applicable to clearing members) will fall in the final quarter of 2016, with implementation dates for other categories of counterparty to follow.

Clearing methods and documentation

Under EMIR, the clearing obligation can be satisfied through clearing (i) as a direct clearing member of an authorised CCP, (ii) as a client of such a clearing member or (iii) through indirect clearing. The next briefing in our "Focus on EMIR" series will cover these different means of accessing clearing and the related documentation and options available to parties in respect of each.

^{1 Cooperation agreements ("MoUs") have been signed with Australia, Hong Kong, Japan and Singapore but are still pending for the remaining jurisdictions. MoUs are required under EMIR as one of the conditions for full recognition by ESMA of a non-EU CCP as a qualifying CCP.}