Report from the Commission to the European Parliament and the Council Under Article 85 of EMIR

Background and proposal for legislative review

Article 85(1) of EMIR requires the European Commission to prepare a report to the European Parliament and the Council on EMIR together with any appropriate proposals for review (the "EMIR review"). The EMIR review was scheduled for submission by 17 August 2015, but was finally submitted and published on 23 November 2016.

Summary The EMIR review does not propose any fundamental change to the core requirements of EMIR. However the Commission has recommended: Introduction of a mechanism for suspending the clearing obligation when required quickly (e.g. in market crisis scenarios) Review of the categorisation of NFCs – and further review on implementation of MIFID II Adjustment of trade reporting requirements to reduce operational burden A possible mandate for supervisory approval of initial margin models Review of extent of frontloading requirements Potential clearing solutions for small financial counterparties A possible longer-term exemption from clearing for pension schemes

As part of the EMIR review, the Commission sought and received input from various EU bodies including the European System of Central Banks ("ESCB") and the European Securities and Markets Authority ("ESMA"). In August 2015 ESMA produced three reports to the Commission to assist the Commission in preparing the EMIR review (the "ESMA Advice") in which ESMA made various recommendations including the possible review of the treatment of certain counterparties as NFC-s.

The Commission has considered these reports, together with feedback from a public consultation, and has concluded that there is no current need for fundamental change to be made to the core requirements of EMIR. In particular, as clearing obligations and margin requirements for non-cleared OTC derivatives transactions are not yet fully in force, it is not possible comprehensively to review the impact of EMIR.

However, the Commission will propose a legislative review of EMIR in 2017 that will be accompanied by an impact assessment which will consider the various issues at stake in more depth. In the EMIR review the Commission has highlighted certain areas where the EMIR requirements could be adjusted without compromising the overall regulatory objectives, in order to simplify the rules to increase efficiency and to reduce disproportionate cost and other burdens for stakeholders.

The specific Commission recommendations are discussed below.

Suspension of Clearing Obligation

ESMA and the European Systemic Risk Board had 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. Whilst EMIR provides a mechanism whereby clearing obligations can be amended or removed through Regulatory Technical Standards ("RTS"), this process can take several months.

The Commission agreed that this is a weakness in the current regime and a mechanism for suspending a clearing obligation has therefore been included as part of the draft proposals on CCP Recovery and Resolution which was published on 22 November 2016. The Commission will also consider introduction of a mechanism suspension of a clearing obligation for other appropriate purposes besides CCP resolution.

Predictability of margin levels

Industry associations and banks noted in the consultation responses that it can be difficult to predict the levels of margin that they will be required to post to CCPs for centrally-cleared transactions.

With respect to non-cleared transactions, financial institutions noted the absence of a requirement for initial margin models to be approved by regulators, leading to uncertainty among market participants as to whether their calculations are considered fully compliant with regulations.

The Commission recommended that better information sharing by CCPs with clearing members could facilitate participants' compliance with margin requirements and better management of their own assets. With regard to non-cleared transactions, the introduction of a mandate for initial margin models to be endorsed by regulators could promote certainty for market participants and authorities alike.

Trade Reporting

Participants in the consultation 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.

Furthermore, respondents argued that the requirement to report transactions existing prior to the start of the application of the reporting obligation (so called 'backloading') presents significant logistical challenges, as well as being of limited historical use. Under Article 9 of EMIR, the Reporting Obligation applies to 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. Transitional provisions applied and are now fully phased in, except that contracts which were terminated between 16 August 2012 and 12 February 2014 must be reported by 12 February 2017. Whilst in theory this means that any future relaxation of the backloading requirement would be of limited use, there is still an appetite in the market for removing this requirement to remove any backlog.

The Commission seems to have taken these comments into account, and has recommended that streamlining reporting requirements in certain areas will promote transparency and improve the functioning of trade repositories.

Frontloading

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 CCP clearing members and other high-volume users of derivatives will also, on the clearing effective date, be required to clear trades entered into during a prescribed period prior to the clearing effective date applicable to them. This is known as “frontloading”.

Respondents to the consultations questioned whether the frontloading requirements were proportionate given the limited number of contracts within scope and given the difficulties associated with applying clearing obligations retrospectively.

In view of these concerns, the Commission has recommended that it is appropriate to review to what extent transactions entered into before a clearing effective date should remain in scope of the relevant requirements.

Non-Financial Counterparties ("NFCs")

The ESMA Advice recommended a review of the treatment of NFCs both for trade reporting and for assessment as to whether NFCs are over the clearing threshold and made various alternative recommendations. One suggestion was the removal of the hedging exemption – but with an appropriate change to the level of the clearing threshold. Another was possible reclassification of the FC/NFC divide.

The Commission has taken the view that it should assess whether adjustments should be made to the scope of the core requirements under EMIR in order to address the challenges faced by NFCs.

Options to be explored include a) whether financial counterparties should report derivatives data on behalf of NFCs, b) whether financial counterparties, but not NFCs, should ensure that operational risk mitigation requirements are applied for transactions with NFCS and c) whether NFCs should be exempted from reporting their intragroup transactions.

However, in response to ESMA's suggestion of removing the hedging exemption for the purpose of assessing whether a counterparty is over the clearing thresholds and instead increasing the level of the clearing threshold, the Commission noted the difficulties in applying the hedging exemption but considered that the nature of hedging activity is still a relevant factor when considering the systemic relevance of NFCs. It observed that entities that hedge are generally not highly leveraged and hold underlying offsetting positions to their OTC derivative contracts.

However, the Commission agreed that further consideration should be given to which NFCs should be captured by clearing and margin requirements. The Commission also noted that classification of counterparties may need to be revisited when MiFID II is implemented, scheduled for January 2018. MIFID II potentially brings a number of new firms into scope, including firms trading in commodities. These firms would therefore become financial counterparties for the purpose of EMIR.

Small derivatives counterparties

The Commission noted that the consultation had shown 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. This group were facing significant challenges in establishing the access to clearing necessary to meet clearing obligations, principally as a result of leverage ratio requirements anticipated by clearing members under the Capital Requirements Regulation.

The Commission has therefore recommended that action should be considered to address the obstacles to client clearing for small financial counterparties.

Pension scheme arrangements

Occupational pension schemes are currently exempt from clearing under EMIR but the exemption is due to expire on 16 August 2017. The exemption can be extended by a Commission delegated act for only one further year.

Pension schemes 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, pension schemes 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 pension schemes were required to clear their derivatives and meet variation margin calls in cash.

The Commission has therefore proposed that an assessment be made as to whether the current exemption could be made permanent without resulting in systemic risk as pension scheme arrangements would still be subject to margin requirements for OTC transactions that are not centrally cleared.

Issues raised in the ESMA reports which are not addressed by the Commission

Segregation and Portability

The ESMA Advice identified some differences in CCP practices in the implementation of Article 39 of EMIR on segregation of assets of clearing members and individual client segregation, and portability of positions on default of a clearing member. ESMA also identified a lack of consistency in the interpretation of "client" due to differing account structures used by CCPs in different markets.

ESMA had recommended the introduction of clarifications and more detailed requirement through regulatory technical standards to include clearer definitions of "account" and "assets" as well as distinguishing between "omnibus gross" and "omnibus net" accounts and related margin period of risk.

The EMIR provisions on segregation and portability may also be in conflict with national insolvency law, and there is no express provision to determine the prevalence of these EMIR provisions in the event of default of a clearing member.

The EMIR Review does not currently make any recommendations in this respect.

Securitisation vehicles

In reviewing the requirements for NFC status, the ESMA Advice focused in particular on securitisation vehicles currently treated as NFCs and noted that treating these "quasi-financial" vehicles as NFCs introduces a "severe bias" in the overall analysis of NFC activity. In the EMIR review, the Commission has not made specific reference to securitisation vehicles and other SPVS (such as repackaging vehicles), although has made recommendations regarding a possible review of the categorisation of NFCs as described above.

However, 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 securitisations and repackaging vehicles will remain dependent on the vehicle falling below the clearing and margin thresholds applicable from time to time.

Recognition of Third Country CCPs

ESMA proposed a review of the entire equivalence and recognition process of third country CCPs to increase its efficiency and effectiveness and better to respond to regulatory differences between third countries. ESMA proposes that the equivalence decision be governed by Regulatory Technical Standards (RTS) and that any recognition process should also include additional risk-based considerations allowing it to deny or suspend the recognition of a third country CCP.

The EMIR review does not currently make any recommendations on this issue. In the light of the UK's decision to leave the EU however, such processes could be critical in enabling UK authorised CCPs to continue to clear derivatives entered by EU counterparties. If ESMA's recommendations were followed, there would be a move away from relying on the UK rules as being equivalent, and toward much closer scrutiny by ESMA of CCP applications.

Procyclicality of CCP margin requirements

The ESMA Advice also analysed the relevant provisions regarding CCPs measures to address procyclicality and their ability to limit procyclical effects on margin requirements and collateral coverage.

The regulatory technical standards governing CCPs require a CCP to ensure that its policy for assessing margin levels delivers stable and prudent margin requirements that limit procyclicality to the extent that the soundness and financial security of the CCP is not negatively affected. In doing so, the CCP has to apply at least one of three provided options. All three options include the introduction of a counter-cyclical component in the CCP's margin calibration methodology to avoid big step changes following volatility peaks. However, the three options provided in Article 28 of the technical standards have different theoretical properties and do not perform equally under different market conditions.

ESMA had therefore recommended revising the existing RTS requirements with a provision for CCPs to define their procyclicality metrics and to test these regularly, taking into account their credit and business cycles, specific product offerings and risk management practices, and to adjust policies and thresholds on the basis of these results.

ESMA also recommended that article 46 of EMIR should be complemented with a requirement for CCPs to take into account any potentially procyclical effects when revising the list of acceptable collateral and haircuts to the extent that this will not affect negatively its soundness and financial security. ESMA expected these changes to increase collateral requirements and their costs and therefore the benefits should be analysed.

However the EMIR review does not currently address these recommendations and it remains to be seen whether they might be addressed in any legislative proposal.

Intragroup Transactions

ESMA had noted note that in the definition of intragroup contract in Article 3 of EMIR, third-country entities are referred to alongside EU entities with the terms “financial counterparty” and “non-financial counterparty”, however FCs and NFCs as defined in EMIR must by definition be EU entities.

The current drafting could, on ESMA's reading (and ours) have the unintended consequence that a transaction between two counterparties in the same group, one established in the EU and the other established in a non-equivalent third country, meets the definition of intragroup transaction. As a result, ESMA had made some suggested drafting changes to address this so that the country of establishment (EU or equivalent third-country) and the nature (financial or non-financial) of both parties to the intragroup transactions is identified unambiguously.

Unfortunately the Commission has not addressed this in the EMIR review, although it remains possible that a straightforward drafting change such as this one could be made in the legislative proposal referred to by the Commission.