EUROPEAN MARKET INFRASTRUCTURE REGULATION ("EMIR")
(i) ESMA Launches First Round of Consultations to Prepare for Central Clearing of OTC Derivatives in the EU
ESMA launched a first round of consultations to prepare for central clearing of OTC derivatives within the European Union on 11 July 2014. The two consultation papers sought stakeholders' views on draft regulatory technical standards ("RTS") for the clearing of Interest Rate Swaps ("IRS") and Credit Default Swaps ("CDS") that ESMA has to develop under EMIR.
With the overarching objective of reducing systemic risk, EMIR introduces the obligation to clear certain classes of OTC derivatives in central clearing houses ("CCPs") that have been authorised ("European CCPs") or recognised ("Third-Country CCPs") under its framework. To ensure that the clearing obligation reduces systemic risk, EMIR specifies a process for the identification of the classes of OTC derivatives that should be subject to mandatory clearing. This includes the assessment of specific criteria that the relevant classes of OTC derivatives have to meet.
ESMA is required to draft RTS on the clearing obligation within six months of the authorisation or recognition of CCPs. ESMA has analysed the classes from several CCP notifications and has determined that some IRS and CDS classes should be subject to the clearing obligation. Although equity and interest rate futures and options are also offered for clearing, ESMA has decided that a clearing obligation is not necessary for these classes at this stage. However, the two consultation papers may be followed by one or more on other asset classes.
For IRS, the draft RTS propose the following four classes, on a range of currencies and underlying indices should be subject to central clearing:
- Basis swaps;
- Fixed-to-float interest rate swaps;
- Forward rate agreements; and
- Overnight index swaps.
For CDS, the draft RTS propose that European untranched index CDS (for two indices) should be subject to central clearing.
The IRS Consultation Paper closed on 18 August 2014 and the CDS Consultation Paper closed on 18 September 2014. ESMA will use the answers received to draft its final RTS on the clearing obligation for IRS and CDS and send them for endorsement to the European Commission. The clearing obligation will take effect following a phased implementation, with the current proposal ranging from six months to three years after the entry into force of the RTS, depending on the types of counterparties concerned.
For further information, please see: http://www.esma.europa.eu/news/Press-release-ESMA-defines-central-clearing-interest-rate-and-credit-default-swaps?t=326&o=home
IRS Consultation Paper: http://www.esma.europa.eu/system/files/2014-799.pdf
CDS Consultation Paper: http://www.esma.europa.eu/system/files/2014-800.pdf
(ii) ESMA Updates EMIR implementation Q&As
ESMA issued a revised "Questions and Answers" document on the implementation of EMIR, (the "Q&A") on 10 July 2014. The Q&A specifically addresses two main issues:
- Clarifies that the clearing exemption for certain European pension schemes does not extend to pension schemes established in third countries; and
- Contains information on the segregation requirements applicable to Third Country CCPs under Article 39 of EMIR.
The latest version of the Q&A can be found here:
(iii) Updated EMIR FAQs from the European Commission
The European Commission has also updated its FAQs on EMIR (Part IV) on 10 July 2014 to include clarity around segregation requirements for non-EU clearing members of EU CCPs.
Please find the FAQs here:
(iv) List of Central Counterparties authorised to offer services and activities in the European Union
ESMA's list of European CCPs that have been authorised to provide services and activities in the European Union was last updated on 16 September 2014. There are now thirteen such European CCPs authorised in the European Union. The updated list can be found at this link; http://www.esma.europa.eu/system/files/ccps_authorised_under_emir.pdf
(v) IOSCO Consults on Risk Mitigation Standards for Non-Centrally Cleared OTC Derivatives
On 17 September 2014, IOSCO published a consultation paper on risk mitigation standards for non-centrally cleared OTC derivatives. The consultation proposes nine standards, which relate to the following areas which aim at mitigating risks in uncleared OTC derivatives:
- Standard 1 : Scope of coverage
- Standard 2 : Trading relationship documentation
- Standard 3 : Trade Confirmation
- Standard 4 : Valuation with counterparties
- Standard 5 : Reconciliation
- Standard 6 : Portfolio Compression
- Standard 7 : Dispute Resolution
- Standard 8 : Implementation
- Standard 9 : Cross-border transactions.
The proposed standards have been developed in consultation with the Basel Committee on Banking Supervision ("BCBS") and the Committee on Payments and Market Infrastructures. They are intended to complement the margin requirements developed by BCBS and IOSCO in September 2013.
The consultation recognises that some jurisdictions have already implemented or are implementing requirements in this area and specifically recognises the risk mitigation measures which have been implemented in the U.S. and the European Union. IOSCO calls for the proposals contained in the consultation paper to be implemented as soon as possible. IOSCO also notes that, due to the global nature of the derivatives markets, any regulatory standards should be compatible across jurisdictions to avoid arbitrage, conflicting rules and to level the playing field.
The consultation closes on 17 October 2014.
(vi) IOSCO Launches Public Information Repository for Central Clearing Requirements
IOSCO unveiled an information repository for central clearing requirements for OTC derivatives, which provides regulators and market participants with consolidated information on the clearing requirements of different jurisdictions.
The repository sets out central clearing requirements on a product-by-product level, and any exemptions from them. The information in the repository will be updated quarterly.
The repository can be accessed at this link:
(vii) ESMA Discussion Paper on Calculation of Counterparty Risk by UCITS for OTC Derivatives subject to EMIR clearing
On 23 July 2014, ESMA published a discussion paper (the "Discussion Paper") on the calculation of counterparty risk by UCITS for OTC derivative transactions subject to clearing obligations under EMIR.
The Discussion Paper is seeking stakeholders' views on how the limits on counterparty risk in OTC derivative transactions that are centrally cleared should be calculated by UCITS, and whether the same rules should be applied by UCITS for both centrally cleared OTC transactions and Exchange Traded Derivatives.
The Discussion Paper is focused on the impact of a default of a clearing member or of other clients of that member on the UCITS that enters into centrally cleared OTC derivative transactions. This takes into account the fact that European CCPs and Third Country CCPs are already subject to stringent collateral requirements, and should generally be considered as entailing low counterparty risk.
This Discussion Paper distinguishes between different clearing arrangements:
- Direct clearing arrangements, i.e.
the UCITS is a client of the clearing member with:
- Individual client segregation;
- Omnibus client segregation;
- Other types of segregation arrangement; or
- Segregation arrangements with a non-EU CCP outside the scope of EMIR.
- Indirect clearing arrangements between the CCP, the clearing member, the client of the clearing member and the UCITS.
The consultation is open for feedback until 22 October 2014. ESMA will use the feedback received from the public consultation to determine its final views on the appropriate way forward, including a possible recommendation to the European Commission on a modification of the UCITS Directive.
(viii) Joint Consultation on Draft RTS on Risk-Mitigation Techniques for OTC-derivative Contracts not Cleared by a CCP
The European Supervisory Authorities ("ESA's") launched a consultation on 14 April 2014 regarding draft RTS on risk mitigation measures for OTC derivative contracts not cleared by a CCP. The consultation closed on 14 July 2014.
For those OTC derivative transactions that will not be subject to central clearing, the draft RTS prescribe that counterparties apply robust risk mitigation techniques to their bilateral relationships, which will include mandatory exchange of initial and variation margins. This will reduce counterparty credit risk, mitigate any potential systemic risk and ensure alignment with international standards.
The draft RTS elaborate on the risk-management procedures for the exchange of collateral and on the procedures concerning intragroup exemptions including the criteria that identify practical and legal impediments to the prompt transfer of funds.
The draft RTS lay down the methodologies for the determination of the appropriate level of margins, the criteria that define liquid high-quality collateral, the list of eligible asset classes, collateral haircuts and concentration limits.
Based on the responses received, the ESAs will prepare the final draft RTS and intend to submit these to the European Commission before the end of 2014.
The responses can be found at this link; http://www.esma.europa.eu/consultation/Joint-Discussion-Paper-Draft-Regulatory-Technical-Standards-risk-mitigation-techniques-#responses
(ix) Treatment of FX Forwards under EMIR
As previously reported, the treatment by regulators of FX Forwards under EMIR varies across the European Union. The reason for these diverging approaches is the fact that a derivative under EMIR is defined by reference to Directive 2004/39/EC (the "MiFID Directive") and Member States transposed the MiFID Directive differently.
Concerns have been expressed by both the European Commission and ESMA about the lack of consistency between EU Member States with regards to the definition of an FX Forward. On 31 July 2014, (further to previous correspondence between ESMA and the European Commission on the topic) ESMA published a letter (dated 23 July 2014), (the "Letter") from the European Commission on the need for clarity regarding the definition of a financial instrument relating to FX.
The Letter outlines the need for a consistent interpretation to ensure the effective application of the reporting regime of EMIR. However, unfortunately the European Commission has now clarified that it is not in a position to develop such a definition using an implementing act, for legal reasons1. However, the Letter provides that MiFID II and related implementing measures (which will apply from 3 January 2017) will be able to provide legal certainty as to the definition of a FX contract. In addition, the Letter suggests that ESMA should consider whether "the current approach by Member States achieves a sufficiently harmonised application of the EMIR reporting obligation in the period before the application of MiFID II or whether further measures by ESMA e.g. guidelines are necessary". The Letter sets out the "broad consensus" on a definition of FX spot contracts, which have been reached following extensive public debate and meetings of the European Securities Committee as follows:
- To use a T+2 settlement period to define FX spot contracts for European and other major currency pairs;
- To use the "standard delivery period" for all other currency pairs to define a FX spot contract;
- Where contracts for the exchange of currencies are used for the sale of a transferable security to use the accepted market settlement period of that transferable security to define a FX spot contract, subject to a cap of 5 days; and
- A FX contract that is used as a means of payment to facilitate payment for goods and services should also be considered a FX spot contract.
Following the publication of the Letter by ESMA, the Central Bank updated its "Frequently Asked Questions", (the "Q&A") to reflect the updated developments at European level. The Q&A now provides as follows;
- All FX transactions with settlement before or on the relevant spot date are not to be reported;
- All FX transactions with settlement beyond seven days are to be reported;
- All FX transactions with settlement between the spot date and seven days (inclusive) are to be reported only if, in a jurisdiction where one counterparty to the trade is located, local laws, rules or guidance would deem the transaction reportable. Where an Irish counterparty is entering into FX transactions with a counterparty located in another jurisdiction, the Irish counterparty should rely on documentation from that counterparty to inform it as to whether there is a requirement in the relevant jurisdiction to report the transaction.
- All FX transactions between two Irish counterparties with settlement between the spot date and seven days (inclusive) are not required to be reported. However, counterparties should have the capacity to report such trades (notwithstanding that there is no obligation to report) and that counterparties build a capacity to report such trades in the future.
The Central Bank has indicated that its guidance is a temporary measure and that the Q&A may be updated / superseded if there are any further developments at a European level on this topic.
(x) European Commission Response to ESMA letter setting out its Intention to Ease EMIR Frontloading Requirements
On 8 May 2014, ESMA sent a letter to the European Commission proposing to limit the scope of the frontloading requirement under EMIR.
The frontloading requirement imposes an obligation on counterparties to clear OTC derivative contracts which have been executed after a CCP has been authorised under EMIR (the first of which was authorised on 18 March 2014) and before the date of application of the clearing obligation (i.e. the date specified for the clearing obligation to apply by ESMA in the relevant regulatory technical standards).
In this way under the frontloading rules an OTC derivative contract concluded after the authorisation of a CCP might at a later date become subject to the clearing obligation before its expiration date. According to Recital 20 of EMIR, the objective of the frontloading requirement is to ensure a uniform and coherent application of EMIR and a level playing field for stakeholders when a class of OTC derivative contracts is declared subject to the clearing obligation.
This frontloading obligation has proved to be particularly controversial as many in the industry have argued that the uncertainty over which OTC contracts will become subject to the clearing obligation and the unknown duration of the frontloading period has created legal uncertainty about the status of OTC derivative contracts entered into after the CCPs are authorised and an inability to correctly price such transactions.
The period during which frontloading is relevant can be divided into two separate periods:
- Period A: the period between the notification of the classes to ESMA and the entry into force of the relevant regulatory technical standards ("RTS") on the clearing obligation; and
- Period B: the period between the entry into force of the RTS and the date of application of the clearing obligation.
In its letter, ESMA suggested that the frontloading requirement should not apply to transactions that are entered into during Period A and should only apply to transactions entered into during Period B. The determinant of whether an OTC contract entered into during Period B will be subject to the frontloading obligation is whether, as at the date of the application of the clearing obligation for that OTC derivative contract and for the counterparty in question, there is a certain minimum remaining maturity.
On 8 July 2014, ESMA received a response from the European Commission whereby the European Commission indicated its agreement with the proposals relating to frontloading which were contained in ESMA's letter of 8 May 2014.
A copy of the European Commission's letter can be found at this link; http://www.esma.europa.eu/system/files/d2392454.pdf
1. Directive 2010/78/EU introduced a sunset clause in Article 64a of MiFID I which provides that "the powers conferred on the Commission in Article 654 to adopt implementing measures that remain after the entry into force of the Lisbon Treaty on 1 December 2009 shall cease to apply on 1 December 2012".; i.e. the legal power of the European Commission to adopt implementing legislation that could clarify the definition of FX financial instruments lapsed on 1 December 2012.
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