Almost two years after draft legislation on over-the-counter
("OTC") derivatives was proposed by the European
Commission and following extensive discussions during the trilogue
negotiations between the European bodies, the European Market
Infrastructure Regulation ("EMIR") will come into
force on 16 August 2012. As an EU regulation, it has direct
effect in EU member states and no national measures are required to
implement its requirements.
However, there are a significant number of implementing measures
required under EMIR before all of its key requirements become fully
operative. Given the extent of the implications for asset
managers who use derivatives in their portfolios, parties to OTC
derivatives contracts should begin to consider those implications
now to assess what changes may be required to their business
models.
Background
EMIR seeks to enact in European legislation the G20 commitments
made in the wake of the financial crisis which included mandatory
clearing of all standardised OTC derivatives contracts, improving
transparency in the derivatives markets by requiring the reporting
of all OTC derivative contracts to trade repositories and the
imposition of new risk mitigation obligations, including new
collateral and capital obligations, in respect of those derivatives
contracts which are not cleared.
Similar legislation, in the form of Title VII of the Dodd-Frank
Wall Street Reform and Consumer Protection Act (the
"Dodd-Frank Act"), has been introduced in the USA and a
regulatory rule-making process is required before it is fully
operational.
Transparency
The objective of the reporting obligation is to give regulators
an understanding of the derivatives market and to assess risks
relating to those markets. Reports, which will have to
contain details of all derivatives contracts traded (whether OTC or
exchange-traded), will have to be made to approved trade
repositories, as opposed to regulators themselves, and it will be
the trade repositories who will feed information to
regulators. The European Securities Market Authority
("ESMA") will be responsible for the surveillance of
trade repositories and for granting / withdrawing their
registration.
EMIR provides that the reporting obligation shall apply to
derivatives contracts which were entered into before 16 August 2012
and remain outstanding on that date; or are entered into on or
after 16 August 2012. ESMA has yet to register any trade
repository and it has not finalised the precise reporting template
but when these are finalised affected firms will be expected to
back-report trades from this August start date. According to
ESMA's June 2012 consultation paper on draft technical
standards for EMIR, the reporting obligation is expected to come
into effect on 1 July 2013, or if no trade repository has been
registered for a particular type of derivatives contract on 1 May
2013, 60 days after the registration of such a trade repository in
respect of that type of derivatives contract.
The reporting obligation is stated to apply to counterparties and
central counterparties. Whether this obligation applies to
the investment fund itself or the investment manager will depend on
the legal structures in place and these will have to be examined on
a case-by-case basis. It may be necessary to review the
contractual relationship between the fund and the investment
manager to address the reporting requirements under EMIR.
Clearing obligation
EMIR also requires counterparties to clear all OTC derivatives
contracts in a class of OTC derivatives that has been declared
subject to the clearing obligation. The relevant classes are
to be determined by regulatory technical standards drafted by ESMA
and ESMA has suggested that the clearing obligation is unlikely to
be applied before the summer of 2013.
Uncleared trades
Where OTC derivatives contracts are not cleared counterparties
will be required to "measure, monitor and mitigate operational
risk and counterparty and credit risk". This must
include at least timely confirmation, where available, by
electronic means, of the terms of the OTC derivatives contract and
"robust, resilient and auditable" processes to reconcile
portfolios and manage associated risk. This will involve OTC
derivatives contracts being marked-to-market daily and the exchange
of collateral or the holding of a proportionate amount of
capital.
Although these requirements apply from 16 August, the European
Supervisory Authorities ("ESAs") must draft regulatory
and technical standards on risk mitigation techniques for uncleared
OTC derivatives before these obligations can be effectively
implemented and these standards will need to be approved by the
European Commission. The ESAs and the Commission recently
agreed to extend the original 20 September 2012 deadline to ensure
that the European rules are consistent with the ongoing global
development of international standards which are expected to be
delivered by the end of 2012.
Comment
Significant operational challenges face asset managers in
implementing these new requirements. These challenges will in
some cases be complicated by overlaps and potential conflicts
between EMIR and the Dodd-Frank Act, depending on the residence of
the counterparties. Although the operation of EMIR will be
phased in, given the extent of the potential implications for asset
managers, the EMIR requirements ought to be considered as early as
possible.
Please get in touch with your usual Asset Management and
Investment Funds Group contact or any of the contacts listed in
this publication should you require further information or legal
advice in relation to the matters referred to in this update.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.