UK: Reform Of OTC Derivatives – Overview Of The Changes Ahead

Last Updated: 25 August 2011
Article by James Cooper, Dianne Bell, Adam Blair and Rupert Connell

Deficiencies in the European derivatives markets are to be tackled under a proposed regulation known as the European Market Infrastructure Regulation (the EMIR). This draft regulation was published by the European Commission in September 2010 and aims to increase transparency and reduce counterparty risk (ie, the risk of default by one party to the contract) in the over-the-counter (OTC) derivatives markets. It also implements commitments made in 2009 by the G20 leaders that all standardised OTC derivatives should be cleared through central counterparties by the end of 2012 and that such arrangements should also be reported to trade repositories.

Standardisation implies a set of fixed parameters that define a product or contract in a manner that will support the trading interests of multiple market participants and enables, for example, trade matching and offsetting. Determining the level of standardisation can involve a number of factors such as legal standardisation (uniformity of contracts), operational standardisation (common trade processing and procedures) and market liquidity.

An amended version of EMIR was recently approved by the EU Parliament's Economic and Monetary Affairs Committee, but debate still continues in the Council of the European Union (the Council) on certain key elements ahead of reaching agreement on its own position and set of amendments. The rules themselves are unlikely to be finalised until autumn 2011. Globally, the new rules on OTC derivatives need to be implemented by the end of 2012 in order to meet the G20 agreed timetable.

Controversy has surrounded the negotiations over EMIR and the matters it seeks to regulate. A number of political issues and other contentious issues remain with the latest draft proposals. This briefing note provides a broad overview of the proposed changes and is the first in a series of briefing notes that will subsequently focus on the different aspects of EMIR and how it will affect European and national regulators and certain participants.


The aim of the proposed regulation is to lay down uniform requirements for OTC derivative contracts, and for the performance of central counterparties (CPPs) and trade repositories. It is designed to address the four objectives raised by the Commission in its 2009 communication "Ensuring Efficient, Safe and Sound Derivatives Markets" made in reflection upon the financial crisis, namely to:

  • allow regulators and supervisors to have full knowledge about the transactions that take place in OTC derivatives markets as well as the positions that are building in those markets;
  • increase the transparency of OTC derivatives markets for their users, in particular, more and better information about prices and volumes should be available;
  • strengthen the operational efficiency of derivatives markets so as to ensure that OTC derivatives do not harm financial stability; and
  • mitigate counterparty risks and promote centralised structures.

EMIR is also one part of a broader initiative to regulate markets that is underway and involving MiFID, CRD IV and CSDs. Many parts of EMIR overlap with matters falling under the scope of MiFID (eg, transaction reporting issues) and will, therefore, depend upon the outcome of the MiFID II Review.

What activities does EMIR regulate?_

Four distinct sections or areas of regulation are covered under EMIR.

Clearing, reporting and risk mitigation of OTC derivatives

The Commission's aim is to bring in as many contracts as possible within the mandatory clearing regime. EMIR will require all "eligible" OTC derivative contracts that are entered into by financial counterparties to be cleared through a CCP. It will set out the process for determining whether a contract is "eligible" for mandatory clearing. There will also be a public register maintained and updated by the European Securities and Markets Authority (ESMA) containing "eligible" classes of derivatives and the CCPs authorised to clear them.

Certain details of OTC derivative transactions must also be reported to registered trade repositories (this will, broadly speaking, include details such as the parties, beneficiaries and main characteristics of the contract). The Commission hopes that such information will be easily accessible to ESMA, national regulators and central banks and will thus generate a greater sense of transparency and a reduction of risk in the OTC derivatives markets.

Different EMIR rules will apply to OTC derivative contracts that are not subject to mandatory clearing by a CCP (eg, nonstandardised or illiquid OTC derivative contracts). In these circumstances, financial counterparties (and some non-financial ones) must meet EMIR's provisions relating to risk mitigation. These involve onerous requirements which are designed to manage operational and credit risk.

Authorisation, supervision and Requirements for CCPs

Once EMIR comes into effect, CCPs will play a central role in the derivatives market and their regulation and supervision will be of critical importance. The provisions define a CCP as any entity that legally interposes itself between the counterparties to the contracts traded within one or more financial markets, becoming the buyer to every seller and the seller to every buyer. CCPs will be used to meet the clearing obligation and must be authorised in their home Member State. In order to be authorised, they must have access to adequate liquidity and will be subject to minimum capital requirements (currently set at EUR5 million under the EMIR). CCPs will also be subject to various organisational requirements, conduct of business rules and prudential requirements, which include having clear and transparent organisational structures; robust governance arrangements and being subject to frequent and independent audits.


EMIR contains provisions to enhance cooperation agreements (known as "interoperability") between clearing houses. Such an arrangement is defined in EMIR as an arrangement between two or more CCPs that involves a cross-system of transactions. The interoperability provisions are limited to cash securities. Under the current draft, CCPs can only enter into interoperability arrangements where certain risk management and approval requirements are met (eg, it has functioned in line with the standards for at least three years before it can apply for authorisation for interoperability).

Registration and surveillance of trade Repositories

A trade repository is an entity that centrally collects and maintains the records of OTC derivatives. These bodies must apply to, and be registered with, ESMA. They will be subject to similar general requirements to those of CCPs, ie, concerning clear organisational structures and suitable senior management systems and controls. The trade repositories will be required to publish aggregate positions by class of derivatives on the contracts reported to it. This information will be made available to EMSA, regulators and central banks.

Once registration with ESMA has been obtained, it will be effective for the EU. Third country trade repositories will be required, under EMIR, to seek recognition from ESMA and meet certain equivalence conditions.

What instruments does EMIR Apply to?

EMIR covers all areas of the OTC derivatives market, including equity, credit, interest rate, and most foreign exchange and commodities contracts. The Commission did not believe there was strong evidence to justify a blanket exclusion of any particular instrument from the scope of the proposals, so the scope is broad. All categories of OTC derivative contracts as set out in Annex 1 Section C of MiFID are covered by EMIR.

"Eligibility" – two processes

1 "Bottom-up" approach: a decision is made by a CCP to clear and it obtains authorisation to do so after informing its regulator. ESMA can then (after a public consultation) decide a clearing obligation should apply at all those contracts in the EU.

2 "Top-down" approach: classes of OTC derivatives contracts can be identified by ESMA (with the European Systemic Risk Board) at any time for inclusion on the public register.

There is no definition of the classes of derivatives that will be subject to the mandatory clearing provisions. Instead, and as mentioned above, EMIR sets out a process for determining whether a contract is "eligible" and therefore caught by the clearing obligation.

Which participants are covered by EMIR?

EMIR applies to financial counterparties and non-financial counterparties (as set out below) whose dealings with OTC derivatives exceed certain thresholds. It does not apply to European central banks, public bodies charged with or intervening in the management of public debt and multilateral development banks.

Financial counterparties

A broad definition of a "financial counterparty" is given in EMIR which covers the following institutions:

  • investment firms;
  • credit institutions;
  • insurance undertakings;
  • assurance undertakings;
  • reinsurance undertakings;
  • UCITS funds;
  • institutions for occupational retirement provision; and
  • alternative investment funds.

Non-financial counterparties

For non-financial counterparties, the scope of this widely framed requirement for CCP clearing has been narrowed. Any EU established undertaking that is not regarded as a "financial counterparty" will be subject to certain requirements under EMIR as a "non-financial counterparty". Where a contract is otherwise deemed eligible, nonfinancial counterparties will only be covered by EMIR where certain thresholds (to be determined later and in the form of technical standards) are exceeded:

  • A non-financial counterparty will only be required to clear trades if it takes positions in the OTC derivatives market that exceed a specified "clearing threshold". The concept of the clearing threshold is intended to assist those non-financial counterparties who use OTC derivative contracts to protect themselves against commercial risks directly linked to their commercial activities. EMIR excludes contracts that are "objectively measurable" as directly linked to the commercial activity of the non-financial counterparty.
  • Even where a non-financial counterparty is not caught within the scope of the clearing threshold, it may still be subject to EMIR's reporting obligation. This obligation will arise where the "information threshold" has been exceeded and will require the reporting of trades to trade repositories. This will enable regulators to identify where non-financials have accumulated significant positions within the OTC derivatives market.

Precise details of both these thresholds are not contained in EMIR. They will be set out in the form of technical standards which ESMA will develop in 2012.

Will EMIR operate retrospectively?

EMIR is not expected to have retrospective effect, but it is likely to impact all those OTC derivatives contracts that ESMA declares to be "eligible", which could mean that all those contracts entered into after EMIR itself came into force would need to be cleared and reported.

What is the status of EMIR now?_

The creation of a European regulatory regime for OTC derivatives has been a highly challenging task. As at the end of the Hungarian Presidency of the Council on 20 June 2011, EMIR continues to raise a number of political landmines and contentious regulatory issues that cannot be resolved until the political issues have settled. The major outstanding issues appear to be:

  • ESMA powers: the role of ESMA, including the process around the authorisation and registration of CCPs.
  • Scope: whether or not the scope of the clearing and reporting obligations should apply to all derivative contracts or just OTC contracts. There are sharply different views on this issue and the extent to which there should be exemptions by type of participant (eg, pension funds) and by asset class (eg, FX).
  • Third country provisions: concerning the recognition of third country CCPS (and the effort to mirror similar US provisions).

EMIR was originally expected to be adopted by the European Parliament at its plenary sitting scheduled for 5 July 2011, but this was postponed until autumn 2011 due to Member States' failure to agree on which derivatives contracts ought to be covered. Once the Council reaches an agreement on its set of amendments, the final EMIR text will be resolved. EMIR is subject to the EU's standard legislative "co-decision" procedure which involves approval by both the European Parliament and the Council. It is hoped that the vote which will take place in the autumn (likely sometime in September 2011) will result in agreement on the text and avoid the need to move to the second reading stage.


EMIR involves a radical shake-up of the OTC derivatives market and creates a number of new obligations and processes. The obligation to centrally clear OTC derivatives contracts is likely to lead to higher costs and more stringent collateral requirements for derivatives traders. Many financial institutions will already be subject to various pressures by the other structural and substantive financial regulatory reforms due for implementation at both the national and European-wide level.

Many fundamental aspects of the legislation remain unclear, creating uncertainty for special interest groups, including pension schemes, real estate investors and private equity funds.

It will be important for firms operating in this area to maintain a watching brief as EMIR progresses towards finalisation. As mentioned above, we plan to release further briefing notes on specific topics of interest arising under the EMIR proposals and plans for the regulation of OTC derivative contracts.

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.

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