United States: Uncertain Seas: European Financial & Regulatory Developments Into 2017

Last Updated: January 18 2017
Article by Peter Green and Jeremy C. Jennings-Mares

1. Brexit

On 23 June 2016, the UK voted in referendum to leave the EU. This outcome was generally a surprise to the financial markets and gave rise to immediate market volatility, particularly in relation to the pound, which fell heavily in value against the euro and dollar. The vote, however, has no immediate effect. The UK currently remains a member of the EU, and existing EU-derived laws and regulations continue to apply to the UK. To commence its exit from the EU, the UK government has to serve notice of its intention to leave under Article 50 of the EU Treaty. The UK then has two years to negotiate the terms of its exit with the EU. If no agreement is reached, then at the end of this period (assuming no extension is agreed), the UK will automatically leave the UK and its trading relationship with the EU will default to World Trade Organisation ("WTO") rules. The UK Prime Minister, Theresa May, has indicated her intention that the Article 50 notice be served by the end of March 2017. The UK Supreme Court is currently considering whether such notice can be served by the UK government under its Royal Prerogative or whether the approval of the UK Parliament is necessary. The Supreme Court's decision is expected in early 2017 but, whatever the outcome, it is not expected to have a major impact on the timing of service of the Article 50 notice.

There is considerable uncertainty as to the nature of the UK's relationship with the EU following its exit. In particular, it is currently unclear the extent to which the UK will seek, and the terms on which it will be able to agree, access to the EU single market for goods and services once it leaves the EU. Having regard to the importance of the financial services industry to the UK and the importance of London as an international financial centre, banks and other financial institutions are already considering carefully the potential implications of Brexit and, in many cases, seeking to consult with the UK government on the impact of the various options for the UK to leave the EU.

We will not consider in detail here the potential options for the future relationship between the UK and the EU. However, it currently seems unlikely that the UK will seek to remain in the European Economic Area ("EEA") (made up of the current 28 EU members plus Norway, Liechtenstein and Iceland). Although this option would enable the UK to retain access to the EU single market, it would continue to be bound by much existing EU law (including being bound to the free movement of people across the EEA) and continue to contribute to the EU budget, both of which were major issues for Brexit supporters. Although Theresa May has, as yet, given very little in the way of detail as to what the UK will seek from the Brexit negotiations, she has indicated the UK is likely to seek a bespoke arrangement, different from any current arrangement between the EU and any non-member state.

One of the key areas for banks and financial services firms currently located in the UK is the extent to which, following Brexit, the UK will be able to continue to benefit from the "single passport" for financial services that operates within EU member states, whereby a firm that obtains authorisation to carry out a particular financial activity or service in one EU member state can carry out that activity or service in other member states without further authorisation. In reality, there is no single EU passport for financial services, but the matter is dealt with separately in relation to each piece of relevant legislation.

Assuming the UK will not remain in the EEA, it seems unlikely that it will be able to maintain its current position in relation to passporting. There are, however, other options that could be sought in the Brexit negotiations. Many pieces of relevant EU financial services legislation enable firms located in non-EU jurisdictions to perform relevant services and activities, often on a pan-European basis, where the EU Commission has determined regulation in the entity's home jurisdiction to be equivalent to relevant rules in the EU. Although such determinations have so far taken considerable time, the UK is in a unique position since, as at the immediate point of exit, EU law will form part of UK law and therefore be, as a matter of fact, equivalent. It should not be controversial for the UK to maintain the bulk of EU financial regulation then in force as much of it derives from international accords and G20 agreements, and the UK has had an important role in the development of much existing EU law in this regard. However, not every piece of EU financial regulation includes equivalence arrangements, including legislation relating to the provision of financial services to retail investors and new proposed rules relating to securitisation.

Having regard to their importance to the UK economy, the regulation of financial services is expected to form a central element of the negotiations with the EU. Other free trade agreements entered into by the EU, including with Canada and South Korea, took many years to negotiate and did not cover financial services in any detail, so it seems unlikely that a comprehensive arrangement can be reached between the EU and the UK in two years. An interim arrangement where the EU Commission provides an immediate equivalence determination where it can, and transitional arrangements are agreed in other fundamental areas, is more realistic. Many banks and financial institutions have already sought to persuade the UK government of the benefit of interim arrangements of this nature and in December 2016, the Chancellor of the Exchequer, Phillip Hammond, indicated that such an arrangement made sense. The issue is, however, politically sensitive, and many Brexit supporters are pushing for a "clean break" from the EU at an early stage.

It remains unclear how much transparency the UK government will be prepared to give in advance of serving the Article 50 notice as to what relationship it will seek with the EU after Brexit. It is equally unclear to what extent and on what terms the rest of EU will be prepared to negotiate continued access for the UK to the EU single market. The position is not helped by the fact that the French presidential election and German parliamentary election (amongst other elections in EU member states) will take place during 2017 and the outcome of these elections will undoubtedly have an impact on the dynamics of the Brexit negotiations.

2. EMIR Implementation

The European Market Infrastructure Regulation ("EMIR")1 regulating derivatives transactions in the EU entered into force on 16 August 2012. However, much of the relevant rule-making under EMIR needs to be introduced by technical standards through delegated legislation. Although this process is well under way, some aspects of EMIR are still in the process of being introduced and this will continue into 2017 and beyond. Two areas in particular that are still not or are only just in the process of being implemented are the provisions for mandatory clearing of derivatives and the margining requirements for OTC derivative transactions that are not subject to central clearing.


One of the central limbs of EMIR is the requirement for mandatory central clearing for derivatives entered into by financial counterparties and certain significant non-financial counterparties ("NFCs+"), subject to the European Securities and Markets Authority ("ESMA") mandating that a particular class of derivative should be subject to such requirement. The first regulatory technical standards ("RTS") on clearing interest rate swaps2 provide for mandatory clearing of the following:

  • fixed-to-floating (plain vanilla) swaps denominated in Euro, GBP, JPY and USD;
  • float-to-float (basis) swaps denominated in Euro, GBP, JPY and USD;
  • forward rate agreements denominated in Euro, GBP and USD; and
  • overnight index swaps denominated in Euro, GBP and USD. The RTS divide market participants into categories in order to ensure the most active market participants are required to clear first, and Category 1 and 2 counterparties became subject to the obligation during 2016. The phase-in schedule is as follows:
  • 21 June 2016 - Category 1: counterparties that are clearing members of an authorised CCP.
  • 21 December 2016 - Category 2: financial counterparties and alternative investment funds ("AIFs") that belong to a group that exceeds a threshold of EUR 8 billion aggregate month end average outstanding gross notional amount of non-centrally cleared derivatives.
  • 21 June 2017 - Category 3: financial counterparties and other AIFs with a level of activity in uncleared derivatives below the threshold of EUR 8 billion aggregate month-end average outstanding gross notional amount of non-centrally cleared derivatives.
  • 21 December 2018 - Category 4: non-financial counterparties above the clearing threshold.

Pursuant to further RTS3 relating to the clearing of interest rate swaps, mandatory clearing will apply from 9 February 2017 for Category 1 counterparties in respect of fixed-to-floating rate interest rate swaps and forward rate agreements denominated in Norwegian krone, Swedish krona and Polish zloty. Category 2 counterparties will be subject to mandatory clearing in respect of such transactions from 9 August 2017, category 3 counterparties from 9 February 2018 and category 4 counterparties from 9 August 2019.

Mandatory clearing of certain credit default swap ("CDS") transactions will also commence in 2017, pursuant to further RTS4. The obligation will apply to untranched index CDS referencing the iTraxx Main and ITraxx Crossover indices with a tenor of five years from 9 February 2017 in respect of Category 1 counterparties. Category 2 counterparties will be subject to mandatory clearing in respect of such transactions from 9 August 2017, category 3 counterparties from 9 February 2018 and category 4 counterparties from 9 August 2019.

An ESMA Consultation Paper5 published in July 2016 considers whether the implementation date for the clearing obligation in respect of financial counterparties in category 3 should be delayed by up to two years for all classes of derivatives above in view of difficulties such counterparties are having in establishing the necessary clearing arrangements. ESMA is likely to revert on this issue during 2017. ESMA confirmed back in 2015 that, for the time being, the clearing obligation will not apply to foreign exchange derivatives. There are also no current proposals to extend the obligation to any classes of equity or commodity derivatives. It is however possible that these areas will be reviewed further in the future.

Risk Mitigation – Collateral

Article 11(3) of EMIR requires financial counterparties to adopt procedures with respect to the timely, accurate and appropriately segregated exchange of collateral with respect to non-cleared derivatives. The European Supervisory Authorities ("ESAs") (being ESMA, the European Banking Authority ("EBA") and the European Insurance and Occupational Pensions Authority ("EIOPA")) are required to develop RTS as to the necessary procedures, levels and type of collateral and segregation arrangements. In April 2014, the ESAs published their first joint consultation on draft RTS6 and their second Consultation Paper on draft RTS7 was published in June 2015, which, among other provisions, prescribed the regulatory amount of initial and variation margin to be posted and collected, and the methodologies by which that minimum amount would be calculated.

Following a somewhat protracted process, the EU Commission adopted a final draft text of relevant RTS8 (the "Risk Mitigation RTS") on 4 October 2016. The Risk Mitigation RTS only directly affect financial counterparties and NFCs+ that are established in the EU. However, non-EU entities that trade with EU entities that are subject to the margin requirements are likely to be obliged to put collateralisation procedures in place in order to allow their EU-established counterparties to comply with EMIR. The Risk Mitigation RTS require the posting of Initial Margin ("IM") and Variation Margin ("VM"). They also set out the eligibility criteria for assets that may be used as collateral, designed to ensure that the collateral is sufficiently liquid, not exposed to excessive credit, market or FX risk, and it holds its value during times of financial stress.

Collateral collected as IM must be segregated from the other assets of the third party or custodian that is holding it. Counterparties that collect IM are forbidden from re-hypothecating, re-pledging or otherwise re-using the collateral. There are some exemptions from the collateral requirements for transactions below certain financial thresholds and intragroup transactions complying with specified criteria. The Risk Mitigation RTS came into force on 4 January 2017. However, only the largest market participants (those trading non-centrally cleared derivatives in excess of €3trn in aggregate notional amount) will initially be subject to the rules. By September 2020, all in-scope entities trading such derivatives in excess of €8bn will be subject to the requirements.

Other aspects of EMIR and the EC Commission Report

Other provisions of EMIR that had been largely implemented prior to 2016 included trade reporting requirements for all counterparties (including non-financial counterparties ("NFCs") to derivative transactions and risk mitigation measures (other than margining) in respect of uncleared derivatives. On 23 November 2016, the EU Commission published a Report9 to the European Parliament and the EU Council of Ministers that recommended a number of changes in relation to EMIR.

In particular, the Report notes that NFCs are, due to limited resources and experience, facing significant challenges in complying with relevant provisions of EMIR, and it is considered that it may be appropriate to remove such entities from the scope of the operational risk mitigation requirements and to simplify their transaction reporting obligations. The Report also recommends that consideration be given as to whether the clearing and margining requirements should apply to any NFCs based on the volume and type of their activity in derivatives markets. The EU Commission also recognises that small financial counterparties are facing significant challenges in establishing access to clearing facilitates in meeting their obligations to clear relevant derivatives. As mentioned above, ESMA has already proposed postponing the date on which the clearing obligation applies to such entities. ESMA also notes in the Report that certain pension funds currently benefit from an exemption from the EMIR clearing requirements – the EU Commission has indicated that it is likely to extend this exemption until August 2018 due to the difficulty such funds would have in meeting variation margin requirements. ESMA suggests further extending this exemption or making it permanent. Following on from this Report, the EU Commission will undertake a legislative review of EMIR in 2017 that will consider the issues raised in more depth and possibly propose relevant amendments to EMIR.

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1 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32012R0648&from=EN

2 Commission Delegated Regulation (EU) 2015/2205, http://eur-lex.europa.eu/legal-content/EN/TXT/?uri=CELEX:32015R2205.

3 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R1178&from=EN

4 http://eur-lex.europa.eu/legal-content/EN/TXT/PDF/?uri=CELEX:32016R0592&from=EN

5 https://www.esma.europa.eu/sites/default/files/library/2016-1125_cp_on_clearing_obligation_for_financial_counterparties.pdf


7 http://www.eba.europa.eu/documents/10180/1106136/JC-CP-2015-002+JC+CP+on+Risk+Management+Techniques+for+OTC+derivatives+.pdf

8 https://ec.europa.eu/transparency/regdoc/rep/3/2016/EN/3-2016-6329-EN-F1-1.PDF

9 http://ec.europa.eu/finance/financial-markets/docs/derivatives/161123-report_en.pdf

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

© Morrison & Foerster LLP. All rights reserved

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Peter Green
Jeremy C. Jennings-Mares
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