On 4 July 2012 the EU Council formally approved the Regulation on OTC derivatives, central counterparties and trade repositories, which the European Parliament had already adopted at first reading on 29 March 2012. The Regulation, which is also known as the European Market Infrastructure Regulation or EMIR, will enter into force shortly after its forthcoming publication in the Official Journal of the EU.
EMIR will radically change the OTC derivatives landscape. Market participants will have to review and, in many cases, adapt their current OTC practices (including documentation, such as ISDA Master Agreements and collateral arrangements).
EMIR is part of the European implementation of the commitments made at the G-20 Pittsburgh summit of September 2009 with regard to over-the-counter (OTC) derivatives. In line with these commitments, EMIR aims to:
- increase transparency regarding OTC derivatives;
- reduce counterparty credit risks under OTC derivative transactions; and
- reduce operational risks in relation to those transactions.
Key features of EMIR are:
- the mandatory clearing of "eligible" OTC derivatives between certain parties through a central counterparty (CCP);
- requirements pertaining to risk management of derivatives transactions that are not centrally cleared;
- the mandatory reporting of all exchange-traded and OTC derivatives to a trade repository; and
- the authorisation, registration and recognition of CCPs and trade repositories, and their supervision.
Mandatory central clearing of OTC derivatives
OTC derivatives must be cleared through a CCP if they meet the following conditions:
- they belong to a class of derivatives that has been declared subject to the clearing obligation by the Commission, pursuant to a proposal by ESMA; and
- they have been concluded between two parties each of which
falls into one of the following categories ("qualifying
- financial counterparties such as investment firms, credit institutions (banks), insurers and reinsurers, pension funds and alternative investment funds (AIFs) managed by authorised or registered managers;
- non-financial counterparties established in the EU whose OTC derivative positions net of their commercial and treasury financing hedges exceed a clearing threshold to be set by the Commission;
- third-country (i.e. non-EU) entities that would be subject to the clearing obligation if they were established in the EU (although an OTC derivative entered into between two such third-country entities will only be subject to the clearing obligation (i) if the contract has a direct, substantial and foreseeable effect within the EU or (ii) if imposition of the clearing obligation is necessary or appropriate to prevent evasion of any EMIR provision).
Contracts subject to the clearing obligation must be cleared through an authorised EU CCP or a recognised third-country CCP.
OTC derivatives concluded between financial counterparties or non-financial counterparties that are not cleared by a CCP will become subject to a number of requirements aimed at mitigating counterparty credit risk and operational risk, including:
- timely confirmation of the terms of OTC derivative contracts;
- formalised processes of portfolio reconciliation;
- daily marking-to-market of outstanding contracts (or where market conditions prevent marking-to-market: marking-to-model);
- the timely, accurate and appropriately segregated exchange of collateral.
Non-financial counterparties will only be subject to the latter two requirements once they have exceeded a clearing threshold.
All counterparties, whether qualifying or not, and CCPs will be required to ensure that the details of all their derivative transactions, whether concluded OTC or on an exchange, are reported to a registered EU trade repository or one that is established in a third country and recognised by ESMA. (If no such registered or recognised repository is available, the transaction must be reported to ESMA.) This "reporting obligation" will apply not only when a new transaction is entered into, but also when an existing transaction is modified or terminated. Reporting must take place no later than the first working day following the conclusion, modification or termination of a contract.
Authorities such as ESMA and national supervisors will have access to transaction data recorded by trade repositories. Trade repositories will also be required to publish aggregate positions by class of derivative.
CCPs and trade repositories
An EU CCP will be required to apply for authorisation to the relevant competent authority of the Member State where it is established. In deciding whether to grant authorisation, the home-state authority must consider the views of a "college", established, managed and chaired by it, whose members also include, among others, ESMA and the competent authorities of those Member States where the activities of the applicant CCP have a significant impact (as defined in EMIR).
Third-country CCPs may be recognised by ESMA. Once recognised they may provide clearing services to clearing members and trading venues within the EU.
EU trade repositories must register with ESMA; these registrations will cover the entire EU. ESMA may also recognise third-country trade repositories if certain conditions are fulfilled.
Exceptions and exemptions
Under EMIR, exceptions and exemptions are available for certain types of derivatives and counterparties. For instance, during the initial three years after EMIR's entry into force, the clearing obligation will not apply to derivatives hedging the investment risks directly relating to the financial solvency of pension funds. Intragroup transactions will also be exempted from the clearing obligation under certain conditions.
Furthermore, as already noted above, derivative transactions of a non-financial counterparty that hedge risks relating to commercial or treasury financing activities of that counterparty are not included in calculating whether its derivative positions exceed the clearing thresholds. However, once a threshold is exceeded, all eligible OTC derivatives entered into by the relevant non-financial counterparty with other qualifying counterparties must be cleared through a CCP.
EMIR will enter into force on the twentieth day following that of its (forthcoming) publication in the Official Journal. As a regulation, EMIR will be directly applicable in all Member States and does not need to be implemented by them in their respective national laws. However, many rules, including the clearing and reporting obligations, will only become effective once the Commission has adopted delegated and implementing acts, including RTSs (regulatory technical standards) and ITSs (implementing technical standards). EMIR requires ESMA – and, in a limited number of cases, the other two European supervisory authorities (EBA and EIOPA) – to develop draft RTSs and ITSs and submit them to the Commission, in most cases by 30 September 2012. The Commission is expected to endorse those draft standards except in very restricted and extraordinary circumstances. On 25 June 2012 ESMA published an extensive consultation paper setting out the RTSs and ITSs which it is required to draft. On the basis of responses to the consultation paper (which must be submitted by 5 August 2012) ESMA will finalise the draft RTSs and ITSs and submit them to the Commission for endorsement. Market participants should be ready to comply with EMIR by the end of this year, although many of the detailed rules will probably only start to apply in the course of next year.
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.