As a Regulation, EMIR will be directly effective in all member states without the need for any national legislation. However, under the four-stage process by which EU financial legislation is made, EMIR is only a ‘framework’, and lacks much technical detail.
Instead, it requires the European Securities & Markets Authority (‘ESMA’) to develop “regulatory technical standards” (‘RTS’) on various points, and then provide them to the EC, who will implement them as directly effective secondary legislation.
The deadline for ESMA to develop these is 30 September 2012. A set of draft RTS were published by ESMA on 25 June and final RTS on 27 September. The deadline set by the G20 for implementing EMIR is the end of 2012.
This report comprises a short summary of the clearing obligation that is the central part of EMIR; some of the main debates over the Regulation, including amendments adopted and rejected; and a detailed breakdown of the contents of the published legislation.
The Clearing Obligation
EMIR implements new requirements for the clearing of OTC derivatives that were agreed by the G20 in 2009 in Pittsburgh:
All standardised OTC derivatives contracts should be […] cleared through central counterparties by end-2012 at latest. OTC derivatives contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.
EMIR requires that some (but not all) OTC derivatives contracts must be cleared through central counterparties (‘CCPs’). Contracts that are not cleared through a CCP will be made subject to increased collateral requirements and other safeguards.
EMIR also includes various prudential and administrative requirements for CCPs, as well as a new reporting requirement for OTC derivatives contracts.
What will the clearing obligation apply to?
The classes of OTC derivative contract to which the clearing obligation shall apply will be decided either:
- by ESMA, after considering the classes of contract that national regulators have authorised CCPs to clear, and deciding in some of these cases to make clearing mandatory for such contracts; or
- by ESMA acting on its own initiative (subject to consultation).
These are known as the ‘bottom-up’ and ‘top-down’ approaches, respectively.
Who will the clearing obligation apply to?
EMIR will apply to
- financial counterparties; and
- non-financial counterparties – i.e. everyone else – who hold large positions in OTC derivatives (other than those OTC derivatives entered into for hedging purposes).
There are certain exemptions for public bodies, pension funds, and intra-group transactions.
As cited above, the impetus for EMIR was the 2009 agreement of the G20 on OTC derivatives. The working party of the Council of the European Union had at one point suggested that the clearing obligation be extended to cover all derivatives, but unsurprisingly this did not make it into the final Regulation.
The European Parliament’s Economic and Monetary Affairs Committee (‘ECON’) had suggested a “narrowly-defined” derogation for UCITS that carry out only low-volume derivatives transactions, exempting them from the EMIR requirements. This was not accepted, however.
Credit Default Swaps
The Report of the European Economic and Social Committee (‘EESC’) on EMIR described Credit Default Swaps (‘CDSs’) as “a potential mortal danger to the world financial system” – and warned the EC not to overestimate the benefits that CCPs could bring to CDS markets. Nevertheless, neither the final version of EMIR, or the draft ESMA technical standards of 25 June makes any specific provision for CDSs.
SMEs/SMUs De Minimis Exemptions
ECON had also suggested “sector-specific clearing thresholds” for small-to-medum-sized undertakings (‘SMUs’), with a view to exempting some of these from the clearing obligation, as well as a de minimis rule with regard to the reporting obligation. Neither appear in the final version of EMIR: there is a single clearing threshold for non-financial counterparties, and all financial counterparties are automatically subject to the clearing obligation. There appear to be no exemptions from the “comprehensive reporting requirement”, either in EMIR itself, or in the draft regulatory technical standards on reportingprepared by ESMA. The reporting requirement will therefore apply to all counterparties (undefined in EMIR, but defined by ESMA in the draft regulatory technical standards as both financial and non-financial counterparties; i.e. all undertakings.)
Reporting Obligation for Non-Financial Counterparties
The original EC proposal for EMIR had required that non-financial counterparties should only report OTC derivatives transactions above a certain level – an ‘information threshold’ for the reporting obligation analogous to the ‘clearing threshold’ for the clearing obligation. ECON proposed that, subject to the de minimis rule above, the reporting obligation for non-financial counterparties should apply to all derivatives trades, rather than just those above the information threshold. The information threshold was subsequently abandoned in the final version of EMIR.
Clearing Threshold for Non-Financial Counterparties
The original EC proposal had stated that non-financial counterparties would become subject to the clearing obligation immediately after exceeding the clearing threshold. ECON proposed, instead, that the obligation should only apply if the threshold had been exceeded on 90 consecutive days, and that subsequently firms should have six months in which to meet their new clearing obligations. In the final text, a 30-day rolling average is used, and a period of four months is allowed.
Arts. 1-3: Scope and Definitions
‘Financial counterparties’ are defined as:
- investment firms authorised under MiFID;
- credit institutions authorised under CRD;
- insurance undertakings authorised under the First Non-Life Directive;
- assurance undertakings authorised under the Consolidated Life Directive;
- reinsurance undertakings authorised under the Reinsurance Directive;
- UCITS authorised under UCITS;
- IORPS authorised under IORPS; and
- Alternative Investment Funds authorised under AIFMD.
All other undertakings are ‘non-financial counterparties’.
Various public bodies are excluded from the clearing obligation (but not the reporting obligation), as are certain arrangements concerning pensions (see ‘Implementation and Transitional Provisions etc.’ below).
Art. 4: Establishing the Clearing Obligation
The clearing obligation will apply to certain types of OTC derivatives contracts (as further described below) entered into:
- between two financial counterparties; or
- between one financial and one non-financial counterparty, where the latter has exceeded the threshold limit; or
- between two non-financial counterparties, both of which have exceeded the threshold limit; or
- between a financial counterparty (or non-financial counterparty over the threshold) and a third country party that would have been subject to the obligation were it based in the EU; or
- between two such third country parties, provided that the contract “has a direct, substantial and foreseeable effect” within the EU. This is in part an anti-avoidance measure, and will be elaborated upon by ESMA in subsequent legislation.
If the clearing obligation applies to a contract - because it concerns a type of OTC derivative covered by the Regulation, and because both parties fall within one of the categories above – then the contract must be cleared through a CCP.
In this case both counterparties must either:
- become a clearing member of a CCP;
- become the client of a clearing member; or
- establish indirect clearing arrangements.
Intragroup transactions are mostly exempt from the clearing obligation (subject to certain notification, risk management and third country provisions in Art. 3).
Arts. 5-6: The Procedure for Applying the Clearing Obligation to Classes of Derivatives
This establishes both the ‘top-down’ and ‘bottom-up’ procedures for recommending derivatives for central clearing which are described above.
Article 5 also provides ESMA with a set of criteria to consider when deciding whether or not to apply the clearing obligation to a given class of derivatives (“with the overarching aim of reducing systemic risk”), and requires them to produce secondary legislation elaborating on these criteria.
The details as to which derivatives are subject to the clearing obligation will be kept in a register run by ESMA.
Arts. 7-8: Access to CCPs for Trading Venues, and to Trading Venues for CCPs
In order to avoid any “market distortion” caused by the new CCP clearing requirement (e.g. an unfair advantage for CCPs already linked with trading venues), EMIR includes a requirement that CCPs must accept clearing contracts from trading venues (and trading venues must provide trade feeds to CCPs) on a non-discriminatory and transparent basis.
Art. 9: Establishing the Reporting Obligation
Both CCPs and the counterparties themselves must report the details of any derivatives contract (including any modifications or terminations of that contract) to a trade repository as soon as possible, and no later than the next working day. In the absence of a trade repository these must be reported to ESMA. Reporting may be delegated. This reporting requirement applies to all derivatives contracts that were entered into, or remained outstanding, on or after 16 August 2012, and supersedes any contractual restrictions on disclosure of information.
ESMA’s regulatory technical standards will set out the precise details to be reported.
Art. 10: Threshold Limit for Non-Financial Counterparties
This establishes that non-financial counterparties will be subject to any clearing obligation stated to apply in respect of an OTC derivative contract if their 30-day rolling average position in such OTC derivative contracts exceeds a certain threshold. Derivatives contracts entered into for the direct purpose of hedging such counterparties’ commercial or treasury financing risks do not count towards the relevant threshold limit.
Once the clearing obligation applies to a non-financial counterparty it has four months in which to begin clearing all future contracts.
If a non-financial counterparty can demonstrate to the national regulator that its 30-day rolling average position in OTC derivatives no longer exceeds the clearing threshold, they will be thereafter excused from the clearing obligation.
This article does not specify the precise threshold figure, but rather asks ESMA to establish this in regulatory technical standards.
Art. 11: Additional Requirements and Safeguards for Non-CCP Cleared OTC Derivatives
Financial and non-financial counterparties entering into OTC derivative contracts that aren’t cleared through a CCP must exercise due diligence to ensure that:
- appropriate procedures and arrangements are put into place to measure, monitor and mitigate operational and counterparty credit risk;
- the terms of the relevant contract are confirmed in timely fashion, and by electronic means if possible;
- processes for reconciling portfolios, managing risks, monitoring the value of contracts and identifying disputes between parties are formalised;
- contracts are marked-to-market on a daily basis (where market conditions allow);
- they have risk management procedures that require timely, accurate and appropriately segregated exchange of collateral; and
- they hold an appropriate and proportionate amount of capital to manage the risk not covered by exchange of collateral.
These requirements will also apply to OTC derivative contracts between third country entities that would have been subject to the above requirement if they were based in the EU, provided that the contract “has a direct, substantial and foreseeable effect” within the EU, or else is necessary to prevent evasion of the Regulation.
Requirements are lessened for intragroup transactions.
ESMA will provide further detail for this section in subsequent legislation.
Art. 12: Penalties
Member states are required to institute penalties for breaching of the rules. These must include “at least administrative fines”, and all punishments should be made public, if possible. Infringement of the rules will not affect the validity of any contract for OTC derivatives, or allow any party to a contract the right to claim compensation from another.
Art. 13: Administrative Powers for Declaring Third Country Equivalence
Arts. 14-54: Rules for Central Counterparties
Most of EMIR is taken up with detailed rules for the authorisation and management of CCPs.
Arts. 55-82: Rules for Trade Repositories
ESMA has extensive powers to request information from trade repositories, and to levy fines (and other punishments) on them for non-compliance.
Art. 83-91: Obligations on ESMA and National Regulators; Implementation and Transitional Provisions etc.
The EC will review the effectiveness of EMIR by 17 August 2014.
For three years after EMIR enters into force (i.e. until 16 August 2015) pension schemes entering into OTC derivatives contracts with the aim of reducing investment risks relating to the solvency of their arrangements will be exempted from the clearing obligation. The exemption will also apply to entities which provide compensation to members of pension schemes in case of default. (The additional requirements and safeguards for non-CCP cleared OTC derivatives will still apply to these contracts, however.)