A summary of the proposed changes to EMIR that are expected to come into effect towards the end of 2018.
What is the EMIR REFIT?
Between May and August 2015, the European Commission carried out an extensive assessment of the European Market Infrastructure Regulation (EMIR). The review resulted in a report published in November 2016, in which the European Commission concluded that, although there was no need for a fundamental change to the nature of the core requirements in EMIR, the legislation imposed disproportionate burdens and overly complex requirements on non-financial counterparties, small financial counterparties and pension funds.
As a result, EMIR was included within the European Commission’s 2016 Regulatory Fitness and Performance (REFIT) programme which resulted, in May 2017, in a proposal from the European Commission (the Commission Proposal) for a Regulation amending EMIR (the Amendment Regulation) to address the issues it had identified. In June 2017, the European Commission adopted a separate proposal to amend EMIR in relation to authorisation and recognition of CCPs. This separate proposal was itself subsequently amended by the European Commission in September 2017. This Article will focus on the first proposal.
What is the current status of the EMIR REFIT?
In December 2017, the Council of the EU (the Council) published a political agreement on the Commission Proposal, which formed the basis for negotiations with the European Parliament. In January 2018, the rapporteur to the ECON Committee in the European Parliament published a draft report on the proposal which has since been the subject of ongoing debate within the ECON committee. Once the ECON Committee has adopted the draft report (expected to be in May), the proposal will be considered by the European Parliament in a plenary session. Once the European Parliament has adopted a first reading position, it is expected that trilogue negotiations will start in an effort to reach agreement among the three EU institutions on the final text of the Amendment Regulation.
Although there appears to be some ambition to finalise the legislative process before the end of summer 2018, it is more likely that the Amendment Regulation will enter into force in late Q3 2018 or early Q4 2018.
What are the proposed changes to EMIR?
As the trilogue negotiations have not yet been concluded, there remains uncertainty in respect of some of the proposed changes to EMIR. Indeed, there are significant differences on some points between the written proposals from each of the three EU institutions. We highlight below the key changes that are being proposed to EMIR.
Definition of financial counterparty
The Commission Proposal suggested expanding the definition of financial counterparty (FC) to capture all alternative investment funds (AIFs), rather than, as currently, only AIFs with an authorised or registered alternative investment fund manager (AIFM). This would have meant that even non-EU AIFs with a non-EU AIFM would have been reclassified as FCs and become directly subject to EMIR. Fortunately, both the Council and the draft ECON report have since sought to narrow this expansion so that the new definition of financial counterparty would now capture EU AIFs (irrespective of the location of the AIFM) and, as under the current definition, AIFs (irrespective of location) with an authorised or registered AIFM.
The Commission Proposal also suggested including securitisation special purpose vehicles in the definition of financial counterparty. Following comment and lobbying from the industry, this has been removed by both the Council and the draft ECON report.
Small financial counterparty
The Commission Proposal, supported by both the Council and the draft ECON report, is to introduce a new concept of a “small financial counterparty” (SFC). An SFC would be exempted from the clearing obligation but, critically, would remain subject to the risk mitigation obligations, including the margin requirements.
The determination for whether an entity is an FC or an SFC would be made using the same clearing thresholds that apply to non-financial counterparties1. However, the determination would only need to be made once a year and the Commission Proposal, which is supported by the Council, suggests a determination based on the aggregate month-end average for March, April and May.
There remains some disagreement as to whether the annual determination is mandatory for all FCs or whether FCs can dispense with the annual determination by essentially “opting up” to full FC status by a one-time notification to ESMA and its national competent authority. Given that Category 1 and 2 FCs should already have put in place clearing arrangements in order to comply with the current EMIR requirements, a mandatory annual determination would merely add a new administrative burden, so it is hoped that the latter approach will be adopted.
Determination of non-financial counterparty clearing threshold
The Commission, Council and draft ECON Report are in agreement that the current 30 day rolling average determination of positions of a non-financial counterparty (NFC) against the clearing thresholds should be replaced with an annual determination on the same basis as described above.
In addition, the Commission, Council and draft ECON Report are in agreement that an NFC that exceeds the clearing threshold for one asset class would now only become subject to the clearing obligation in respect of that particular asset class, rather than in respect of all asset classes (as is currently the case). The draft ECON report builds on this and introduces corresponding changes to the margin requirements, so that these only apply to the asset class for which the clearing threshold is exceeded.
Since inception, the requirements of the reporting obligation have been among the most problematic and contentious of EMIR. Whilst steadfastly retaining the concept of two-sided reporting, the Amendment Regulation is expected to contain some more minor concessions in this regard.
Firstly, where an FC has entered into derivative transactions with an NFC that is below the clearing threshold (NFC-), then the FC will be responsible for reporting on behalf of both parties. The Council and the draft ECON report provide some additional protection for FCs in respect of this new obligation, by requiring the relevant NFC- to provide relevant information. There are also likely to be additional provisions dealing with the scenarios where an NFC- wishes to report for itself and where an NFC- has entered into derivative transactions with third country entities that would be an FC if it were established in the EU.
Secondly, the Commission Proposal suggested that the CCP be solely responsible for reporting exchange-traded derivatives on behalf of all parties. However, both the Council and the draft ECON report have rejected that change, with the draft ECON report instead suggesting further review of this in the future.
Thirdly, the Commission Proposal also suggested the removal of the reporting obligation for intra-group trades, where at least one of the counterparties is (or would be, if it were established in the EU) an NFC. This found support from the draft ECON report, but the Council proposed that this removal should be conditional upon both parties being NFC.
Fourthly, the Commission, Council and draft ECON Report are in agreement on the removal of the current obligation to report historic derivative transactions which were no longer outstanding on the original reporting start date (12 February 2014) but which were outstanding on or entered into after the entry into force of EMIR (16 August 2012).
Finally, the Amendment Regulation looks likely to adopt a provision from the Securities Financing Transaction Regulation, by providing for an automatic delegation of the reporting obligation to UCITS management companies in respect of derivative transactions entered into by the relevant UCITS, and to AIFMs in respect of derivative transactions entered into by the relevant AIFs.
Removal of frontloading obligation
EMIR currently requires OTC derivatives contracts to be cleared if they have been entered into (or novated) before the clearing obligation takes effect, provided the contracts were entered into after a specified date and have a remaining maturity which is higher than a minimum specified by the European Commission when introducing the clearing obligation (this is called the frontloading obligation). The Commission, Council and draft ECON Report appear to be in agreement to remove this controversial requirement.
FRAND (Fair, Reasonable And Non-Discriminatory commercial terms)
The Commission Proposal introduces an obligation on clearing brokers to provide services on fair, reasonable and non-discriminatory commercial terms (“FRAND”), with further detail to be set out in a Commission delegated act. This provision builds on existing requirements in EMIR and MiFID2, but confers considerable discretion on the European Commission and hence creates uncertainty as to what it will ultimately involve.
Perhaps unsurprisingly, the Council political agreement amends the proposals to specify a range of factors on which FRAND requirements would be based, for example fairness and transparency on fees and reasonable commercial terms to ensure unbiased and rational contractual arrangements. The Council’s amendments also make it clear that there is no requirement to provide clearing services and that brokers are permitted to control the risks associated with the services they offer. Both the Council and the draft ECON report would also include a requirement for transparency.
Power to suspend the clearing obligation
The Commission Proposal gives the European Commission the power to suspend the clearing obligation for three months, extendable for successive periods of three months up to a total of twelve months, for specific classes of OTC derivatives or a specified type of counterparty. This power would be triggered by a request from ESMA and be exercisable in certain prescribed circumstances, for example that the only CCP able to clear those derivatives is likely to cease trading. The Council proposes to extend any such suspension to the trading obligation in MiFIR. However, the draft ECON report proposes to shorten any proposed extension to successive periods of one month up to a maximum of six months.
Extension of pension scheme clearing exemption
The current transitional exemption for pension scheme arrangements from the clearing obligation in respect of certain OTC derivatives expires on 16 August 2018. The Commission Proposal, supported by the Council, suggests extending this for another three years. The draft ECON report proposes further wording calling on pension schemes and CCPs to use their best efforts to contribute to those technical developments and requiring the European Commission to establish an expert working group to examine the problem.
The timing in respect of this particular amendment is very tight, given the expiry of the current transitional exemption and the expected entry into force of the Amendment Regulation. If the timetable for the latter comes under threat, the European Commission may need to make a separate proposal which can be moved quickly through the legislative process or otherwise leave the industry exposed to a period of regulatory risk.
Segregation of positions and assets by clearing members and CCPs
EMIR already requires CCPs to keep records and accounts that distinguish their own assets from the assets of each of their clearing members. Furthermore, clearing members must keep records and accounts that distinguish their own assets from assets held for the account of their clients.
The Commission Proposal goes further and provides that such assets and positions are not to be considered to be part of the insolvency estate of the CCP or clearing member. The rationale of including this provision is not entirely clear and, perhaps unsurprisingly, the Council and the draft ECON report take a different approach, requiring only that national insolvency law not prevent the CCP from complying with its existing EMIR obligations in respect of porting and liquidation of accounts.
The Amendment Regulation is expected to explicitly require ongoing supervisory procedures for risk management procedures, including in relation to margining. The European Supervisory Authorities (ESAs) will be mandated to develop draft regulatory technical standards and specify further detail in this regard.
What about FX transactions?
The Commission Proposal did not suggest any exemption for any FX transactions from the obligation to exchange variation margin. Both the Council and the ECON committee did, at different points during their own processes, suggest amendments to provide an explicit exemption for physically-settled FX forwards from the obligation to exchange variation margin other than between the most systemic counterparties (namely, credit institutions and investment firms). However, probably in light of the separate workstream of the ESAs to amend the margin regulatory technical standards to provide for the same exemption2, both the Council and the ECON committee have since reduced their proposed amendments to a new recital to EMIR rather than an actual exemption.
What should you be doing about the EMIR REFIT?
Until the text of the Amendment Regulation is finalised, there is clearly a limit to what can be done. Some may wish to get involved with the industry lobbying efforts, whereas for others a “watching brief” will be more appropriate.
Although the Amendment Regulation is likely to contain some phase-in periods, these look to be relatively limited in nature. In particular, it appears that the changes to the definition of financial counterparty will apply immediately upon the entry into force of the Amendment Regulation.
Some of the changes discussed above will require existing processes to be updated, new processes to be established, and fresh client/counterparty outreaches. The experience of implementing EMIR has demonstrated that these will require a significant amount of lead time, so our suggestion is that firms commence their planning earlier rather than later.
1 ie €1bn for each of Credit and Equity and EUR 3 billion for each of Interest Rate, FX, and Commodity and other.
2 The ESAs published the text of their proposed amendment to the margin RTS in December 2017. As at the date of this article, it has not yet been finalised.
This document (and any information accessed through links in this document) is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.