EMIR – an overview

Summary of main points for market participants to note arising from the European Market Infrastructure Regulation

The European Market Infrastructure Regulation (EMIR)1 introduces various requirements designed to address the risks associated with exposure to counterparty credit risk and a perceived lack of transparency in the over the counter (OTC) derivatives markets, as well as the structural and regulatory inadequacies highlighted by the collapse of Lehman Brothers and the near collapse of Bear Stearns and AIG in 2008. Along with the Dodd Frank Act in the US, EMIR responds to the G20 commitment, agreed in Pittsburgh in September 2009, that all standardised OTC derivative contracts should be cleared through central counterparties (CCPs), that OTC derivative contracts should be reported to trade repositories, and that contracts that are not centrally cleared should be subject to higher capital requirements.

As an EU Regulation, the provisions of EMIR (unlike EU Directives) have direct effect (once they come into force) without the need to be implemented in individual EU member states through national legislation or rules. This reduces the scope for variation between member states resulting from differing implementation approaches. It is also important to note that EMIR is relevant to the wider group of the European Economic Area or EEA (ie the EU plus Norway, Iceland and Liechtenstein).  However,  the provisions of EMIR do not have direct effect in Norway, Iceland and Liechtenstein and need to be transposed into national law by virtue of the obligations of those countries under the treaty establishing the EEA.

The following is a summary of the main points to note for parties who enter into OTC derivative contracts, which can be divided into three topics covering:

  • the clearing obligation for certain OTC derivative contracts
  • risk mitigation for non centrally cleared OTC derivative contracts, and
  • reporting of both OTC derivative contracts and exchange traded derivative contracts to trade repositories.

As far as market participants are concerned, it is important to note that the obligations in EMIR apply to the actual counterparties to derivative transactions, rather than any agent through which a counterparty may act. In a fund context, the counterparty to a trade will be the fund (albeit acting through the agency of its investment manager), in which case the relevant obligations are imposed on the fund rather than the investment manager. For more information on the way in which EMIR applies to an Alternative Investment Fund (AIF) see our separate elexica article.

Certain entities are exempt from the requirements contained in EMIR by virtue of their status.  EMIR does not apply at all to the members of the European System of Central Banks (ESCB) or those bodies in EEA states performing similar functions to the ESCB, nor does it apply to other EEA public bodies involved with the management of public debt or the Bank for International Settlements (BIS). With effect from 08 November 2013 the list of exempted entities was broadened so as to include central banks and public bodies charged with or intervening in the management of the public debt in Japan and the USA. Other bodies such as multilateral developments banks, the European Financial Stability Facility and the European Stability Mechanism are subject only to the trade repository reporting requirement.      

It should be noted that EMIR contains various requirements relating to the registration and supervision of bodies proposing to provide CCP and trade repository services within the EEA, which are beyond the scope of this note.

Current status

EMIR was published in the EU Official Journal on 27 July 2012 and came into force on 16 August 2012. Since then, its provisions have started to apply progressively in line with the analogous provisions contained in the related secondary (Level 2) legislation which it contemplates.

Much of the Level 2 legislation which EMIR contemplates is now in place and takes the form of three Commission Implementing Regulations2 which were published in the Official Journal on 21 December 2012 and came into force on 10 January 2013, six Commission Delegated Regulations3 which were published in the Official Journal on 23 February 2013 and came into force on 15 March 2013 and a Commission Delegated Regulation4 , which was published in the Official Journal on 21 March 2014 and came into force on 10 April 2014.  See later in the relevant sections of this article for details of the dates when particular provisions started, or will start, to apply.

Draft Level 2 regulatory technical standards on exchange of collateral for uncleared trades are in the process of being produced jointly by the European Securities and Markets Authority (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA).  A joint consultation paper was published on 14 April 2014 to which responses were invited by 14 July 2014.

As far as the extra territorial application of EMIR is concerned, it is not currently clear when the EU Commission will produce the Level 2 provisions in the context of Article 13 of EMIR establishing the extent to which the legal and supervisory rules in the US, Japan, Australia, Hong Kong, Singapore, Switzerland, Canada, India and South Korea are considered to be equivalent to those contained in EMIR.

As far as the EMIR clearing obligation is concerned, on 12 July 2013 ESMA published a discussion paper to seek views on its proposed approach to the preparation of the Level 2 regulatory technical standards that it is required to produce under Article 5(2) of EMIR. The deadline for responses was 12 September 2013. On 11 July 2014 ESMA published two consultation papers dealing respectively with the introduction of the clearing obligation under EMIR for interest rate swaps (in relation to which the deadline for responses was 18 August 2014) and credit default swaps (in relation to which the deadline for responses was 18 September 2014). On 01 October 2014 ESMA published and submitted to the EU Commission for endorsement the final draft text of the Level 2 regulatory technical standards relating to the clearing obligation for interest rate swaps. The EU Commission informed ESMA in its letter dated 18 December 2014 that it was going to endorse the draft regulatory technical standards with amendments. In response, ESMA submitted, on 29 January 2015, its revised regulatory technical standards to the Commission for approval, following which there will be a three-month period (extendable for further three months) for objection by the EU Parliament and Council before the provisions can be published in the Official Journal and come into force. As regards the forthcoming draft regulatory technical standards on the clearing obligation for credit default swaps, ESMA decided in November 2014 to hold their delivery until the EU Commission finalises its assessment process of the regulatory technical standards on the clearing obligation for interest rate swaps. On 01 October 2014 ESMA published a consultation paper on the introduction of the clearing obligation for non-deliverable FX forwards (in relation to which the deadline for responses was 06 November 2014). In a feedback statement to its consultation paper, published on 04 February 2015, ESMA stated that it did not intend to propose a clearing obligation for FX forwards at that stage. This, however, does not prejudice ESMA’s ability to propose a clearing obligation for those instruments at a later point in time following further market developments.

Additional guidance on the various provisions of EMIR and the related Level 2 provisions is contained in two sets of FAQs, the first of which was published by the EU Commission  and was last updated on 10 July 2014, the second by ESMA, which was last updated on 24 October 2014.

What is the meaning of “derivative” and “OTC derivative” under EMIR?

Although EMIR was introduced largely to address problems in the OTC derivatives markets, it is important to note that not all of its provisions are limited to OTC derivatives and that some (in particular those relating to the reporting obligation) apply to derivatives more generally. 

The EMIR definition of a derivative covers all derivatives listed in section C of annex 1 to the Markets in Financial Instruments Directive (MiFID). Although this definition ties in neatly with the scheme of regulation for such financial instruments under MiFID, the lack of a harmonised definition in MiFID as to what exactly amounts to a derivative causes problems when determining if and how the obligations in EMIR apply to certain products, especially in a cross-border context. Particular issues have been highlighted in the context of FX and commodities.  Click here to see our separate elexica article discussing these issues and summarising the key developments to date.

EMIR defines an OTC derivative contract as a derivative which is not executed on an EEA regulated market (as defined in MiFID) or on a non-EEA market considered to be equivalent to an EEA regulated market (in accordance with the criteria for determining equivalence set out in MiFID). Thus, derivatives traded on a multilateral trading facility (MTF), or what will be considered as an Organised Trading Facility (OTF) under the forthcoming amendments to MiFID contemplated by MiFID 2 will be considered to be OTC for this purpose. ESMA confirms in its FAQs (OTC Answer 1 (d)) that transactions, such as block trades, which are executed outside the trading platform of a regulated market, but which are subject to the rules of the regulated market and executed in compliance with those rules (including the immediate processing by the regulated market after execution and clearing by a CCP), should not be regarded as OTC derivative transactions for these purposes.

The clearing obligation for OTC derivative contracts

Article 4 of EMIR imposes an obligation on counterparties to OTC derivative contracts to clear certain specified contracts. Clearing must be done through a central counterparty (CCP) which is either:

  • established in an EEA member state and authorised by the relevant local regulator in that member state to clear the class of derivative in question, or
  • established in a non EEA member state and recognised by ESMA to provide clearing services within the EEA.

What is clearing?

Clearing is a concept which is well established in the exchange traded derivatives sphere and relates to the process for managing the counterparty credit risk inherent in open derivatives positions between the point when a trade is entered into and the relevant obligations are discharged. Typically it involves trades between market participants being replaced with corresponding trades in such a way that a CCP is interposed between the relevant market participants and becomes the ultimate buyer to every sell trade and the ultimate seller to every buy trade. Interposing the CCP between the market participants in this way is designed to minimise the adverse, potentially systemic, effects of a default (typically on insolvency) by a market participant. This is because the CCP is obliged to perform its obligations, whether or not the ultimate counterparty to the trade is in default.  

In this context clearing is defined in EMIR as “the process of establishing positions, including the calculation of net obligations, and ensuring that financial instruments, cash, or both, are available to secure the exposures arising from those positions”. Beyond this, there appears to be considerable flexibility in the actual clearing models which may be used for these purposes.

Clearing can be “direct” in the sense that the parties to the trade are members of the CCP through which the trade is cleared, or “indirect” in the sense that one or both of the parties to the trade is not a member of the relevant CCP, but clears the trade through an entity which is a member of the relevant CCP. A party which clears via the latter route would need to enter into appropriate client clearing documentation with its chosen clearing member(s). 

Which market participants are subject to the clearing obligation?

In determining which market participants are subject to the clearing obligation, EMIR distinguishes between financial counterparties and non financial counterparties.

A financial counterparty (FC) includes:

  • an investment firm authorised in accordance with MiFID (Directive 2004/39/EC)
  • a credit institution authorised in accordance with the Banking Consolidation Directive (Directive 2006/48/EC)
  • an Undertaking for Collective Investment in Transferable Securities (UCITS) and, where relevant, its management company, authorised in accordance with UCITS IV (Directive 2009/65/EC) and
  • an alternative investment fund (AIF) managed by an alternative investment fund manager (AIFM) which is authorised or registered in accordance with the Alternative Investment Fund Managers Directive (AIFMD) (Directive 2011/61/EU).

The definition also includes other EU regulated bodies such as insurance undertakings and institutions for occupational retirement provision.

A non financial counterparty (NFC) is any undertaking established in the EEA which is not a financial counterparty or a CCP (as defined in EMIR). It is important to note in this context that the definition uses the term “undertaking” which is likely to include trusts and partnerships as well as corporate entities. As far as individuals are concerned, the EU Commission’s FAQs on EMIR (Section II: Scope, Question 14) indicate that individuals carrying out an economic activity are capable of being considered to be undertakings (and thus classified as NFCs) provided they offer goods and services in the market . This conclusion is based on an analysis of the jurisprudence of the European Court of Justice in the context of competition law, which, according to the Commission, has consistently held that the concept of an undertaking covers any entity engaged in an economic activity, regardless of its legal status or the way in which it is financed. ESMA has endorsed this view in its FAQs on EMIR (in Part IV: Reporting to TRs).

An NFC is only subject to the clearing obligation if the average of the gross notional value of its OTC derivative positions over a rolling 30 day period exceeds the relevant threshold set out in Commission Delegated Regulation 149/2013 (this kind of NFC is referred to in this note as an NFC+). In determining whether the relevant threshold has been exceeded, the NFC must include all OTC derivative contracts entered into by it and any other NFCs  or "non financial entities" within its group, which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the NFC in question or of the group as a whole ("hedging contracts"). ESMA has confirmed in its FAQs (OTC Answer 3 (b.4)) that the term “non-financial entity” in this context should be interpreted as meaning an undertaking that would be an NFC if it were established in the EU. Given that EMIR is relevant to the EEA, we would argue that this interpretation should extend to entities established in the EEA. ESMA also confirms that, for the avoidance of doubt, OTC derivative contracts cleared on a voluntary basis should be included in the calculation of the clearing threshold (OTC Answer 3 (b.2)). 

Article 10(4) of EMIR contemplates Level 2 regulatory technical standards specifying the criteria for determining which OTC derivative contracts are hedging contracts for the purpose of the calculation, as well as separate clearing thresholds for each class of OTC derivative contract. The relevant provisions are contained in Commission Delegated Regulation 149/2013.  

The clearing thresholds as contained in Commission Delegated Regulation 149/2013 are set out below.

  Clearing thresholds for NFC+
Type of contract Clearing threshold (gross notional value)
OTC credit derivatives  €1 bn
OTC equity derivatives  €1 bn
OTC interest rate derivatives  €3 bn
OTC foreign exchange derivatives  €3 bn
OTC commodity derivatives and other OTC derivative contracts not already mentioned  €3 bn

The following points are of particular note:

  • If an NFC crosses the threshold for one class of OTC derivative contract, it will automatically cross the clearing threshold for all other classes of OTC derivative contract. As well as causing an NFC to be considered as an NFC+ in relation to all derivative classes (rather than just the class for which the threshold is crossed), this will potentially trigger clearing and margining requirements in relation to all OTC derivative classes for other entities in the same group.
  • The clearing thresholds refer to the gross notional value of OTC derivative positions. 
  • All NFCs which are above one or more of the relevant clearing thresholds are required to immediately notify ESMA as well as the NFC’s competent authority. Furthermore, ESMA states in its FAQs (OTC Answer 2 (a) and 2(c)) that once the NFC’s group exceeds the clearing threshold (which will presumably happen once the NFC exceeds the clearing threshold, either alone or together with other relevant group members as already described), a notification should be submitted to the competent authority in each member state in which the group has legal entities that trade OTC derivatives. The group should also submit a single notification to ESMA, listing all of the NFC group legal entities within the EU which trade OTC derivatives (we assume that this requirement should apply to the EEA and not just the EU).
  • In order for NFCs to be able to determine whether they have exceeded the relevant thresholds, they will need to have arrangements in place to ensure the daily monitoring of the gross notional values in respect of all relevant OTC derivative contracts (including in relation to any group entities).

Scenario based approach to determining when counterparties must clear

For the clearing obligation to be triggered, the OTC derivative contract must be entered into:

  • between two FCs
  • between (i) an FC and (ii) an NFC+
  • between two NFC+
  • between (i) an FC or NFC+ and (ii) an entity established outside the EEA which would be subject to the clearing obligation if it were established within the EEA or
  • between two entities established outside the EEA, both of which would be subject to the clearing obligation if it they were established within the EEA, provided the contract has a "direct, substantial and foreseeable" effect within the EEA or where necessary to prevent the evasion of any provisions of EMIR (there are Level 2 regulatory technical standards on the interpretation of that phrase. See later in this article for more details).

Non-EEA undertakings are, therefore, potentially subject to the EMIR clearing obligation. In addition, an undertaking established outside the EEA can be caught if it can be said that it would be subject to the clearing obligation if it were established in the EEA and it enters into a certain type of OTC derivative contract with the relevant type of counterparty (we refer to this type of undertaking as a “hypothetical” FC or NFC+).

An example of the potential extra territorial application of the EMIR clearing obligation arises in the context of an alternative investment fund (AIF) under the AIFMD. As well as the fact that the definition of an AIF includes funds established inside or outside the EEA, the AIFMD provides for the possibility of alternative investment fund managers (AIFMs) established outside the EEA to be authorised or registered (depending on the circumstances). As a result, an AIF established outside the EEA could potentially be treated as an FC, or a “hypothetical” FC, NFC or NFC+ under EMIR depending on the circumstances. This is of particular significance in the context of non-EEA AIFs managed by non-EEA AIFMs.

What must be cleared?

Rather than being introduced for all classes of OTC derivative contracts at once, the EMIR clearing obligation will be introduced progressively on a class by class basis.

In order for a class of OTC derivative contract to be subject to the clearing obligation:

  • a CCP must be authorised by the relevant local regulator (if established in the EEA) or recognised by ESMA (if established outside the EEA), and
  • Level 2 regulatory technical standards must have been adopted by the EU Commission (following advice from ESMA in accordance with either the “bottom up” or “top down” approach – see below) and come into force specifying the class of OTC derivative contract subject to the clearing obligation and the date from which the clearing obligation takes effect (including details of the phase in arrangements and the categories of counterparty to which the obligation relates).

The process for introducing a clearing obligation for a particular class of OTC derivative contract can be either “bottom up” (ie it is triggered by a CCP being authorised or recognised to clear the class of OTC derivative contract in question) or “top down” (ie ESMA initiates the process where it considers that a particular class of OTC derivative contract should be subject to the clearing obligation but no CCP has yet been authorised or recognised to clear the class of contract in question). ESMA has confirmed however that no CCP will be forced to clear contracts that it is not able to manage and that the clearing obligation will actually enter into force following the bottom up approach. The top down approach is therefore intended to ensure the development of clearing solutions for particular classes of derivatives. Under the "bottom up" approach, when a CCP is authorised by a local regulator to clear a class of OTC derivatives contract, that local regulator is obliged to notify ESMA, which triggers the commencement of a 6 month period within which ESMA has to hold a public consultation and develop and submit to the EU Commission a draft of the Level 2 regulatory technical standards referred to above. The EU Commission is then empowered to adopt the regulatory technical standards and therefore bring the relevant clearing obligation into effect. 

Having arisen for a particular class of OTC derivative contract, the clearing obligation will cease to apply if, later on, there ceases to be a CCP authorised or recognised (as appropriate) to clear the class of OTC derivative contract in question.

Derivative contracts of a class which is subject to the clearing obligation must be cleared if they are entered into or novated either:

  • on or after the date when the clearing obligation takes effect, or
  • on or after the date when the relevant local regulator notifies ESMA that it has authorised a CCP to clear the class of derivative in question but before the clearing obligation takes effect, and the contract in question has a remaining maturity which is greater than the "minimum remaining maturity" specified in the relevant Level 2 regulatory technical standards introducing the clearing obligation for the class in question (this is referred to as “frontloading”). 

The fact that the clearing obligation can apply to OTC derivative contracts entered into or novated on or after the date when ESMA is notified that a CCP has been authorised to clear a particular class of derivative makes it necessary, as a practical matter, to monitor the public register maintained by ESMA under article 6 of EMIR (see below) to keep track of what has been notified to ESMA for this purpose.

The frontloading period in relation to various classes of derivative contracts is being triggered progressively as CCPs start to be authorised to clear them.

When does the clearing obligation commence?

The clearing obligation under EMIR will arise on different dates for different classes of OTC derivative contract.

The Level 2 regulatory technical standards introducing the clearing obligation for a particular class of derivative will specify the date or dates when the clearing obligation will arise, as well as the minimum remaining maturity for derivatives of that class that are entered into before the clearing obligation arises.

As far as the introduction of the clearing obligation for the first classes of OTC derivatives is concerned, in July 2013 ESMA published a discussion paper seeking views on its proposed approach to the preparation of the relevant Level 2 regulatory technical standards. The deadline for responses was 12 September 2013. On 11 July 2014 ESMA published two consultation papers dealing respectively with the introduction of the clearing obligation for interest rate swaps (in relation to which the deadline for responses was 18 August 2014) and credit default swaps (in relation to which the deadline for responses was 18 September 2014). On 01 October 2014 ESMA published and submitted to the EU Commission for endorsement the final draft text of the Level 2 regulatory technical standards relating to the clearing obligation for interest rate swaps. The EU Commission informed ESMA in its letter dated 18 December 2014 that it was going to endorse the draft regulatory technical standards with amendments. In response, ESMA submitted, on 29 January 2015, its revised regulatory technical standards to the Commission for approval, following which there will be a three-month period (extendable for further three months) for objection by the EU Parliament and Council before the provisions can be published in the Official Journal and come into force. As regards the forthcoming draft regulatory technical standards on the clearing obligation for credit default swaps, ESMA decided in November 2014 to hold their delivery until the EU Commission finalises its assessment process of the regulatory technical standards on the clearing obligation for interest rate swaps. On 01 October 2014 ESMA published a consultation paper on the introduction of the clearing obligation for non-deliverable FX forwards (in relation to which the deadline for responses was 06 November 2014). In a feedback statement to its consultation paper, published on 04 February 2015, ESMA stated that it did not intend to propose a clearing obligation for FX forwards at that stage. This, however, does not prejudice ESMA’s ability to propose a clearing obligation for those instruments at a later point in time following further market developments. 
  

Public register of derivatives required to be cleared

Article 6 of EMIR requires ESMA to maintain on its website a public register containing, amongst other things, details of all classes of OTC derivative contracts that are subject to the clearing obligation, as well as details of those CCPs that are authorised or recognised to clear particular classes of derivative and the dates on which the clearing obligation takes effect. The public register also contains details of the date when a CCP is authorised to clear a particular class of derivative  so that market participants can monitor the position regarding frontloading (see above). 

Click here to see the public register which ESMA is required to maintain under Article 6 of EMIR.

Click here to see the separate list of authorised CCPs on the ESMA website.

Exemptions from the clearing obligation

Intra group

EMIR contains an exemption from the clearing obligation covering certain intra group derivative transactions. If a transaction is exempt in this way, it will still be subject to the risk mitigation requirements for non centrally cleared OTC derivative contracts set out elsewhere in EMIR, unless also exempt from those requirements as a separate matter (see below).

The exemption from the clearing requirement for intra group transactions will not apply automatically and the relevant local regulator must be notified at least 30 calendar days before the exemption is relied upon. 

Where both counterparties are established in an EEA member state, both must notify the relevant local regulator and can only rely on the exemption if neither regulator objects to its use within 30 days of being notified. Where one counterparty is established in the EEA and the other is established outside the EEA, it is only necessary for the counterparty established in the EEA to notify the relevant local regulator in this way. In this situation, however, the exemption can only be relied upon if the regulator positively authorises its use. EMIR does not provide for the possibility of intra group transactions benefiting from the exemption where both counterparties are established outside the EEA (and subject to the EMIR clearing obligation).

Pension scheme arrangements

Article 89 of EMIR provides for the possibility of a three year exemption from the clearing obligation for OTC derivative contracts that are objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangements as defined in article 2(10), as well as for entities established for the purpose of providing compensation to members of pension scheme arrangements in the case of a default (eg in the UK, the Pension Protection Fund). The three year period runs from the date when EMIR came into force (ie from 16 August 2012) and ends on 16 August 2015. 

The EU Commission, in its report published on 03 February 2015, proposed the extension of this period by additional two years up to August 2017. The decision is based on the insufficient progress made thus far by CCPs and the derivatives industry in developing potential solutions for the transfer of non-cash collateral to meet variation margin calls. The Commission intends to continue monitoring the situation in order to assess whether this period should be further extended by one more year.

It is important to note that the three year exemption is only from the clearing obligation, so that the EMIR risk mitigation requirements for uncleared OTC derivative contracts (see below) will still apply to pension scheme arrangements.  A question for pension scheme trustees is therefore whether to rely on the three year exemption or to elect to clear voluntarily at this stage.  In this connection, mandates with investment managers may need to be revisited to cover clearing and investment guidelines may need to be adjusted to reflect differing margining requirements. For more information on EMIR and pensions, see our separate elexica article.

Foreign Exchange/FX

As far as OTC foreign exchange derivatives are concerned, although ESMA and the EU Commission have consistently made it clear that they are within the scope of the EMIR clearing obligation, recital 19 of EMIR raises the possibility of them not being one of the classes of OTC derivative contracts for which the clearing obligation is ultimately introduced. This recital states that when determining the classes of OTC derivative contracts that are to be subject to the clearing obligation, due account should be taken of the specific nature of each class and that CCP clearing may not be the optimal solution for dealing with settlement risk, which is the predominant risk inherent in foreign exchange derivative transactions. The announcement by the US Treasury in November 2012 of a limited exemption from the clearing requirement in the Dodd Frank Act for certain deliverable swaps and forwards indicates the possibility of a similar approach being taken in the EU. Spot (ie non derivative) foreign exchange contracts are, of course, out of scope on the basis that they fall outside the definition of a derivative for these purposes.

The lack of a harmonised definition of the terms "derivative" and "derivative contract" at EU level is causing problems in determining which products are subject to the requirements in EMIR, particularly in the context of FX products. Click here to see our separate elexica article discussing the issues in this context and summarising the key developments to date.

Risk mitigation techniques for non centrally cleared OTC derivative contracts

For OTC derivative contracts which are not cleared by a CCP, article 11 of EMIR imposes various additional requirements designed to ensure that counterparties have adequate procedures and arrangements in place to monitor and manage the risks involved.

What are the requirements?

  • Appropriate procedures and arrangements must be in place to measure, monitor and mitigate operational risk and counterparty credit risk, including at least:
    • the timely confirmation, where available, by electronic means, of the terms of the relevant OTC derivative contract (article 11(1)(a)) by the deadlines set out in Commission Delegated Regulation 149/2013 (FCs must have procedures in place to report on a monthly basis the number of unconfirmed OTC derivative transactions that have been outstanding for more than five business days but, according to ESMA’s FAQs (OTC Answer 8 (b)), only need to submit these reports where the relevant competent authority asks for them); and
    • formalised processes which are robust, resilient and auditable in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them, and to monitor the value of outstanding contracts (article 11(1)(b)).  Commission Delegated Regulation 149/2013 which contains the relevant Level 2 provisions on this point also refers to the possible need for FCs and NFCs with 500 or more contracts outstanding with the same counterparty to engage in portfolio compression to reduce counterparty credit risk.
  • The value of outstanding contracts must be marked to market on a daily basis. Where market conditions prevent this, reliable and prudent marking to model shall be used instead (article 11(2)). There are fairly onerous requirements where a model is used, including that approval of the model must be given by the board or a committee appointed by the board, but there is no requirement for the mark to market to be agreed between the parties for this purpose. 
  • Risk management procedures must be in place that require the timely, accurate and appropriately segregated exchange of collateral with respect to OTC derivative contracts (article 11(3)). The relevant Level 2 provisions are in the process of being produced – see below for further detail.
  • It is necessary to hold an appropriate and proportionate amount of capital to manage the risk not covered by appropriate exchange of collateral (article 11(4)).  There are currently no plans to produce Level 2 provisions in relation to this requirement, given the view of ESMA, the EBA and EIOPA that the existing, wider EU capital regimes for regulated entities provide sufficient protection and that risk mitigation for other entities should be achieved through exchange of collateral in this context. 

Who is subject to the requirements?

The article 11 EMIR requirements apply differently, depending on the type of counterparty. 

  • The requirements in article 11(1)(a) and (b) for timely confirmation and portfolio reconciliation, dispute resolution and portfolio compression apply to financial counterparties (FCs) and non financial counterparties (NFCs) - the obligations regarding reporting the number of unconfirmed OTC derivative transactions outstanding for more than five business days apply only to FCs
  • The requirements in article 11(2) and article 11(3) for daily valuation and exchange of collateral apply to FCs and those NFCs whose total OTC derivative positions exceed the relevant threshold (NFC+)
  • The requirements in article 11(4) apply to FCs only.

Unlike the clearing obligation, which takes a scenario based approach and looks at both counterparties to the OTC derivative contract, the risk mitigation provisions in Article 11 are less clear. As can be seen from the above, Article 11 does not take a scenario based approach but is stated to apply on a per counterparty basis. There is therefore some uncertainty about whether Article 11 applies where an FC or NFC enters into an uncleared OTC derivative contract with a non-EEA counterparty that is not an FC or NFC. As far as ESMA is concerned, and as stated in its FAQs on EMIR (OTC Answer 12 (b)), Article 11 applies wherever at least one counterparty is based in the EU. Therefore, in ESMA’s opinion, the Article 11 requirements should apply to the EU-based counterparty even though the other counterparty is based in a non-EU country and is not subject to EMIR. Following this logic, the Article 11 requirement should also apply where at least one counterparty is based in an EEA member state, assuming the relevant provisions have been put in place to impose the relevant requirements in the EEA state in question.

An added complication is that the obligations, as set out in Article 11, can be divided into two types for this purpose: those that are capable of applying to a single party and those that must necessarily involve both parties to the OTC derivative contract.

  • In the first category falls the requirement for daily valuation (Article 11(2)) and to ensure an adequate amount of capital (Article 11(4)). These obligations are capable of applying to the FC or NFC (as appropriate) only and so would appear to be compatible with ESMA's interpretation.
  • In the second category falls the requirement for timely confirmation, portfolio reconciliation, dispute resolution (Article 11(1)) and exchange of collateral (Article 11(3)). The nature of these requirements is such that it would need the involvement of both parties to the OTC derivative contract for the EEA-based counterparty to be capable of performing its obligations. However, it is difficult to see how ESMA’s interpretation of the Article 11 requirements works at a practical level where only one of the counterparties to the trade is subject to the requirement in question. As far as the Article 11 requirements regarding timely confirmation of trades, portfolio reconciliation and dispute resolution are concerned, although these are not directly applicable to non-EEA based entities (third country entities) that are not FCs or NFCs, where such third country entities are trading with an FC or NFC, then the third country entity will be expected to comply with the relevant timeframes so as to facilitate compliance by the FC or NFC with its obligations. In other words, the obligations in respect of timely confirmations, portfolio reconciliation and dispute resolution are likely to be “indirectly” applicable, effectively, to those counterparties classified as third country entities.

It is clear from Article 11(12) of EMIR that the risk mitigation provisions of Article 11(1) to 11(11) can apply where both counterparties are non-EEA counterparties that are not FCs or NFCs, provided that both would be subject to the risk mitigation obligations if they were established in the EEA and the relevant uncleared OTC derivative contracts have a "direct, substantial and foreseeable" effect within the EEA or where the risk mitigation obligations are necessary or appropriate to prevent evasion of EMIR (there are Level 2 regulatory technical standards on the interpretation of that phrase. See later in this article for more details).

Which transactions do the requirements apply to?

The article 11 EMIR requirements apply to those OTC derivative contracts which are not cleared by a CCP. 

The risk mitigation provisions do not state explicitly which contracts they apply to in terms of the date when those contracts must have been concluded. Our reading of those articles, the related Level 2 provisions and the EU Commission’s and ESMA's FAQs on EMIR is that:

  • the requirements contained in article 11(1)(a) apply to contracts entered into on or after the date when the related Level 2 provisions started to apply, and
  • the requirements contained in articles 11(1)(b), 11(2) and 11(4) apply to any contracts which are outstanding on or after the date when the relevant Level 2 provisions started to apply (in the case of articles 11(1)(b) and 11(2)) and start to apply (in the case of article 11(4)) (irrespective of when they were entered into).

As far as article 11(3) is concerned, the relevant requirements are expressly stated to apply to contracts:

  • entered into on or after 16 August 2012 (as far as FCs are concerned), and
  • entered into on or after the relevant clearing threshold is exceeded (as far as NFC+ are concerned).

Have the various requirements started to apply yet?

Although the provisions in article 11 of EMIR are now in force, not all of the relevant requirements under article 11 have started to apply.  Recital 93 of EMIR and the EU Commission’s and ESMA's FAQs on EMIR suggest that as a general rule for the article 11 obligations to apply, the Level 2 provisions relating to them must also have started to apply.  Bearing this in mind, the following points should be noted. 

  • The Level 2 provisions relating to articles 11(1)(a), 11(1)(b) and 11(2) are contained in Commission Delegated Regulation 149/2013 which was published in the Official Journal on 23 February 2013. Those which relate to articles 11(1)(a) and 11(2) (ie timely confirmation and daily valuation) came into effect and started to apply on 15 March 2013; those relating to article 11(1)(b) (ie portfolio reconciliation, dispute resolution and portfolio compression) started to apply on 15 September 2013. For further details of the obligations which started to apply on 15 March 2013 click here; for details of the obligations which started to apply on 15 September 2013 click here.
  • As far as the requirements contained in article 11(4) are concerned, there are currently no plans to produce Level 2 provisions, given the view of ESMA, the EBA and EIOPA that the existing, wider EU capital regimes for regulated entities provide sufficient protection and that risk mitigation for other entities should be achieved through exchange of collateral in this context. As a result, the requirement contained in Article 11(4) has not yet started to apply and is unlikely to do so in the foreseeable future.
  • Despite the fact that there does not appear to be any provision in EMIR overriding the general position as stated in recital 93, the EU Commission’s FAQs on EMIR state that the obligations in article 11(3) started to apply from the date when EMIR came into force (ie 16 August 2012). In view of the fact that the relevant Level 2 provisions have not yet been finalised (a joint ESMA, EBA and EIOPA consultation paper was published on 14 April 2014 to which responses were invited by 14 July 2014), the EU Commission’s FAQs state that in the interim counterparties have the freedom to apply their own rules on collateral in accordance with the conditions laid down in article 11(3). As soon as the relevant Level 2 provisions enter into force, however, counterparties must change their rules to the extent necessary in order to comply with the new requirements.

It is important to note that any OTC derivative contracts which are not yet subject to the clearing obligation under article 4 of EMIR will be treated as contracts which are not cleared by a CCP and, therefore, subject to the article 11 requirements to the extent that those requirements have started to apply.

The reporting obligation

In order to address a perceived lack of transparency in the OTC derivatives market as to the level of derivatives trading (which is considered to have been a contributing factor to the financial crisis), article 9 of EMIR imposes an obligation on CCPs and counterparties to derivative trades to report certain details of each trade.

The reports must be submitted to bodies referred to as trade repositories, which are either established in an EEA member state (and registered by ESMA to act as a trade repository) or established outside the EEA (and recognised by ESMA to act as a trade repository).  

What trades does the reporting obligation apply to?

The reporting obligation covers all derivative contracts which are concluded, as well as those which are modified or terminated.  It is important to note in this context that the obligation is not limited to OTC derivative contracts and includes listed/exchange traded derivatives.

The reporting obligation applies in respect of derivative contracts which:

  • were entered into before, and which remained outstanding on, 16 August 2012, or
  • are entered into on or after 16 August 2012.

Who is subject to the reporting obligation?

The obligation in article 9 of EMIR is expressed to apply to all CCPs and counterparties to derivative contracts. EMIR does not expressly define the term “counterparty”; however ESMA has confirmed in its FAQs on EMIR (in Part IV: Reporting to TRs) that the term “counterparty” in this context should be interpreted as meaning FCs and NFCs as defined in Articles 2(8) and (9) of EMIR. Although ESMA does not discuss the meaning of the term “CCP” in this context, following the same logic it could be argued that the term should be interpreted as limited to those CCPs which are authorised or recognised under EMIR.  

EMIR authorises counterparties and CCPs which are subject to the reporting obligation to delegate the reporting of the relevant details to a third party (although they will, however, remain responsible for ensuring compliance by the third party with the reporting obligation on their behalf). In this connection, ISDA and the FOA have published a template Reporting Delegation Agreement.  For further details, see our separate elexica article. EMIR also provides that counterparties and CCPs should ensure that the details of derivative trades are “reported without duplication”. ESMA provides useful guidance in its FAQs (TR Answer 7 (b)) by explaining that the requirement to report without duplication means that each counterparty should ensure that there is only one report (excluding any subsequent modifications) produced by them (or on their behalf) for each trade they carry out. To the extent that their counterparty is obliged to produce a report, this does not count as duplication. ESMA also emphasises that where two counterparties submit separate reports relating to the same trade, they should ensure that the data common to both reports are consistent.

Has the reporting obligation commenced yet?

The reporting start date for all derivative classes was 12 February 2014 (ie 90 calendar days after 14 November 2013 when the first trade repositories were registered by ESMA (see Article 5 of Commission Implementing Regulation 1247/2012)).

What is the deadline for submission of the reports?

As a general rule, reports must be submitted no later than the working day following the conclusion, modification or termination of the trade in question.  

As far as derivative trades entered into before 12 February 2014 are concerned, the reporting deadlines are as follows:

  • trades which were still outstanding on 12 February 2014 and which were outstanding on 16 August 2012 had to be reported within 90 days of 12 February 2014 (ie by 13 May 2014) 
  • trades which were not outstanding on 12 February 2014, but which were entered into before, and which were still outstanding on, 16 August 2012 must be reported within three years of 12 February 2014 (ie by 12 February 2017)
  • trades which were not outstanding on 12 February 2014, but which were entered into on or after 16 August 2012 must be reported within three years of 12 February 2014 (ie by 12 February 2017).

These timeframes are based on our reading of EMIR and Commission Implementing Regulation 1247/2012, as well as on previous discussions with the FCA in the UK.  However, the FCA has taken an alternative view of how the reporting deadlines apply to those AIFs established outside the EU which become a FC after 12 February 2014.  Click here for our separate elexica article providing further details of the FCA’s position in that situation.

How does the EMIR reporting obligation interact with the MiFID transaction reporting obligation?

To the extent that a counterparty to a trade which is subject to the EMIR reporting obligation is a MiFID investment firm, that counterparty will also be subject to the transaction reporting requirements contained in article 25(3) of MiFID (which will be replaced by article 26 of the Markets in Financial Instruments Regulation (MiFIR) when MiFID 2 starts to apply).

MiFIR contains a number of provisions designed to avoid the need for such counterparties to submit a transaction report to the relevant competent authority under MiFID as well as a report to the relevant trade repository under EMIR in respect of the same transaction. It does this by:

  • providing for the possibility of a trade repository which is recognised or registered under EMIR being approved as an Approved Reporting Mechanism (ARM) for the purposes of the MiFID transaction reporting requirement (the significance of this is that an ARM is able to submit transaction reports to the relevant competent authority on behalf of a MiFID investment firm)
  • inserting a provision in EMIR requiring a trade repository to transmit data to the relevant competent authority in accordance with article 26 of MiFIR and
  • providing that where a MiFID investment firm submits a report in accordance with Article 9 of EMIR to a trade repository which is approved as an ARM, containing the information that needs to be included in the relevant MiFID transaction report, the MiFID investment firm will be deemed to have satisfied the relevant MiFID transaction reporting requirement as long as the trade repository submits the required information to the relevant competent authority within the relevant time limit.  Where any failure in the completeness, accuracy or timely submission of a transaction report is attributable to the trade repository, the MiFID investment firm will not be responsible for this failure.

Until MiFIR starts to apply on 03 January 2017, the MiFID investment firm must rely on Article 25(5) of MiFID which provides for the possibility of the transaction reporting obligation being waived where the transaction is reported to the relevant competent authority by a “trade matching or reporting system approved by the competent authority”.  Otherwise, the MiFID investment firm remains responsible for submission of the MiFID transaction report.  Whether or not the MiFID transaction reporting obligation will be waived in this situation depends on whether the trade repository in question is recognised by the relevant competent authority as an approved trade matching or reporting system for this purpose.

Interaction between EMIR and similar regimes in third countries

EMIR is only one of a number of parallel initiatives underway internationally which are designed to fulfil the G20 commitment to address the perceived risks associated with OTC derivatives. Given the international and cross-border nature of the OTC derivatives markets, this raises the possibility of transactions between counterparties located in different countries being subject to overlapping, or even conflicting, requirements.

In order to address this possibility, EMIR contains provisions designed to ensure not only that OTC derivative transactions that have a sufficient connection with the EEA will trigger its requirements, but also that those requirements are deemed satisfied where the parties to the transaction in question are subject to equivalent requirements in a non-EEA country. The relevant provisions are contained in Article 13 of EMIR and in Level 2 provisions contained in Commission Delegated Regulation 285/2014 which are designed to identify those OTC derivatives which have a “direct, substantial and foreseeable” effect within the EEA for the purposes of Articles 4(4) and 11(14) of EMIR.

Where one of the counterparties is established in an “equivalent” non-EEA state

Article 13 of EMIR establishes that where one of the counterparties to a transaction which would otherwise be subject to the requirements of EMIR is established in a non-EEA state whose domestic regime imposes equivalent requirements to those contained in Articles 4, 9, 10 and 11 of EMIR, both counterparties will be deemed to have fulfilled the obligations contained in those articles. In effect, therefore, the EMIR requirements will be deemed satisfied for both counterparties on the basis that the transaction in question will be subject to the requirements in the relevant third country.

Article 13 provides for a mechanism whereby the EU Commission may adopt Level 2 measures declaring the regime in the relevant non-EEA state to be equivalent for this purpose. ESMA delivered its technical advice to the EU Commission on the equivalence (or not) of the legal and supervisory rules of the US, Japan, Australia, Hong Kong, Singapore and Switzerland to those of the EU on 03 September 2013, and on the equivalence (or not) of the legal and supervisory rules of Canada, India and South Korea to those of the EU on 02 October 2013, along with supplementary advice on issues not previously covered in relation to Australia, Hong Kong, Singapore and Switzerland. On 30 January 2014 ESMA published a supplement to the advice it published on 03 September 2013, in which it considers the equivalence of the regulatory regime in Japan for commodity CCPs and the regulatory regime for CCPs under EMIR.  It is not currently clear when the EU Commission will produce the relevant Level 2 provisions in this context.

In summary the EMIR requirements can be deemed satisfied in this way where:

  • both counterparties are established in an equivalent non-EEA state
  • one counterparty is established in an equivalent non-EEA state and the other counterparty is established in a non-equivalent non-EEA state, or 
  • one counterparty is established in an equivalent non-EEA state and the other counterparty is established in an EEA member state.

Where one of the counterparties is established in an EEA member state and the other counterparty is established in a non-equivalent non-EEA state, the EMIR requirements will apply.

One consequence of EMIR’s requirement that at least one of the counterparties is established in the equivalent non-EEA state is that there may be certain anomalous scenarios in which the Article 13 relief is not available - eg where a Cayman fund managed out of the US transacts with an EEA dealer registered as a Swap Dealer with the CFTC.

Where both counterparties are established in a “non-equivalent” non-EEA state

Article 13 of EMIR does not address the situation in which both counterparties are established in non-equivalent non-EEA states. This is the situation that the Level 2 regulatory technical standards contained in Commission Delegated Regulation 285/2014 are designed to cover.

Where both counterparties to a transaction are based in a non-EEA state which has not been declared by the EU Commission to be equivalent for these purposes, the transaction will only be subject to the provisions of EMIR if it has a "direct, substantial and foreseeable" effect within the EEA or it is otherwise necessary to prevent the evasion of any provisions of EMIR.

Commission Delegated Regulation 285/2014 entered into force on 10 April 2014 (ie the 20th day after publication in the Official Journal).  Article 3, which specifies the cases where it is necessary or appropriate to prevent the evasion of EMIR, started to apply from that date.  Article 2, which contains the provisions defining when a contract will have a direct, substantial and foreseeable effect, started to apply on 10 October 2014.

"Direct, substantial and foreseeable" effect within the EEA

Commission Delegated Regulation 285/2014 provides that a contract between two counterparties established in non-equivalent non-EEA states will be considered to have a "direct, substantial and foreseeable" effect within the EEA in either of the following two situations.

  • One of the counterparties benefits from a guarantee provided by an FC established in the EEA which: 
    • covers a minimum aggregate notional amount of OTC derivatives exposures by the counterparty benefiting from the guarantee (where the guarantee covers all such liability the minimum amount is EUR 8 billion; where the guarantee covers a percentage of such liability the minimum amount is EUR 8 billion divided by the percentage of liability covered by the guarantee), and 
    • represents an amount which is at least 5% of the total OTC derivatives exposures of the FC providing the guarantee. 
  • Both counterparties execute the transaction via a branch in the EEA and would qualify as FCs if they were established in the EEA.

Commission Delegated Regulation 285/2014 contains an explicit definition of a guarantee for this purpose5 as well as additional provisions:

    • dealing with the possibility of a change in circumstances, causing a contract which is not initially considered to have a direct, substantial and foreseeable effect subsequently to be considered as having that effect;
    • confirming that where an OTC derivative contract becomes covered by a guarantee after it is concluded, the derivative contract will nevertheless be considered as having a direct, substantial and foreseeable effect from the point when it is covered by the guarantee if the relevant conditions are satisfied; and
    • confirming that where the liability resulting from the OTC derivative contracts covered by the guarantee is in fact below the EUR 8 billion threshold, the OTC derivative contracts will not be considered to have a direct, substantial and foreseeable effect even where the maximum amount of the guarantee and the total OTC derivatives exposure of the FC providing the guarantee are above the relevant thresholds.
Imposing EMIR requirements on non-EEA counterparties where necessary to prevent the evasion of EMIR

Commission Delegated Regulation 285/2014 provides that an OTC derivative contract will be deemed to have been designed to circumvent the application of any provision of EMIR if the way in which that OTC derivative contract has been concluded is considered, viewed as a whole, and having regard to all the circumstances, to have as its primary purpose, the avoidance of the application of any provision of EMIR.

Commission Delegated Regulation 285/2014 goes on to state that this will be the case where the primary purpose of an arrangement or series of arrangements related to the OTC derivative contract is to defeat the object, spirit and purpose of any provision of EMIR that would otherwise apply, including when it is part of an artificial arrangement or artificial series of arrangements. "Arrangements" consist of any contract, transaction, scheme, action, operation, agreement, grant, understanding, promise, undertaking or event. An “artificial arrangement” is one that intrinsically lacks business rationale, commercial substance or relevant economic justification.

The table below contains a summary setting out when the requirements in Articles 4, 9, 10 or 11 of EMIR will, and will not, apply to a transaction, depending on where the counterparties are established.

Counterparty A  Counterparty B  Result 
Established in EEA member state   Established in EEA member state  EMIR will apply 
Established in EEA member state   Established in non-equivalent non-EEA state  EMIR will apply 
Established in EEA member state   Established in equivalent non-EEA state  Both counterparties deemed to comply with relevant EMIR requirements 
Established in equivalent non-EEA state  Established in equivalent non-EEA state  Both counterparties deemed to comply with relevant EMIR requirements 
Established in equivalent non-EEA state  Established in non-equivalent non-EEA state  Both counterparties deemed to comply with relevant EMIR requirements 
Established in non-equivalent non-EEA state  Established in non-equivalent non-EEA state  EMIR will apply if:
  • contract has “direct, substantial and foreseeable effect” in the EEA, or 
  • necessary to prevent evasion of EMIR provisions

What should I be doing?

The requirements of EMIR represent a sea change in the OTC derivatives market. If they have not done so already, firms should be getting to grips with the new requirements and carrying out an impact assessment in terms of the business, operational and legal changes involved.

When the first clearing obligation is introduced, there is likely to be a rush by end users to establish relationships with clearing members and to put documentation in place. This bottle neck may cause difficulties both from a timing and a bargaining perspective. To ease the process of migrating OTC derivatives trading relationships to a cleared environment, ISDA and the FOA published the Client Cleared OTC Derivatives Addendum on 11 June 2013. For further information on the Addendum see our separate elexica article.

There is likely to be a first mover advantage for those firms who can establish terms with clearing members, carry out dry runs of transactions, update systems and procedures, amend derivatives risk management plans and undertake stress testings sufficiently in advance of mandatory clearing. It is essential that clients understand the service being offered by clearing houses and the levels of protection and risks involved.

NFCs should, amongst other things, be analysing whether they will be treated as NFC+ and subject to the clearing obligation and what this would imply from a business perspective.

We will be updating this note as the regulation develops, and working with clients to establish scaleable solutions to best deal with the new requirements.

 


1. Regulation (EU) No 648/2012 of 4 July 2012 on OTC derivatives, central counterparties and trade repositories

2. Commission Implementing Regulation 1247/2012 on the format and frequency of the data to be reported to trade repositories, Commission Implementing Regulation 1248/2012 on the format of the application for registration as a trade repository and Commission Implementing Regulation 1249/2012 on the format of the records to be maintained by central counterparties

3. Commission Delegated Regulation 148/2013 on the minimum details of the data to be reported to trade repositories, Commission Delegated Regulation 149/2013 on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non financial counterparties, and risk mitigation techniques, Commission Delegated Regulation 150/2013 on the details of the application for registration as a trade repository, Commission Delegated Regulation 151/2013 on the data to be published and made available by trade repositories and operational standards for aggregating, comparing and accessing the data,  Commission Delegated Regulation 152/2013 on capital requirements for central counterparties, and Commission Delegated Regulation 153/2013 on requirements for central counterparties

4. Commission Delegated Regulation 285/2014 of 13 February 2014 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on direct, substantial and foreseeable effect of contracts within the Union and to prevent the evasion of rules and obligations

5. “guarantee” means an explicitly documented legal obligation by a guarantor to cover payments of the amounts due or that may become due pursuant to the OTC derivative contracts covered by that guarantee and entered into by the guaranteed entity to the beneficiary where there is a default as defined in the guarantee or where no payment has been effected by the guaranteed entity.