The European Market Infrastructure Regulation (EMIR) has a significant history since it entered into force on 16th August 2012. Now, the phase-in process is about to approach new deadlines, and other major changes are looming on the horizon.
Historically, the Regulation came in the aftermath of the financial crisis as part of the global OTC Reform, with the aim to increase transparency and reduce systemic risk in the derivatives trading. To this end, it introduced three main obligations for firms: 1) to report all transactions in derivatives contracts, 2) to centrally clear OTC derivatives and, 3) for non-cleared OTC derivatives, to use risk-mitigation techniques (RMTs), including the exchange of collateral. Additionally, EMIR established a regulatory framework for central counter-parties (CCPs) and trade repositories.
While the use of RMTs and reporting obligation have existed since 2013 and 2014 respectively, some obligations such as the exchange of collateral and the clearing obligation are still in the phase-in process. The Regulation is currently undergoing a review which will likely result in a number of changes to current regulatory requirements. With the final outcomes of the review process expected in the coming months, it may be time now for businesses to begin anticipating potential opportunities and challenges the updated EMIR will bring for their business.
EMIR phase-in process: next deadlines are approaching
The mandatory central clearing of certain OTC trades follows an extended phase-in process, with the European Commission (EC) releasing application dates in its Regulatory Technical Standards (RTS). The clearing obligation began coming into force in mid-2016 and will only be complete for all asset classes and counterparties by mid-2019. To-date, the EC has determined that three types of derivatives contracts are subject to mandatory clearing: IRS’s (interest rate swaps) denominated in G4 currencies (i.e. EUR, USD, GBP and JPY), IRS’s denominated in non-G4 currencies (i.e. NOK, PLN and SEK) and Index CDS’s (credit default swaps).
Applicable effective dates vary in relation to the classification of counterparties. As a quick reminder, firms may fall within any of clearing categories below:
- Category 1: Clearing Members (CM) in the asset classes subject to the clearing obligation.
- Category 2: FCs and AIFs whose month-end average of outstanding gross notional amount of non-centrally cleared derivatives is above EUR 8 billion.
- Category 3: FCs and AIFs that fall below the above mentioned EUR 8 billion threshold.
- Category 4: NFCs not belonging to any other category.
In accordance with the latest relevant RTS, counterparties in categories 1 and 2 should already be clearing the three types of OTC derivatives. FC’s and NFC’s belonging to category 3, however, are expected to centrally clear all three OTC classes as of 21 June 2019. NFCs belonging to Category 4 are expected to begin clearing IRS’s in G4 currencies on 21 December 2018, Index CDS’s on 9 May 2019, and IRS’s in non-G4 currencies on 9 August 2019. To ensure that the pertinent deadlines are met, affected counterparties should begin making the necessary preparations and explore the market for clearing services.
EMIR: important amendments ahead
Pursuant to the Article 85 of EMIR Regulation (EU) No 648/2012 on the Regulation review, the EC submitted last year a report to the European Parliament and the Council containing two sets of targeted amendments. The first draft followed on the Commission’s regulatory fitness and performance (REFIT) program and seeks to simplify the regulation of OTC derivatives. The second draft, however, was devised with a view to improve the supervision of EU based and third country CCPs. Depending on the final versions of the texts, a number of market participants could either benefit from reduced costs or see their compliance duties increased in scope.
EMIR Refit, towards a simplification?
EMIR Refit targeted amendments aim to simplify the rules for OTC derivatives and make them more proportionate, with a view to reducing regulatory costs and burdens on market participants. EMIR Refit hopes to accomplish all of this without undermining the stability of the European financial system.
A number of EMIR Refit changes to clearing will have immediate impact on currently affected firms:
- End of the “frontloading” requirement – firms will not be mandated anymore to clear OTC contracts entered into after a CCP has been authorized under EMIR and before the date of application of the clearing obligation.
- Introduction of a clearing threshold for small FCs (SFCs) – FCs with very small volume of activity would be classified as SFC if they don’t exceed a threshold, and should not be subject to the clearing obligation.
- NFCs to clear only those asset classes for which they breach the threshold – currently NFC’s are mandated to clear all OTC derivatives if they breached only the clearing threshold in one asset class.
- Extension by 3 additional years of the exemption from the clearing obligation for Pension scheme arrangements (PSAs) – while the clearing obligations took effect earlier this year, the proposal would further extend the exemption.
- The EC could temporarily suspend clearing obligations – for a specific type of OTC or a specific type of counterparty.
- Subsume AIFs under the category of FCs – AIFs would be required to comply with all the EMIR obligations; while today they could benefit from certain exemptions as an NFC.
In addition to changes to clearing requirements, EMIR Refit would also bring significant simplification to reporting requirements:
- End of the “backloading” requirement for transactions that were outstanding as of the reporting obligation – firms will not be mandated anymore to report back-dated transactions.
- Exemption to report intragroup (entities belonging to the same group) transactions where one of the counterparties is an NFC – intragroup transactions with an NFC should be exempt from the reporting obligation, regardless of the place of establishment of the NFC.
- End of the reporting obligation for the Exchange-traded transactions (ETDs) – CCPs will be mandated and legally liable to report transactions on behalf of both counterparties.
- FC transacting with a small NFC will report on behalf of both parties for OTC derivatives transactions – FCs will be mandated and legally liable to report transactions on behalf of both counterparties.
EMIR Refit follows an ordinary legislative proposal. The Council agreed on its General Approach in May 2018, and the Parliament adopted its own amendments in June 2018. The draft Regulation amending EMIR is currently undergoing inter-institutional negotiations, but the final outcome is hard to predict. However, we can expect the negotiations to amend the above EC draft proposal, and a number of key provisions are likely to find its way into the final text.
EMIR CCP supervision and the Brexit risk
The second set of amendments seeks to increase the regulatory oversight of CCPs and is currently one step behind EMIR Refit in the legislative process as inter-institutional negotiations are yet to begin. Most remarkable changes involve expanding the supervisory powers of the European Securities and Markets Authority (ESMA) and augmenting the recognition procedure for third country CCPs, which would take into account the importance of a CCP to the clearing system of one or more EU Member States.
Key EMIR changes to third country CCPs include:
- Introduction of a classification of third country CCPs by ESMA – non-systemically important third-country CCPs (Tier 1) and systemically important third-country CCPs (Tier 2).
- Tier 1 CCPs are CCPs that present low risk to the European financial system. They are allowed to operate in the EU, assuming that they continue to be subject to the existing arrangements for EMIR equivalence and recognition as a third country.
- Tier 2 CCPs would be subject to additional requirements compared to Tier 1 CCPs. Tier 2 CCPs are considered systemically important (or likely to become systemically important in the near future) for the financial stability of the Union, or for one or more of its Member States. Tier 2 CCPs would be subject to a stricter supervision by the ESMA.
While the impact of this set of amendments on banks and investment firms would be rather indirect, a potential game-changing provision is the proposed explicit power of EU supervisors to require Tier 2 CCPs to relocate to the EU territory. For UK-based clearing houses, this would come in addition to a more immediate challenge if the UK leaves the EU without an agreement that would temporarily allow UK-based firms continued access to the Single Market. In the worst case scenario, when passporting is not valid anymore on 29 March 2019, CCPs based in the UK will not be able to provide services to firms based in Europe. To remedy this, they could establish themselves in the EU or a third country recognized under EMIR, or request EU supervisors to allow them to benefit from a potential third-country equivalence regime with the UK.
To underscore the importance of CCPs, since EMIR came into force and the clearing obligation became mandatory for some derivatives, the volume of IRS’s that are centrally cleared increased from 36% (end 2009) to 75% (end 2017). Globally, as of December 2017, more than 60% of all OTC derivatives contracts (amounted to $532 trillion, of which the large majority, $427 trillion, are IRS’s) were centrally cleared by CCPs. Given that the vast majority of euro-denominated OTC derivatives clearing currently takes place in the UK (75% of euro-denominated IRS’s are cleared in the UK, in addition to OTC denominated in some other Members States’ currencies), increased clearing costs and service disruptions should be viewed as potential risks for firms relying on the London-based clearing infrastructure. Service disruptions are viewed to be less likely of a risk but not impossible
Changes for next year?
According to both proposals, the amended EMIR would enter into force 20 days after the publication in the Official Journal of the European Union. Considering that EMIR Refit is currently undergoing inter-institutional negotiations and that the EMIR CCP draft proposal will likely enter negotiations soon, we estimate that first amendments could become applicable in 2019 in principle. However, this principle depends also on the political agenda in a year of European elections.
Such timeline would be very challenging in terms of the implementation of the new requirements, e.g. AIFs could be potentially categorized as FCs. Therefore AIF’s would need to be compliant with some EMIR requirements within the 20 days after the entry into force of the proposal. Furthermore, banks would potentially need to find a CCP authorized by a competent authority to clear a class of OTC derivatives, as an alternative to UK-based CCPs after Brexit.
Denis Costermans, Associate Partner, Advisory Services, EY Luxembourg
Marc Tilahy, Manager, EMIR specialist, Advisory Services, EY Luxembourg
The authors of this article are solely responsible for the content published.