Letter to EMIR 1/3 – Refresher on European Market Infrastructure Regulation (EMIR)

Dear Reader,

This letter is part of a series of three on the European Market Infrastructure Regulation (EMIR):

• Letter 1/3: An update on EMIR
• Letter 2/3: Recent developments in the EMIR area with EMIR Refit and the new technical reporting standards applicable from April 2024. It will provide an overview of the challenges that banks may face.
• Letter 3/3: An overview of Digital Regulatory Reporting (DRR) as a potential solution for improving the quality and convergence of reported data. In cooperation with ISDA (International Swaps and Derivatives Association).

As part of our efforts to inform our members about market infrastructures, the ABBL and LuxCMA are organising a conference on the subject on 23/11. The first in Luxembourg! Come and explore the pioneering world of Luxembourg market infrastructures.

What is EMIR?

Regulation (EU) No 648/2012 on OTC Derivatives, Central Counterparties and Trade Repositories dated 4 July 2012, as amended (EMIR), was adopted in 2012 as an implementation of the G20 commitment to reduce systemic, operational and counterparty risk and increase transparency in OTC derivatives markets.

The aim of EMIR is to prevent a fallout from future financial market crisis such as occurred in 2008.

EMIR came into force on 16 August 2012, and it provides for obligations applicable to counterparties to derivatives contracts as well as for uniform requirements applicable to trade repositories and central counterparties, including authorisation and registration requirements. Following an extensive assessment of EMIR by the European Commission in 2015. Regulation (EU) 2019/834 of the European Parliament and of the Council (EMIR ReFIT) was adopted in 2020 and supplements EMIR.

To whom it should apply

The EMIR obligations apply to financial and non-financial counterparties when parties to a derivative contract.

As per Article 2(8) of EMIR, a financial counterparty is defined as:

• any investment firm authorised in accordance with Directive 2014/65/EC;
• any credit institution authorised in accordance with Directive 2013/36/EC;
• any insurance undertaking or reinsurance undertaking authorised in accordance with Directive 2009/138/EC.
• any UCITS and, where relevant, its management company, authorised in accordance with Directive 2009/65/EC, unless that UCITS is set up exclusively for the purpose of serving one or more employee share purchase plans.
• any institution for occupational retirement provision (IORP) as defined in point (1) of Article 6 of Directive (EU) 2016/2341 of the European Parliament and of the Council.
• any alternative investment fund (AIF), as defined in point (a) of Article 4(1) of Directive 2011/61/EU which is either established in the Union or managed by an alternative investment fund manager (AIFM) authorised or registered in accordance with Directive 2011/61/EU, unless that AIF is set up exclusively for the purpose of serving one or more employee share purchase plans, or unless that AIF is a securitisation special purpose entity as referred to in point (g) of Article 2(3) of Directive 2011/61/EU, and, where relevant, its AIFM established in the Union.
• any central securities depository in accordance with Regulation 909/2014/EU

As per Article 2(9) of EMIR, a non-financial counterparty is defined as “an undertaking established in the Union other than CCPs and financial counterparties”.

It is to be noted that, reporting obligations also apply to ManCos of funds which are financial counterparties under EMIR and counterparties to OTC derivatives.

EMIR classification

Financial counterparties and non-financial counterparties to derivative contracts under EMIR are classified in different categories, such as:

(i) financial counterparties (FCs) , further split into: 

• (a) financial counterparties below the “clearing threshold” (FC-) and
• (b) financial counterparties above the “clearing threshold” (FC+) and

(ii) non-financial counterparties, further split into: 

• (c) non-financial counterparties above the “clearing threshold” (NFC+s), and
• (d) non-financial counterparties below the “clearing threshold” (NFC-s).

Note: “Financial counterparties”:

• (a) an investment firm authorised in accordance with Directive 2014/65/EU;
• (b) a credit institution authorised in accordance with Directive 2013/36/EU;
• (c) an insurance undertaking or reinsurance undertaking authorised in accordance with Directive 2009/138/EC;
• (d) a UCITS and, where relevant, its management company, authorised in accordance with Directive 2009/65/EC, unless that UCITS is set up exclusively for the purpose of serving one or more employee share purchase plans;
• (e) an institution for occupational retirement provision (IORP), as defined in point (1) of Article 6 of Directive (EU) 2016/2341 
• (f) an alternative investment fund (AIF), as defined in point (a) of Article 4(1) of Directive 2011/61/EU, which is either established in the Union or managed by an alternative investment fund manager (AIFM) authorised or registered in accordance with that Directive, unless that AIF is set up exclusively for the purpose of serving one or more employee share purchase plans, or unless that AIF is a securitisation special purpose entity as referred to in point (g) of Article 2(3) of Directive 2011/61/EU, and, where relevant, its AIFM established in the Union;
• (g) a central securities’ depository authorised in accordance with Regulation (EU) No 909/2014 of the European Parliament and of the Council.

How to do “determine the threshold”?

For the purposes of determining whether counterparties fall above or below the “clearing threshold”, FCs and NFCs calculate their aggregate month-end average position for the previous 12 months against the clearing thresholds defined in regulatory technical standards supplementing EMIR.

Where a FC calculates its positions and the result of that calculation exceeds the clearing threshold, the FC will become subject to the clearing obligation for all OTC derivative contracts pertaining to any class of OTC derivatives for which the clearing obligation is applicable (regardless of not exceeding the clearing threshold of each asset class.

Where a NFC calculates its positions and the result of that calculation exceeds the clearing thresholds, the NFC will become subject to the clearing obligation only for the OTC derivative contracts in asset classes for which the result of the calculation exceeds the clearing thresholds.

In the event where counterparties choose not to calculate their positions; they will automatically be deemed to have exceeded the “clearing thresholds” and will be subject to all relevant obligations (including notably the clearing obligation) under EMIR.

Typical FCs include EU credit institutions, investment firms and AIFs while NFCs include special purpose vehicles and standard Luxembourg corporates.

EMIR obligations apply differently based upon the counterparty’s classification.

Counterparties to derivatives are subject to several obligations, including:

• (i) a mandatory clearing obligation for certain classes of OTC derivatives,
• (ii) risk mitigation techniques for OTC derivatives not subject to clearing (i.e. timely confirmation, daily mark-to-market valuation, portfolio reconciliation & dispute resolution, collateral exchange and portfolio compression) and
• (iii) reporting obligations for all derivatives, including exchange traded derivatives.

Such obligations are further detailed in delegated and implementing regulations issued by the Commission, as well as Guidelines published by the ESMA and the CSSF.

Checklist

Who am I entering into a derivatives contract with? 

I need to know if my counterparty is a financial or non-financial counterparty, or from outside the EU, and if they have to follow EMIR or similar rules in their countries.

• Why am I entering into this derivatives contract? 

Is the contract’s economic objective for hedging or speculative purposes?

• What kind of derivatives contract am I entering into? 

I need to know if the derivatives contract is traded on an exchange or over-the-counter (OTC), and if it is a derivative or a spot contract under EMIR.

Do I have to clear the derivatives contract through a central counterparty (CCP)? 

I need to check the clearing obligation and the clearing thresholds set by EMIR, and if the contract is eligible for clearing by a CCP that is authorised or recognised under EMIR.

If I have to clear the derivatives contract, do I have the appropriate processes and procedures to do it? 

I need to establish a clearing arrangement with a CCP and follow the procedures and standards of the CCP.

If I do not have to clear the derivatives contract, have I planned to comply with the risk mitigation techniques as set out under EMIR and its delegated and implementing acts? 

The following risk mitigation techniques would need to comply with when entering into an OTC derivatives contract:

• I may need to implement procedures and arrangements to measure, monitor and mitigate the operational and counterparty credit risks arising from my OTC derivative contracts, such as timely confirmation, portfolio reconciliation, dispute resolution and portfolio compression.
• Depending on with whom I trade with, I may need to apply daily valuation methods and mark-to-market or mark-to-model techniques to value my OTC derivative contracts, and report any valuation disputes to the competent authority of either party or of the trade repository. I may also need to conduct periodic and robust stress tests of my procedures and arrangements to measure, monitor and mitigate the operational and counterparty credit risks, and ensure that I have liquidity and capital resources in line with the EMIR requirements and the applicable prudential framework to meet my obligations under my OTC derivative contracts.
• I may have to exchange collateral in accordance with (i) the EMIR margin requirements and (ii) eligibility criteria with my counterparties to cover the current and potential future exposure of my OTC derivative contracts, unless I qualify for an exemption based on the type, size or nature of my or my counterparty’s OTC derivatives activity

Am I keeping records of the derivatives contract and the procedures to comply with the risk mitigation techniques? 

I need to keep accurate, complete, and accessible records of the contract and the risk mitigation activities for at least five years after the contract ends, and be able to provide them to the EU authorities or the trade repository if asked.

If I have an EMIR classification subject to reporting obligations, what do I need to report?

I need to define my EMIR classification via the calculation of my aggregate month-end average position for the previous 12 months against the clearing thresholds. If subject to the reporting obligation, I need to report the derivatives transactions details as well as the daily positions details of outstanding contracts to a trade repository within the specific deadlines required by EMIR.

Dear Reader, see you this week for EMIR Letter 2/3, with our thoughts on EMIR-related developments!

Contributors

Marilyn Rinck, Adviser on Financial market at the ABBL, and Natacha Dats, Chairperson of the ABBL Working group on Market Infrastructures.

Special thanks for their contribution to Allen & Overy