European Derivatives Regulation in a Post Brexit World
By Karen Stretch, Karina Bielkowicz & Christian Parker, with assistance from Shanel Hassan
Spotlight on the European Markets and Infrastructure Regulation (“EMIR”)
“Firms must continue to abide by their obligations under U.K. law, including those derived from EU law and continue with implementation plans for legislation that is still to come into effect.”
Although three weeks have now passed following the widely unexpected outcome of the United Kingdom (the “U.K.”) European Union (“EU”) referendum of Thursday 23 June 2016, that the public had voted in favour of the U.K. to leave the EU (so called “Brexit”), the hot topic on the financial services community’s lips remains what a post Brexit world will bring.
This Client Alert provides legal reaction to Brexit for European derivatives and derivatives regulation, focusing on EMIR. However, echoing the Financial Conduct Authority (“FCA”) sentiments above and on the basis that the legal status quo is expected to remain unchanged for at least two years, this Client Alert, on the eve of EMIR’s four year anniversary, serves as a general status update on the implementation of EMIR following our two previous related Stay Currents:
Autumn 2013 EMIR Stay Current (“European Derivatives Regulation: Spotlight on the European Markets and Infrastructure Regulation (“EMIR”)”) (the “2013 EMIR Stay Current”); and
July 2015 Stay Current (“European Derivatives Regulation: Spotlight on the European Markets and Infrastructure Regulation (“EMIR”) - Where Are We Now? - Part 2 Summer 2015”) (the “2015 EMIR Stay Current”).
Brexit and EMIR
“Brexit casts doubt on derivatives rules”
How does the referendum result affect EMIR compliance?
It does not: until the Article 50 notice
How will or could Brexit affect EMIR?
As an EU regulation, EMIR takes direct effect across EU Member States. The terms of any U.K. Article 50 Agreement will dictate if and how EMIR will apply post Brexit. Hence, the exact effects of Brexit on EMIR and related legislation will be unknown until any such agreement or other withdrawal takes effect and possibly not until sometime after.
If the “Norwegian” (or similar) route is followed (i.e. if the U.K. joins the European Free Trade Association joining Iceland, Liechtenstein, Norway and Switzerland and becomes a member of the European Economic Area (“EEA”) (Iceland, Liechtenstein and Norway only)), the U.K. would remain a member of the so called “EU single market” and continue to be subject to, and benefit from, ongoing EU regulations and directives. However, since EMIR has its genesis from the global intergovernmental commitments cemented at the 2009 G20 summit in Pittsburgh, even if the U.K.’s withdrawal follows an alternative route and ongoing EU legislation does not automatically apply it is unlikely that Brexit will result in any radical changes to the way in which derivatives activity is undertaken in the U.K. Indeed, we expect that the U.K. will adopt either identical or similar legislation to EMIR and the post Brexit analysis set out below assumes that this is the case.
Potential post Brexit EMIR analysis
Post Brexit, the key step for EMIR analysis will be ascertaining a U.K. incorporated entity’s EMIR counterparty status and unless, following the U.K.’s withdrawal, there are no changes to the way EMIR applies to U.K. incorporated entities, we would expect that the U.K. will become a third country entity (“TCE”) for the purposes of EMIR.
By way of reminder, EMIR’s international reach and effect on TCEs emanates from two key aspects of EMIR, the first being those EMIR provisions which directly impose mandatory clearing obligations and risk mitigation techniques on certain transactions with entities that would be subject to EMIR if incorporated in the EU (“Hypothetical Counterparties”) and between TCEs; and secondly, EMIR’s “equivalence” concept: Should the European Commission declare that the “legal, supervisory and enforcement” arrangements of a third country are “equivalent” in relation to clearing, reporting and risk mitigation, the counterparties to a transaction shall be deemed to have fulfilled their corresponding EMIR obligations where at least one of the counterparties is established in that third country.
In summary, by virtue of being a TCE:
Any U.K. counterparty otherwise amounting to an Financial Counterparty (“FC”) or Non-Financial Counterparty (“NFC”) would no longer automatically be subject to EMIR. Rather, EMIR would only apply in the limited circumstances prescribed by EMIR, being for clearing where either (i) one counterparty is an EMIR FC or NFC+ and the second counterparty is a Hypothetical Counterparty, or (ii) two TCEs transact and such contract is determined to have a “direct, substantial and foreseeable effect” in the EU or where imposing the clearing obligation is “necessary or appropriate to prevent the evasion of any provisions of EMIR”. Satisfying the latter standards will also trigger the so-called risk mitigation techniques for over the counter (“OTC”) derivative contracts not cleared by a central counterparty (“CCP”).
If, post Brexit, the EU makes any equivalence determinations in relation to the U.K., usual business with entities directly subject to EMIR should be possible. Given the U.K.’s current derivatives regulatory regime has been established in accordance with EMIR, and we expect this to continue, any equivalence determination should not be difficult to achieve. However, as the United States (“U.S.”) and EU CCP equivalence discussions are testament to, the question of equivalence can become politicised and in practice therefore any decision may take longer than expected.
Any U.K. incorporated CCP would have to be formally recognised by the European Securities and Markets Authority (“ESMA”) as a third country CCP (Article 25, EMIR). Such registration could not occur until the U.K.’s CCP regulatory and supervisory regime first receives an equivalence determination, which, on the basis that the U.K.’s framework is already EMIR compliant should be a formality for a CCP or indeed a trade repository (to which an analogous analysis applies) incorporated in the U.K.
To facilitate their own EMIR compliance and as is often the case for current TCEs, it is likely that any EU based FC will insist, as a prerequisite to trade, that the U.K. entity (irrespective of its TCE status) comply with EMIR related requirements.
Brexit and ISDA documentation
In the absence of any bilaterally agreed provisions, the occurrence of the referendum should not require or trigger any immediate changes or events to standard ISDA documentation. EMIR related provisions now widely included in ISDA Schedules as standard should not be immediately effected either. Market events that have followed could however now (and in the future) trigger credit related events, for example linked to the credit worthiness of a counterparty or exposure issues requiring more collateral to be posted.
Governing law and jurisdiction: Once any Article 50 Agreement becomes effective, it may be the case that neither Rome I nor Rome II in relation to governing law nor the Brussels Convention related references in Section 13(b) of the ISDA Master Agreement apply in the same way as today.
Entities will also need to consider an approach for other European legislative references that may become obsolete post Brexit including for example references now becoming more widespread in ISDA Schedules in relation to the European Banking Resolution and Recovery Directive.
For a general discussion of the implications of Brexit, please see our June 2016 Stay Current, “
II. The Implementation of EMIR
Current Status of key EMIR obligations
1. MANDATORY CLEARING
(partially since 21 June 2016)
Ongoing implementation and process: See tables below. Further products expected to be covered in the future.
(since 12 February 2014)
3. Risk MITIGATION TECHNIQUES for uncleared OTC derivatives
(partially since 13 March 2013)
Go-live date for final draft regulatory technical standards (“RTS”) relating to margin requirements for uncleared OTC derivatives.
A. Key new document releases and resources
ISDA Regulatory Margin Self-Disclosure Letter (30 June 2016)
Updated ESMA Q&A paper (6 June 2016)
ISDA 2016 Variation Margin related new Credit Support Annexes and draft Protocol (from 14 April 2016)
ISDA (updated) EMIR Classification Letter and accompanying Guidance Note (13 April 2016)
B. Progress on the EMIR obligations
1. The mandatory clearing obligation
There has been progress since the 2015 Stay Current and the first EMIR go-live clearing date has now passed: From 21 June 2016, Category 1 entities were required to clear certain G4 denominated interest rate derivatives.
Following closely behind are the go-live dates for certain index credit default swaps and interest rate swaps denominated in certain non-G4 European currencies (Swedish Krona (“SEK”), Polish Zloty (“PLN”) and Norwegian Krone (“NOK”)). The latter RTS are not yet published and remain subject to a period of scrutiny by the European Parliament and the Council and will then take effect over a three-year period similar to the two RTS already published, i.e. six months after entry into force of the RTS for Category 1 entities, 12 months after entry into force of the RTS for Category 2 entities, 18 months after entry into force of the RTS for Category 3 entities and three years after entry into force of the RTS for Category 4 entities.
Set out below are two tables providing key information in relation to the EMIR clearing obligation:
TABLE 1: Based on a table extracted from the ESMA websitethis table shows the current status for those classes of derivatives that ESMA has proposed are subject to the clearing obligation.
TABLE 2: This table shows key dates for those two clearing related RTS that have now been published.
Status of RTS
Interest Rate (1)
Basis, fixed-to-float, forward rate agreements (“FRA”) and overnight index swaps in Euro (“EUR”), British Pound Sterling, Japanese Yen and U.S. Dollar
11 Jul 2014
1 Oct 2014
Final Report (n°1)
6 Mar 2015
Opinion on the RTS on interest rate swaps (“IRS”)
RTS published in the
1 Dec 2015
Interest Rate (2)
FRA and fixed-to-float swaps in NOK, PLN and SEK
11 May 2015
Paper (n° 4)
10 November 2015
Final Report (n°3)
RTS endorsed by the European Commission
10 June 2016
Lookalike/flexible equity derivatives and contracts for difference
11 Jul 2014
1 Oct 2014
Final Report (n°1)
No RTS proposed at this stage
Index credit default swaps (“CDS”)
11 Jul 2014
1 Oct 2015
Final Report (n°2)
20 Nov 2014
Letter to the Commission on RTS on clearing obligation
RTS published in theOfficial Journal
19 April 2016
Non-deliverable forward (“NDF”)
1 Oct 2014
4 Feb 2015
Feedback statement on NDF
No RTS proposed at this stage
4 Feb 2015
EMIR Counterparty Category
Clearing Start Date
Frontloading Start Date
G4 rates products (1. above)
Index CDS (4. above)
G4 rates products (1. above)
Index CDS (4. above)
21 June 2016
9 February 2017
21 February 2016
9 October 2016
21 December 2016
9 August 2017
21 May 2016
9 October 2016
21 June 2017
9 February 2018
21 December 2018
9 May 2019
RECAP: Does the EMIR clearing obligation apply to me?
The EMIR mandatory clearing obligation applies to all trades between FCs and NFC+s, all trades between FCs or NFC+s and certain Hypothetical Counterparties and on a limited basis to trades between two TCEs. The temporary relief granted to certain pension scheme arrangements__that would otherwise be subject to the clearing obligation remains available until 16 August 2017__.
In the event that two entities of different clearing categories enter into an interest rate product caught by the EMIR clearing obligation, the parties must clear the trade by the later applicable effective date. For example, a derivative in scope for the first clearing RTS entered into between a Category 1 entity and a Category 2 entity must be cleared by 21 December 2016 rather than 21 June 2016.
The G4 IRS RTS are very much seen as the blue print for the EMIR clearing obligation and pending equivalence determinations include a temporary derogation for certain intragroup transactions entered into between one TCE and an EU entity, provided that certain conditions are satisfied (the same derogation is also included in the CDS RTS).
So, what next?
Likely eclipsed by events later that week or by the fact that many of the large institutions to which the clearing obligation now applies have been clearing such liquid interest rate swaps for some time, the first clearing go-live date passed with little comment.
As the dates for the other categories approach we expect discussion regarding client and indirect client clearing
With a go-live date of 12 February 2014, the Article 9 EMIR reporting requirement has now been in effect for over two years. Although the reporting obligation is now usual business for counterparties, ongoing issues do remain and primarily relate to (i) the scope of the reporting requirement and the uncertainty remaining around the definition of “derivative” and (ii) how the reporting obligation may be refined, not only within the EU but on a global basis, in an effort to achieve international harmonisation across reporting requirements, with a big focus on the production of standardised data.
The status of FX transactions and MiFID II
As detailed in both our 2013 EMIR Stay Current and 2015 EMIR Stay Current, due to the lack of a harmonised implementation across Europe of MiFID
Although remaining in draft form, the MiFID Commission Delegated Regulation of 25 April 2016
Single sided reporting and the EMIR review
Notwithstanding the various market initiatives to facilitate the reporting process, compliance with the reporting obligation remains a resource and preparation intense activity. Even where buy-side entities have delegated the reporting obligation, legal responsibility to comply with the reporting requirement remains and reports must therefore be checked and processes considered. Such factors combined with the continued lack of global harmonisation and consistency of data across international reporting requirements devalue the volume of data now being sent to trade repositories and related debate and discussion is on-going at the highest industry levels. A possible move to global entity based or single sided reporting and the related merits to abate such concerns was most recently highlighted by the April 2016 paper published by ISDA in conjunction with 12 other high profile trade associations including AIMA and GFMA
The data to be reported
In November 2015, ESMA published its Final Reportin relation to the new RTS and implementing technical standards (“ITS”) relating to the EMIR reporting obligation. The aim remains to clarify the interpretation of the data fields required for reporting to trade repositories and the most appropriate way of populating them. ESMA itself acknowledged in the report that given the short period of time during which the initial reporting related RTS and ITS had to be produced “…the practical implementation of EMIR reporting and the experience gained so far has shown several shortcomings and limitations that need to be addressed so that the EMIR reports can better fulfil their objectives”. The European Commission was expected to respond to the final report within three months but this three-month period expired on 13 February 2016 and at the time of writing no further action has currently been taken.
In May 2016, ISDA published a paper relating to the Principles on the Development of Derivatives Product Identifierswhich ultimately supports the work of the International Organization of Securities Commission and the Committee on Payments and Market Infrastructures which are trying to establish a globally consistent derivatives product identifier. The creation of a global derivatives product identifier would be a major step for the global harmonisation of derivatives data reporting. Potential issues with the use of one mooted solution, the International Securities Identification Number (ISIN) as a standard identifier were highlighted in a recent International Financing Review article. An analogy used in a recent article published in the IQ: ISDA Quarterly publicationneatly summarises the current problem, comparing the different reporting standards worldwide to car dealerships which are required to report facts globally about different cars sold — if some dealerships report size as weight, some as number of people a car holds and others as length it becomes easy to see how issues may arise and comparative analysis very difficult.
On the current timeline, MiFID II will become effective on 3 January 2018. It is only then that the formal amendments to the definition of “derivative” will take effect. Ahead of the MiFID II
Notwithstanding the publication of any such best practice standards, the reality is that any changes to EMIR or indeed other derivatives regulatory regimes including the Dodd-Frank Act
RECAP: Does the EMIR reporting obligation apply to me?
All counterparties within the scope of EMIR as well as CCPs must, no later than the working day following the occurrence of the relevant reporting trigger, report details of “any derivative contract” to an ESMA registered trade repository – the trigger being not only each new derivative transaction (including cleared or non-cleared, OTC and exchanged traded derivatives) but also any modification to, or termination of, an existing derivative contract.
3. Risk mitigation techniques for non-cleared OTC derivatives – provision of margin
More than three years following the go-live of the first risk mitigation technique for OTC derivatives which are not cleared, timely confirmation, the RTS relating to the final outstanding EMIR obligation from this category remain in draft form.
Progress has however been made and on 8 March 2016 the final draft RTS on risk mitigation techniques for OTC derivatives contracts not cleared by a CCP under Article 11(15) of EMIR
Given “Everybody’s been moving toward September 1 . It’s still a good date”
The key concern is consistent international application and the issues that may arise with different timetables, assuming Japan and the U.S. remain on track to implement from 1 September 2016. The ESAs’ position and potential concerns from an industry perspective were also highlighted by ISDA in its “derivatiViews”
The final draft RTS
The final draft RTS published in March largely reflect the proposals considered in our 2015 EMIR Stay Current. There are, however, some key changes including delayed implementation of margin for physically settled FX swaps whilst MiFID II is finalised and in relation to intragroup transactions. The profile of the draft final RTS can be summarised as follows:
Articles 1-11: Risk Management procedures (including scope of margin and exclusions)
Articles 12-21: Calculation and Collection of Margins
Articles 22-8: Eligibility and Treatment of Collateral
Articles 29-30: Collateral Valuation
Articles 31-34: Operational Procedures and Documentation
Articles 35:38: Procedures and criteria relating to exemptions for Intragroup Derivative Contracts
Article 39: Transitional Provisions
Do the new initial and variation margin rules apply to me?
It remains the intention that the new initial and variation margin rules will only apply to systemically important FCs and NFCs including transactions entered into by such counterparties with a Hypothetical Counterparty.
Two NFCs (or TCEs which would be NFCs, if they were established in the EU) transacting together can agree not to exchange initial and variation margin.
For any given pair of counterparties, the least onerous margin requirements apply to the transaction.
No initial margin at 1 September 2016 (now delayed) if one of the counterparties has an aggregate notional average quarterly value of OTC derivatives below EUR 3 trillion.
For those counterparties with derivatives activity of less than EUR 3 trillion, posting of initial margin will be staggered over the next four years, until September 2020, from which the only exemption to the posting of initial margin is where at least one of the counterparties has an aggregate average notional derivatives activity of less than EUR 8 billion (calculations include all intragroup transactions and all non-centrally cleared OTC derivatives contracts of the group).
Generally all new transactions are covered.
Pending expected resolution of current definitional uncertainty and to avoid an unlevel playing field, the final draft RTS proposed a delayed implementation for FX forwards to the earlier of entry into force of the related delegated act and 31 December 2018.
No initial margin for certain foreign exchange contracts.
Phase-in of margin for single stock equity options and index options to seek to avoid any international regulatory arbitrage.
Potential exemptions for posting or collection of initial or variation margin for:
Certain derivatives associated with covered bonds for hedging purposes; and
Where the counterparty is based in a jurisdiction where netting/collateral protection is not ensured.
When and how much?
Largest entities will be subject to the requirements first with small entities given more time.
Initial margin requirements phased in over 4 years; 1 September 2016 start date for posting of initial margin (now delayed).
Amounts of initial margin must be calculated pursuant to either the so called “standardised approach” or using a counterparty or third party agent developed model. ISDA’s work on its industry proposed proprietary standard model for calculating initial margin, the so called “ISDA SIMM” (standard initial margin model) continues. Most recently, on 3 June 2016, ISDA published on its website initial work-in-progress drafts of certain ISDA SIMM documents.
For the biggest counterparties, posting of variation margin was also scheduled to start on 1 September 2016 and for all other counterparties 1 March 2017 (new timetable to be confirmed).
So if I need to comply, what collateral do I need to post?
Parties can agree a de minimis level of initial and variation margin of up to EUR 500,000 (or currency equivalent).
Parties can agree bilaterally to include an initial margin threshold of up to EUR 50 million, below which no initial margin need be transferred.
Focus remains on most liquid collateral and the draft final RTS prescribe eligibility criteria for both initial and variation margin (Article 22).
Concentration limits for initial margin (Article 28).
Initial margin must be segregated (Article 33).
Daily calculation of variation margin.
Are intragroup transactions covered?
Pursuant to Article 11 EMIR, intragroup transactions can be exempted (by way of approval or notification process) from posting collateral if certain requirements relating to risk management procedures are met and there is an absence of any practical/legal impediments to the transferability of own funds and the repayment of liabilities between the counterparties. So as to seek to ensure that the criteria for granting an exception are applied consistently across Member States, the final draft RTS provide further clarity and detail on these aspects. In May 2016, pending finalisation of the final draft RTS, the FCA communicated that it had produced a draft application form as a guide for the information that an entity seeking to avail itself of the exemption should be in a position to provide.
For relevant intragroup transactions, the deadline for exchange of initial margin is 1 March 2017.
In the absence of an equivalence determination, intragroup trades involving one or more group entities in non-EU jurisdictions are also waived from margin requirements for three years post effective date, allowing time for the necessary equivalence decisions to be adopted by the European Commission.
Although the European plans are now delayed, the market continues to prepare for the changes that are afoot:
2016 ISDA Variation Margin initiatives. On 14 April 2016, ISDA published what was the first in a series of various documents to facilitate compliance with the new margining techniques, the 2016 Credit Support Annex for Variation Margin (New York law). Corresponding English law and Japanese law versions have now followed and on 15 July 2016, ISDA published a consultation draft of its 2016 Variation Margin Protocol designed to facilitate the multiple changes required by the new margin rules across multiple jurisdictions and counterparties. ISDA have requested feedback by close of business on Friday 29 July 2016.
ISDA Regulatory margin self-disclosure letter. On 30 June 2016, ISDA published its Regulatory Margin Self-Disclosure Letter which, in relation to the margin requirements relating to Canada, the EU, Japan, Switzerland and the U.S., seeks to help parties ascertain which margin rules apply and if so, how.
RECAP: Do the risk mitigation techniques apply to me?
All categories of EMIR counterparty as well as TCEs in specific cases must comply with at least certain of these EMIR obligations, the exact level of compliance being dependent on individual counterparty type.
C. Equivalence and extra-territoriality
As set out above, focus on EMIR’s international reach emanates from two key aspects of EMIR — those EMIR provisions which directly impose mandatory clearing obligations and risk mitigation techniques on certain transactions between FCs and NFC+s and a Hypothetical Counterparty and two TCEs, and EMIR’s “equivalence” concept. Although dependent on the exact terms of the U.K.’s exit from the EU, in a post Brexit world obtaining a determination of equivalence for the current arrangements is likely to be key for U.K. incorporated entities.
Brexit has diverted attention away from what has been the most significant equivalence development of 2016, the resolution of the longstanding issue between the U.S. and the EU relating to the mutual recognition of CCPs.
Agreement was signalled on 10 February 2016 when the European Commission and the U.S. Commodity Futures Trading Commission (“CFTC”) published a joint statement announcing that they had a common approach regarding requirements for CCPs in the EU and U.S.
The related joint statement issued by the European Commission and CFTC
Although less politically prolific, progress has also been made in relation to other jurisdictions too and November 2015 marked further progress when the European Commission adopted five CCP equivalence decisions for Canada (limited to the provinces of Alberta, British Columbia, Manitoba, Ontario and Quebec), Mexico, the Republic of Korea, South Africa and Switzerland. Equivalence decisions in relation to other jurisdictions and for the jurisdictions already benefiting from CCP equivalence determinations but in relation to the other key EMIR obligations remain outstanding.
III. Closing Remarks
Whilst Brexit does create uncertainty, until details of the U.K.’s exit are finalised, counterparties must follow the FCA message and continue with business as usual, closely monitoring any new EMIR developments. Current expectations indicate that each of the EMIR obligations will be live at least in part prior to any U.K. withdrawal taking effect and, on the current timetable, MiFID II will also be effective prior to any withdrawal too. In the near term, we expect the most significant EMIR related change to be the margin rules and all affected parties should ensure that documents are in place or updated to provide for the new rules. Not to be forgotten also that the results of the EMIR Review are expected later this year and therefore further changes may be proposed to the existing framework, all potentially before the fly in the regulatory ointment that is Brexit crystallises.
EMIR RELATED TERM
Alternative investment fund.
FCs and NFC+s who are current clearing members of at least one of the CCPs authorised or recognised before publication of the relevant RTS to clear at least one of the relevant classes of derivatives.
Essentially other systemically important FCs and NFC+s, being those counterparties which are not Category 1 entities but which belong to a group whose derivatives activities exceed certain thresholds.
FCs, which are not otherwise captured by Categories 1 and 2, and AIFs comprising NFC+s.
NFC+s not captured by any other Category definition.
“Financial Counterparties” or “FCs
EU banks and other regulated entities including AIFs.
“Non-Financial Counterparties” or “NFCS”
Catch all category – all other undertakings established in the EU other than CCPs or FCs.
“Active” NFCs i.e. those NFCs that exceed certain thresholds for derivatives trades.
“TCEs” or Third Country Entities”
Any entity established in a country outside of the EU.
An entity that would be subject to EMIR if it were incorporated in the EU.