News & Events

On 4 May 2017 the European Commission published a proposal (the "EMIR Proposal") to amend certain provisions of EMIR. The EMIR Proposal caught the market by surprise and initially it introduced a number of material changes.

On 21 November 2017, during the Estonian Presidency a compromise proposal from the European Council Working Group on Compromise was agreed and published by the Council of the European Union (the "Compromise")¹. As has been outlined below, a number of proposed amendments aim at reducing the burden and costs of non-financial counterparties ("NFCs"). Many of these measures are part of the European Commission's Regulatory Fitness and Performance ("REFIT") programme which purports to reduce costs and simplify European policies. In particular, reporting for many NFCs with low trading activity has proved to be an onerous burden which, following 5 years since EMIR came into force, now finds little justification.

Revised FC definition

The definition introduces fewer changes that initially envisaged in the EMIR Proposal and makes a single material change by including an "alternative investment fund manager (AIFM)".

As a consequence, fund managers that are classified as NFCs will become financial counterparties ("FCs") once these changes come into force although the current Compromise does not provide any transition provisions.

Exclusion of SSPEs from the FC definition

The EMIR Review proposed a significant change for securitisation special purpose entities ("SSPEs") since it intended to reclassify them as financial counterparties. However, the Compromise proposes not to include SSPEs in the definition of FC so in principle, SSPEs will not be affected. As explained in our issue in our Delta Report issue of July 2017², this change posed structural challenges for SSPEs in the context of posting margin. This was likely to be one of the most contested changes of the EMIR Review and gave rise to material concerns amongst market participants.

Clearing for NFC+s

Currently, pursuant to Article 10(1)(b) of EMIR, if an NFC exceeds the relevant clearing threshold it will become a NFC+ and therefore will be subject to the clearing as well as margin exchange obligations, among other additional obligations under EMIR. EMIR currently does not distinguish between types of OTC derivatives, so for example, once the clearing threshold for interest rate derivatives has been exceeded, such entity would have to clear any other classes of OTC derivatives subject to mandatory clearing.

With the aim to reduce costs and the burden for NFCs, the scope of the clearing obligation will be reduced by limiting the clearing obligation to the particular asset class for which the clearing threshold has been exceeded. As a consequence, if only the interest rate clearing threshold has been exceeded, such counterparty will only have to clear interest rate derivatives subject to the mandatory clearing obligations and not other classes of derivatives subject to the mandatory clearing obligations.

Removal of frontloading

The Compromise finally removes the requirement for frontloading. The frontloading requirement is set out in Article 4(1)(b)(ii) of EMIR. Frontloading is the obligation to clear OTC derivative contracts (pertaining to a class of OTC derivatives that has been declared subject to the clearing obligation) entered into or novated on or after notification by a competent authority to ESMA on the authorisation of a CCP but before such clearing obligation takes effect, if they have a remaining maturity at least equal to the "minimum remaining maturity" determined in the relevant technical standards.

Due to the legal uncertainty, the operational burden and pricing implications this has been one of the most discussed issues since EMIR came into force so this will be a change welcomed by all OTC market participants.

Accordingly, the clearing obligation will only apply to OTC derivatives that were entered into or novated on, or after, the date from which the clearing obligation takes effect.

Suspension of the clearing obligation

Currently under EMIR the clearing obligation only ceases to apply if a NFC+ no longer exceeds the relevant clearing threshold for a period of 30 working days. The Compromise introduces the power of the European Commission to suspend the clearing obligation in certain situations including:

• The criteria on the basis of which a specific class of OTC derivative has been made subject to the clearing obligation are no longer met.
• A CCP ceases to offer a clearing service for a specific class of OTC derivative or for a specific type of counterparty.
• In order to avoid or address a serious threat to the financial stability in the EU, and that suspension is proportional.

The suspension must be requested by the European and Securities Market Authority ("ESMA") to the European Commission for either a specific class of OTC derivative or for a specific type of counterparty. A new feature introduced by the Compromise is that competent authorities may also request that ESMA submits a suspension request, provided that they provide reasons and submit evidence that at least one the conditions set out above has been met. Following this, ESMA will within 48 hours have the option to either request that the European Commission suspends the relevant clearing obligation or reject the request from the competent authority provided that it provides reasons in writing.

Physically settled deliverable FX forwards, VM exemption

The Compromise introduces new wording exempting physically deliverable FX forwards from exchanging initial margin ("IM") and variation margin ("VM") except for transactions concluded between credit institutions (authorised under the Capital Requirements Directive³ or the Capital Requirements Regulation⁴) which would still have to post VM for those trades. This change was not discussed in the initial EMIR Proposal and is the result of recent discussions as to the need to align the stricter EU regime with that of other regimes like that in the United States. These changes, if they go ahead, will permit non-financial and smaller financial counterparties to reduce the risks associated with their currency risk exposures without being subject to VM posting.

For a detailed analysis please see Phillan Amin's article in this issue of the Delta Report⁵.

FRAND access to clearing: no obligation to contract

The Compromise introduces the novel concept of "FRAND" (fair, reasonable and non-discriminatory) a principle that should govern contractual and commercial relationships between clearing members and clients. The idea behind FRAND is to facilitate clearing for counterparties with a limited volume of activity in the OTC derivatives market. It is unclear what exactly FRAND involves, in particular the "non-discriminatory", requirement and how far a clearing house may go when refusing to provide clearing services to a particular client. As English case law illustrates, "fair" and "reasonable" remain concepts that by definition are never precise and will vary their meaning depending on the circumstances, the profile, knowledge and experience of each of the parties and the relevant market. To mitigate this uncertainty, the European Commission will be empowered to adopt a delegated act in accordance with Article 82 of EMIR in order to specify the conditions under which commercial terms in respect of clearing services are considered to be fair, reasonable and non-discriminatory

It may be argued whether a "FRAND framework" is actually needed. For example, Article 39(7) of EMIR imposes on CCPs and clearing members the obligation to offer clearing services on reasonable commercial terms. In addition, pursuant to Article 25 of the MiFID II RTS 6⁶ , clearing members must apply due diligence when assessing whether they can provide clearing services to clients.

The Compromise explicitly excludes from the FRAND principle the introduction of an "obligation to contract" or any form of price regulation, in line with the demands of market participants. Clearing members and clients are explicitly allowed to refuse to provide clearing services on risk grounds (note these grounds are not limited to counterparty risk in the text, in either the relevant recitals or articles).

Intragroup transactions reporting exemption

Recital 12 of the Compromise explicitly extends the exemption of intragroup transactions involving only NFCs to transactions with third-countries entities that would qualify as a NFC if they were established in the EU within the same group. Ultimately, provided a transaction constitutes an intragroup transaction between NFCs, the risk that such transaction may pose is unlikely to be significant. However, this measure is not expressly included in the articles of the Compromise.

Reporting liability

Since EMIR came into force, Article 9 was clear that "all counterparties and CCPs shall ensure that the details of any derivative contract they have concluded and of any modification or termination of the contract are reported to a trade repository (…)". In practice, due to the lack of operation teams, systems and knowledge, most NFCs have relied on their FC counterparties to arrange the reporting under EMIR, albeit the NFCs remain liable for such reporting.

Generally, it has become market practice that an NFC enters into a "Reporting Delegation Agreement" with a FC whereby the FC agrees to report the relevant data on behalf the NFCs. However, these agreements include ample exclusions of liability other than typically in the event of negligence, wilful default or fraud. Also, the Compromise, looks at the requirement to report exchange-traded derivatives ("ETDs"), which in practice means a significant burden on counterparties because of the high volume of ETDs that are concluded on a daily basis. There is an ongoing debate whether when it comes to ETDs only, CCPs should be legally responsible to report on behalf of their clients.

The Compromise imposes a legal liability on all FCs that report on behalf of NFC-s although NFC-s will remain responsible for the accuracy of the data. However, this will not apply if the NFC- enters into an OTC derivative contract with a third country entity. A reflection of how sensitive this issue is the fact that the Compromise has proposed two options to deal with this, option 1 and option 2 the main difference being that under option 2, CCPs are not under the obligation to report on behalf of their clearing members' clients.

Option 1

• CCPs would be solely responsible and legally liable to reporting "on behalf of each of themselves, the clearing members and their clients" details of derivative contracts that are not OTC derivative contracts as well as for ensuring the accuracy of the reported details.
• FCs will be solely responsible and legally liable for reporting on behalf of both counterparties OTC derivative contracts concluded with an NFC- as well as for ensuring the accuracy of the reported details. An NFC- will retain the right to report themselves, however, they should inform their FC accordingly. In this case, the responsibility and legal liability for reporting and for ensuring the accuracy of those details will remain with that NFC-.
• The management company of an undertaking for collective investment in transferable securities ("UCITS") will be responsible and legally liable for reporting the details of OTC derivative contracts to which that UCITS is a counterparty as well as for ensuring the accuracy of the details reported.
• The manager of an AIF shall be responsible and legally liable for reporting the details of OTC derivative contracts to which that AIF is a counterparty as well as for ensuring the accuracy of the details reported.

Counterparties and CCPs may also delegate the reporting obligation although the responsibility and legal liability for reporting will in this case remain with the FCs and CCPs.

Option 2

• CCPs would be solely responsible and legally liable for reporting "on behalf of each of themselves and the clearing members" details of derivative contracts that are not OTC derivative contracts as well as for ensuring the accuracy of the reported details.
• FCs will be solely responsible and legally liable for reporting on behalf of both counterparties details of OTC derivative contracts concluded with a NFC- as well as for ensuring the accuracy of reported details. An NFC- will retain the right to report themselves, however, they should inform their FCs accordingly. In this case, the responsibility and legal liability for reporting and for ensuring the accuracy of those details will remain with that NFC-.
• The management company of a UCITS will be responsible and legally liable for reporting the details of OTC derivative contracts to which that UCITS is a counterparty as well as for ensuring the accuracy of the details reported.
• The manager of an AIF shall be responsible and legally liable for reporting the details of OTC derivative contracts to which that AIF is a counterparty as well as for ensuring the accuracy of the details reported.

The main aspect for FCs is the degree of liability and responsibility placed upon them. There is resistance in the dealer's market to accept sole liability and responsibility for FCs, even if receiving incomplete/inaccurate data and this point is currently being discussed. Industry groups are working towards a more balanced allocation of liability and responsibility between FCs and NFC-s.

Reporting obligation for UCITS and AIF

Recital 15 of the Compromise clarifies that where one or both of the counterparties is a UCITS or an alternative investment fund ("AIF") it should be specified that the management company of a UCITS and the manager of an AIF are responsible and legally liable for reporting on behalf of the relevant UCITS and AIF, respectively, as well for ensuring the accuracy of the reported details.

This is a welcome clarification which previously had prompted queries to ESMA which did not fully clarify the position regarding this issue⁷.

Coming into force

The EMIR Proposal states that it will take effect 20 days after publication in the Official Journal of the European Union. Although this is the average period time for EU legislation between publication and coming into force, there are concerns whether that time will be sufficient for those entities that, as a result of the proposed amendments, will be reclassified as a FC.

Next steps

The EMIR Proposal is only the first formal step of the EU legislative process and it is currently being reviewed and amended by the EU Parliament⁸. At the time of writing this article, a vote of the proposal was scheduled to take place on 16 May.

Conclusions

From a regulatory viewpoint, 2017 was primarily a year for implementing laws and regulations that had already been agreed in principle and as such, it did not bring material changes to the existing EMIR framework. 2018 is likely to be the year in which significant changes to the EMIR architecture are agreed. If finally implemented in the form of the Compromise, these changes will likely be welcome by the derivatives industry, in particular NFCs.

In 2012, EMIR was implemented with a view to reduce systemic risk and make the OTC derivatives market safer. Five years later, with a more mature derivatives market, these changes are implemented with a view to make them less onerous and to ensure proportionality.

Eduardo Barrachina is a senior associate in the White & Case’s Capital Markets Practice in London and is an English and Spanish qualified lawyer. Eduardo specialises in OTC derivatives and structured finance transactions, covering different products and instruments. He also has sound experience on multijurisdictional capital markets deals acting for the arranger, both conventional (EMTNs, Certificates of Deposit) and Islamic finance (Sukuks and Islamic CDOs). Eduardo specialises in derivatives and related products across all formats, in particular credit and other fixed income derivatives, repackaging of financial assets, TRS and other collateralised funding structures and regulatory capital transactions. Eduardo acts for a number of leading investment banks and large corporates amongst other clients. Key areas of focus of Eduardo in the current market include the implementation of the derivatives regulatory reform, including the proposed EMIR changes, the BRRD, the BMR and Brexit, close-out advice and legal aspects in respect of emerging market assets. Eduardo has also solid experience in working with structured products and derivatives in emerging markets like Mexico, the Middle East, Brazil or Turkey.

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