The regulation on OTC derivatives, central counterparties ("CCPs") and trade repositories (commonly known as "EMIR") was published in the Official Journal of the European Union on 27 July 2012 and will enter into force on 16 August 2012. EMIR will introduce several new requirements on financial counterparties and non-financial counterparties entering into derivatives contracts, including mandatory clearing, reporting and risk mitigation procedures (including electronic confirmations, daily mark to market procedures, margining, collateral and, in certain cases additional capital requirements). EMIR also introduces an authorisation and supervisory framework for CCPs, and a registration regime for trade repositories.
Whilst EMIR will enter into force on 16 August 2012 many of its obligations will have limited practical effect as they require the implementation of draft technical standards which are yet to be finalised. The European Securities and Markets Authority ("ESMA") has recently published a consultation paper on its draft technical standards for EMIR. These standards must be submitted to the European Commission for approval by 30 September 2012. Commission approval of the draft technical standards is currently expected by the end of December 2012.
That said relevant parties need to start thinking about how they will meet their obligations under EMIR, including authorisation/registration requirements, establishing relationships with clearing members, margin requirements, collateral and/or capital requirements.
EMIR imposes an obligation on financial and non-financial counterparties to clear certain classes of OTC derivative contracts. Broadly speaking this includes certain options, futures, swaps, forwards and contracts for differences falling within Annex 1, Section C (4) to (10) of the Markets in Financial instruments Directive. However, an OTC derivative contract will not be subject to the clearing obligation unless: (i) the relevant transaction is of a class of derivative mandated by the Commission as being subject to the clearing obligation in accordance with the procedures outlined in EMIR and (ii) the parties to the contract are subject to clearing. Contracts entered into by non-financial counterparties will be subject to the clearing obligation if the rolling average position of a non-financial counterparty (and its non-financial counterparty group members) over 30 working days exceeds the relevant clearing threshold (excluding certain contracts which are objectively measurable as reducing risks directly related to their commercial or treasury financing activities).
The process for the Commission determining whether a specific class of derivatives is subject to mandatory clearing is highly convoluted and could take up to 9 months from the date that the relevant home state authority notifies ESMA that it has authorised a CCP to clear a class of derivatives (the "notification date"). The clearing obligation may apply retrospectively to classes of derivatives entered into on or after the notification date (i.e. before the Commission has declared those contracts subject to mandatory clearing) – if that class is subsequently declared eligible for clearing but only if the contracts have a minimum remaining maturity higher than that determined by the Commission as being subject to clearing. For these purposes, ESMA will notify the market as soon as possible that it has received a notification from a competent authority - in order to allow market participants to prepare for a potential clearing obligation. However, this places counterparties in the rather unhelpful position of entering into OTC derivative contracts without fully understanding the costs attached to such transactions.
Financial and non-financial counterparties are required to ensure that the details of any derivative contracts (and not just OTC derivatives) they have concluded (and any modification or termination of such contracts) are reported to a registered trade repository. However, counterparties can delegate the reporting of the derivative contracts to a third party. Technical standards setting out the form and content of these reports are not expected to be finalised and approved until the end of 2012.
The reporting obligation will apply to derivative contracts entered into before 16 August 2012 and which remain outstanding on that date; and those contracts entered into on or after 16 August 2012. However, according to ESMA in its recent Consultation Paper, the requirement to report will only take place from the reporting start date. The reporting start date means:
- 1 July 2013: where a trade repository has been authorised before 1 May 2013 to receive reports
- 60 days after a trade repository has been established – if the trade repository was not established before 1 May 2013
- 1 July 2015: if no trade repository is established, reports will have to be submitted to ESMA
ESMA has proposed that: (a) derivative contracts entered into on or after 16 August 2012 but before the reporting start date must be reported to a trade repository within 90 days of the reporting start date; and (b) derivative contracts entered into before 16 August 2012 and were outstanding on the date of entry into force of EMIR will be required to be reported to a trade repository within 180 days of the reporting start date.
As recognised by ESMA in its recent consultation paper, the reporting obligation in EMIR will be more burdensome than the current transaction reporting obligation under MIFID. Whilst ESMA states that it will work towards the objective of common reporting there is no indication as to how long this will take to achieve and so some firms will be required to comply with two different sets of reporting requirements for an unspecified period of time.
Risk Mitigation Techniques
Both financial counterparties and non-financial counterparties that are subject to the clearing obligation will be required to have procedures in place to measure, monitor and mitigate risk in respect of non-cleared OTC derivatives by using, for example, electronic confirmations, and daily mark to market procedures, margining and, for financial counterparties, additional capital requirements. Those obligations will not apply to certain intra-group transactions. In addition some of the specific details have yet to be determined in technically binding standards.
The European Supervisory Authorities are required to submit draft technical standards to the Commission on certain risk mitigation techniques (including the levels and type of collateral and segregation arrangements required and the level of additional capital) that will apply to OTC derivative contracts that are not cleared by a CCP by 30 September 2012. However, a recent press release indicates that publication of these standards will be delayed and a fresh deadline will be set at a later date.
In addition to the above, ESMA is required to submit draft technical standards to the Commission on some of the risk mitigation requirements in EMIR (including timing confirmations, reconciliation procedures, portfolio compression, marking to market/to model and intra-group exemptions) that will apply to OTC derivative contracts that are not cleared by a CCP. These are expected to be submitted to the Commission by 30 September 2012. Commission approval of the draft technical standards is currently expected by the end of December 2012.
CCPs and Trade Repositories
An EU CCP will be required to be authorised in the member state where it is established in order to provide clearing services (This requirement is not just limited to clearing OTC derivatives contracts). The relevant authority has up to 6 months to approve a completed application. Existing CCPs have up to 6 months to apply for authorisation from the date that the Commission adopts ESMA's draft regulatory technical standards (expected to be approved by the end of 2012).
Third country (i.e. non-EU) CCPs must be recognised by ESMA in order to provide clearing services to clearing members of trading venues established in the EU. Existing CCPs have to apply for recognition within 6 months of the Commission adopting ESMA's draft regulatory standards.
EU trade repositories must register with ESMA in order to accept trade reports. ESMA may also recognise third country (i.e. non-EU) trade repositories if certain conditions are fulfilled. Existing trade repositories are required to apply for recognition within 6 months of Commission adopting ESMA's draft regulatory standards.
Many important details have yet to be finalised but it is clear that EMIR will accelerate the existing trend towards the use of CCPs for clearing, impose onerous new requirements on non-financial firms (e.g. real estate and energy companies) that are major participants in the derivatives markets, increase costs for both cleared and non-cleared derivatives (e.g. via margin requirements collateral and/or capital requirements, as well as transaction reporting costs), increase concentration risk in CCPs and increase the power of ESMA within the European derivatives market. But this is not the end of the story since further changes to the derivatives market are expected in MiFID II.