Am I the counterparty to the derivative trade for EMIR purposes?
Who is the counterparty?
The first issue that funds and/or their investment manager have to address is: who is the actual counterparty to the derivative contract for EMIR purposes?
The term 'counterparty' is broadly understood to mean the principal party to the derivative trade. The European Securities and Markets Authority (“ESMA”) has clarified in its "questions and answers" (“ESMA Q&A”) that where an investment manager enters into a derivative trade on behalf of a fund it manages, the principal to the derivative trade for EMIR purposes will be the fund rather than the investment manager. This means that primary responsibility for compliance with the counterparty obligations in EMIR will fall on the fund rather than the investment manager, even if, as a contractual matter, the investment manager undertakes to comply with the requirements under EMIR for and on behalf of the fund. Conversely where the investment manager enters into derivative trades for its own account, the investment manager will be the principal for EMIR purposes.
Possible future changes to the counterparty test
Rather unhelpfully, the UK’s Financial Conduct Authority (“FCA”) has indicated that it takes the view that where a UK investment manager enters into a derivative trade on an aggregated basis for more than one fund (e.g. entering into block trades) and the derivative trade is not allocated at the time the derivative is executed, the investment manager will have the primary obligation to report details of the derivative trade to a registered trade repository for EMIR purposes as if it were the principal party to the trade - albeit that the investment manager should declare its agency status in Field 12 of the trade report . When the trade is subsequently allocated, the FCA states that the aggregated trade should be reported to the registered trade repository as “cancelled” and the individual allocations should be reported by or on behalf of the fund (to the extent that the reporting requirement applies to the fund).
It is unclear, at this stage, whether the FCA’s counterparty re-characterisation test only applies to the reporting requirement or whether it applies to the other counterparty obligations under EMIR.
What to do now?
Whilst the FCA’s unofficial interpretation has not been formally adopted at a UK or EU level, we understand that the FCA is currently consulting with its EU counterparts and trying to persuade them that ESMA's Q&As should be amended to reflect the FCA’s view.
So in order to reduce the risk of being caught by this curious interpretation of the application of EMIR, investment managers should consider:
- Pre-allocating aggregated trades and disclosing the identity of the fund or client to the other counterparty to the derivative trade at the point when the trade is executed
- Taking steps to allocate the trade immediately after the trade is executed, but before the reporting requirement applies (reporting applies on a T+1 basis)
I am the counterparty - how am I categorised for EMIR purposes?
The second issue for funds and/or their investment managers is to work out how the fund will be categorised for EMIR purposes as this will determine which specific counterparty obligations will apply.
There are broadly speaking two categories of counterparty under EMIR as follows:
- A financial counterparty (“FCP”) - e.g. an investment firm authorised under MiFID, a bank authorised under Directive 2006/48/EC, an AIF that is managed by an authorised or registered Alternative Investment Fund Manager (“AIFM”) under Directive 2011/61/EU, an insurance undertaking authorised in accordance with Directive 73/239/EEC, certain reinsurers, UCITS funds and their management companies and certain pension funds
- A non-financial counterparty (“NFC”) (i.e. an undertaking established in the European Union that is not an FCP or a CCP). A sub-category of NFC is those whose rolling average position over a 30 working day period in OTC derivatives (net of their commercial and treasury financing hedges) exceeds a relevant clearing threshold (“NFC+s”)
AIFs managed by an authorised or registered AIFM and UCITS
UCITS, UCITS management companies and all AIFs managed by an authorised or registered AIFM (both EU and non-EU) will be categorised as FCPs for EMIR purposes. This will mean that all of the counterparty requirements under EMIR are potentially applicable: clearing, reporting, and risk mitigation. It is important to note that this classification applies even to AIFs managed by small AIFMs who are “below threshold” for the purposes of the AIFMD and therefore only registered, and not fully authorised, under the AIFMD.
Other EU funds
Other funds established in the EU that are not managed by an authorised or registered AIFM (e.g. because they do not fall into the very broad definition of an AIF or because transitional or grandfathering provisions under the AIFMD mean their AIFM is not required to be authorised or registered) nor UCITS are likely to be categorised as NFCs rather than FCPs for EMIR purposes. They will be subject to the reporting requirement and some of the risk mitigation requirements in EMIR. If the fund’s gross notional position in eligible OTC derivative contracts exceeds certain clearing thresholds continuously for a period of 30 working days, it will potentially be subject to the clearing obligation as it will be categorised as an NFC+.
The relevant clearing thresholds for each derivative asset class are:
- Credit derivatives: Euro 1 billion
- Equity derivatives: Euro 1 billion
- Interest rate derivatives: Euro 3 billion
- FX derivatives: Euro 3 billion
- Commodity and other derivatives: Euro 3 billion
It is important to note that the gross notional position of worldwide group entities should be included in the clearing threshold calculation, which will mean that NFC group fund entities will have to have a process in place to monitor the derivative positions of worldwide group entities. Once the fund or its group exceeds the clearing threshold in respect to one derivative asset class, it will be deemed to have exceeded the clearing threshold for all other derivative asset classes. The positions of group entities who qualify as FCPs can be ignored for these purposes and any derivative contracts that are entered into for hedging or treasury financing purposes can be excluded.
Broadly the term “group” is understood to mean those “group of undertakings consisting of a parent undertaking and its subsidiaries” within the meaning of the EU consolidated accounts directive and the Capital Requirements Directive IV1. For some funds this may include portfolio companies in which the fund invests.
What to do now?
It is important for funds to establish how they are categorised for EMIR purposes. Funds which are categorised as NFCs and are part of a group need to obtain advice on which entities form part of its group for EMIR purposes and whether any OTC transactions satisfy the hedging criteria (as the term is defined in EMIR) to ensure that both tests are consistently applied across the group. When a fund which is categorised as an NFC exceeds the clearing threshold, it will be required to notify its regulator using the correct form. The FCA is the relevant regulator in the UK.
Non-EU funds (other than those managed by an authorised or registered AIFM)
Funds incorporated outside of the EU will generally be categorised as third country entities (“TCEs”). TCE’s which enter into derivative trades with EU counterparties are not, for the most part, directly subject to the requirements in EMIR. However, the extraterritorial reach of EMIR means that the clearing obligation may potentially apply to non-EU funds when they trade with EU counterparties. This will be the case if they would be categorised as an FCP or an NFC+ if they were established in the EU. Indeed, non-EU funds have been receiving various documents from EU counterparties requesting confirmation of their categorisation for EMIR purposes. This documentation may also contain provisions on the EMIR reporting and risk mitigation which are directly applicable to the EU counterparty but not necessarily to the non-EU fund. Care should be taken when dealing with such documentation since agreeing to enter into such documentation may impose certain contractual obligations on non-EU funds and counterparties which would not otherwise apply to them under EMIR.
In addition, where a non-EU fund enters into a derivative contract with another non-EU counterparty, it may be subject to the clearing requirement and the collateral requirements for non-cleared derivative contracts where the derivative contract has a direct, substantial or foreseeable effect in the EU.
A derivative contract would be deemed to have a direct, substantial and foreseeable effect in the EU where:
- The Commission has not issued a positive equivalence decision in relation to the third country firm’s legal and supervisory framework; and
- Either of the TCE’s obligations are guaranteed by an EU FCP and:
- That guarantee covers OTC derivative contracts with a gross notional value of Euro 8 billion; and
- The guaranteed obligations represents at least 5 per cent of the aggregate current exposure of the EU FCP in respect to OTC derivative contracts; or
- The two non-EU counterparties execute their transactions through their EU branches.
What to do now?
The extra-territorial reach of EMIR means that non-EU funds need to consider how they would be categorised if they were established in the EU, or whether their contracts have a direct, substantial and foreseeable effect in the EU, and have arrangements in place to ensure that they comply with their obligation under EMIR. In particular, non-EU AIFMs will need to consider how they may be treated under the AIFMD regime in the future, if, for example, they elect to opt into the AIFMD passporting regime, as this will have an impact on the categorisation of the AIFs they manage for EMIR purposes.
Who and what?
Generally, the reporting requirement in EMIR only applies to funds or pooled vehicles established in the EU unless the non-EU fund is an AIF that is managed by an authorised or registered AIFM (together “reporting counterparty funds”). The reporting requirement applies to OTC as well as exchange traded derivatives contracts.
All reporting counterparty funds must have arrangements in place to enable them to report details of concluded, modified or terminated derivative contracts to a trade repository. There are 85 field items that need to be reported to trade repositories which include common data (i.e. details of the derivative contract) and counterparty data (e.g. information relating to the counterparty).
The obligation to report is the responsibility of both counterparties (assuming both counterparties have a primary reporting obligation). Reporting counterparty funds can delegate reporting to their investment manager, the other counterparty or a third party. It is important that any such delegation arrangements are documented as the reporting counterparty fund will remain responsible under EMIR for ensuring that the report submitted to the trade repository is accurate and submitted on time.
Where the reporting counterparty fund intends to report directly to the trade repository, it will be required to have a trade reporting agreement in place with one of the following trade repositories:
In order to comply with the reporting requirements, reporting counterparty funds must have a pre-legal entity identifier code, which can be obtained from a pre-local operating unit (e.g. the London Stock Exchange, which has the authority to allocate pre-legal entity identifier codes to legal entities using the agreed principles outlined by the LEI Regulatory Oversight Committee) and have arrangements in place to generate a unique trade identifier code and product identifier code for each derivative transaction.
The reporting requirement is already in force. All derivatives trades that are entered into, modified or terminated on or after 12 February 2014 must be reported to a registered trade repository no later than the close of the next business day. All live derivative contracts entered into on or after 16 August 2012 had to be reported to a registered trade repository by end of business on 13 February 2014. Historic OTC derivative contracts will also have to be reported in future, as follows:
- Derivative contracts that were live on 16 August 2012 and were still live on the 12 February 2014 must be reported to a trade repository within 90 days of the latter date
- Derivative contracts that were live on 16 August 2012 or after 16 August 2012 but not live on 12 February 2014 must be reported to a trade repository within 3 years of the reporting start date (i.e. by 12 February 2017)
EMIR also imposes some risk mitigation obligations. The aim of these obligations is to ensure that parties mitigate credit risk, even though these OTC derivatives are not cleared. Most of the risk mitigation rules are already in force, except the requirements on collateral and additional capital, which have yet to be finalised.
Application to AIFs and UCITS
Funds and pooled vehicles that are AIFs managed by an authorised or registered AIFM or UCITS will be subject to all of the risk mitigation requirements in EMIR as they will be categorised as FCPs.
Broadly, the risk mitigation requirements will require such AIFs and UCITS to:
- Confirm the terms of the OTC derivative contracts with their counterparty
- Daily mark to market outstanding contracts (or where market conditions prevent mark to market, reliable and prudent marking to model must be used instead)
- Have formalised processes for portfolio compression (i.e. effectively closing out contracts to reduce the number of outstanding contracts to one): the rules require a counterparty with 500 or more bilateral (non-cleared) contracts which are outstanding with a single counterparty to have procedures in place to determine regularly (at least twice a year) whether to conduct a portfolio compression exercise in order to reduce their counterparty credit risk. The rules do not require compression but they do require a counterparty with a portfolio of a certain size to consider whether compression is appropriate. Counterparties must ensure that they are able to provide a reasonable and valid explanation to the relevant regulator for concluding that portfolio compression is not appropriate
- Have formalised processes for portfolio reconciliation: all counterparties must agree with their counterparties the terms on which portfolios shall be reconciled before entering into the derivative contract. This can be done by the parties themselves or by a qualified and duly mandated third party. Portfolio reconciliation must cover key trade terms that identify each particular contract and include at least the valuation attributed to each contract
- Have dispute resolution procedures in place: when concluding contracts with each other, counterparties must have agreed detailed procedures and processes relating to the identification, recording and monitoring of disputes relating to the recognition or valuation of the contract and to the exchange of collateral between counterparties
Other EU funds and pooled vehicles
Other EU funds and pooled vehicles that are categorised as NFCs rather than FCPs will be subject to all of the risk mitigation requirements if they are NFC+s. If they are NFCs only, they will not be subject to the daily mark to market requirements or the collateral requirements for non-cleared trades.
What to do now – FCPs and NFC+s?
In addition to complying with the obligations outlined above, and even though the detailed rules on collateral requirements for non-cleared OTC derivative contracts have yet to be finalised, funds that are classified as FCPs or NFC+s, should start to think about whether sufficient collateral is available to support their non-cleared OTC derivative contracts.
Non-EU Funds (other than those managed by authorised or registered AIFMs)
The risk mitigation obligations will only apply to non-EU funds if they would be subject to the requirements if they were based in the EU and only if: (a) if the contract has a direct, substantial and foreseeable effect within the EU as described above; or (b) imposition of the obligations is necessary or appropriate to prevent evasion of any EMIR provision. This may be the case where the contract is part of “artificial arrangements” (e.g. it intrinsically lacks business rationale, commercial substance or relevant economic justification).
With the exception of the collateral and additional capital requirements, all of the risk mitigation requirements already apply. However, the FCA has indicated that it expected counterparties which were unable to comply with the risk mitigation requirements for non-cleared trades relating to portfolio reconciliation, dispute resolution and compression from 15 September 2013 to have a detailed and realistic plan to achieve compliance within the shortest time-frame possible. The FCA has now indicated that it expects that such plans will be completed and implemented by 30 April 2014 and that counterparties must be able to demonstrate compliance after that date.
EMIR requires all standardised OTC MiFID derivative contracts to be centrally cleared through an authorised or registered CCP.
Application to AIFs and UCITS
Broadly, AIFs managed by an authorised or registered AIFM, UCITS and UCITS management companies will be subject to the mandatory clearing obligation if they enter into OTC derivatives that have been declared subject to the mandatory clearing obligation by the European Commission (the “Commission”) and the counterparty to the trade is another FCP or an NFC+ (including a TCE that would be a FCP or NFC+ if it were established in the EU).
The Commission, with the assistance of ESMA, is yet to determine which MiFID OTC derivative contracts will be subject to the mandatory clearing requirement under EMIR, but now that the first CCP has been authorised to clear then the mandatory clearing obligation could apply at some point in Q4 2014
That said, on the 8 February 2013, the Commission published a declaration stating that the obligation for NFC+s to centrally clear their OTC derivative contracts would be phased-in over “an appropriate period of time”, the suggestion being that this period will be similar to the one proposed in the technical standards for bank guarantees (i.e. over a period of 3 years). This means that even if the Commission declares certain standardised derivative contracts to be subject to the mandatory clearing obligation at the end of 2014, NFC+s and FCPs that trade with NFC+s may not be required to clear until 2017 at the earliest.
Other EU funds and pooled vehicles
Other EU funds and pooled vehicles that are categorised as NFCs rather than FCPs will be subject to the mandatory clearing obligation if they are NFC+s and they enter into OTC derivatives that have been declared subject to the mandatory clearing obligation by the Commission and the counterparty to the trade is another NFC+ or an FCP (including a TCE that would be an NFC+ or an FCP if they were established in the EU).
Non-EU Funds (other than AIFs managed by an authorised or registered AIFMD)
Non-EU funds that would be treated as an FCP or an NFC+ if they were established in the EU will be subject to the clearing obligation under EMIR where they enter into OTC derivative trades which have been declared subject to mandatory clearing with EU FCPs or NFC+s . They will also be subject to the clearing obligation when they enter into OTC derivative trades with another TCE and the derivative contract has a direct, substantial or foreseeable effect in the EU as described above.
Are there exemptions for intra-group transactions?
There are exemptions from the mandatory clearing obligation in EMIR and certain risk mitigation obligations (i.e. the collateral requirements) for non-cleared derivative trades in relation to intra-group transactions. However, the exemption does not apply automatically to transactions within its scope. Instead counterparties that wish to use it must apply to their home state regulator for approval. In addition, where a TCE is involved, an equivalence decision from the Commission on the non-EU country’s legal framework may be required, which in many cases will be a difficult test to satisfy.
 Directive 2013/26/EU and Regulation 575/2013.