EMIR review: a quick fix or a structural improvement?
On 4 May 2017, the European Commission published its legislative proposal for the long-awaited review of Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (‘EMIR’).
This proposal follows the Commission’s report of 23 November 2016 to the European Parliament and the Council in which it provided a summary of the areas where previous consultations and specific input from various authorities had shown that action was necessary to ensure fulfilment of the objectives of EMIR in a more proportionate, efficient and effective manner. In that preliminary report the Commission highlighted the areas where the EMIR requirements could be adjusted without compromising on its objectives. The legislative proposal covers a wide array of topics and proposes modifications of EMIR with a view “to simplify the rules and make them more proportionate”. ISDA submitted commentary on the European Commission’s proposal on behalf of the wider market on 18 July 2017.
In this contribution I will analyse the current proposals in detail, discuss whether they constitute an improvement or create new, maybe unforeseen, problems and what the next steps will be towards finalisation of the legislative process. I will also touch upon some of the main points from ISDA’s comments.
How did we get here?
The review of EMIR was already set in stone in the Level 1 text and judging from the date in Article 85(1) of EMIR by which the European Commission should have reported and submitted appropriate proposals on the review, the European legislator probably anticipated a much quicker and smoother implementation of all key obligations for counterparties to derivative contracts under EMIR than reality has shown. The European Commission proposal of 4 May is the next phase in a process which started in earnest with a public consultation by the European Commission on 21 May 2015, which triggered a response from more than 170 stakeholders1 as well as reports from the European Securities and Markets Authority (ESMA)2, the European Systemic Risk Board (ESRB)3 and the European System of Central Banks (ESCB)4, all in line with the process prescribed by EMIR5. The review of EMIR was also explicitly made part of the Regulatory Fitness and Performance Programme (REFIT) and the 10 priorities of the Commission of 25 October 20166.
On 13 August 2015, the International Swaps and Derivatives Association (ISDA) submitted a consolidated and lengthy response to the consultation on behalf of the wider market, following extensive discussions with its members in the period following the publication of the consultation paper7.
The review of EMIR is complemented by proposals from the European Commission for more robust supervision of central counterparties (CCPs) given the impact they may have on the European Union’s financial stability and the role of UK CCPs as third-country CCPs post Brexit8, and a proposal on recovery and resolution of CCPs9. Also, the regulatory review in Europe is not an isolated initiative but is reflected by a similar process currently undertaken by the CFTC through Project KISS (‘Keep It Simple, Stupid’)10 following President Trump’s Executive Order on Core Principles for Regulating the U.S. Financial System of 3 February, 201711.
So what are the proposed changes?
Below, I will discuss and comment on some of the European Commission’s main proposals.
New counterparty classification
The European Commission proposes a change in the existing counterparty classification under EMIR with the introduction of the so-called small financial counterparties (SFCs) for which central clearing would not be economically feasible because of their small volume of activity and where there would not be any concern of systemic risk. The proposal does this by introducing the existing clearing threshold for non-financial counterparties in Article 10(4)(b) of EMIR also for financial counterparties and in doing so effectively creating FC-s. In essence this would mean that in the ‘new’ EMIR the counterparty classification would consist of: (i) financial counterparties above the clearing threshold (FC+s); (ii) financial counterparties below the clearing threshold (FC-s); (iii) non-financial counterparties above the clearing threshold (NFC+s); (iv) non-financial counterparties below the clearing threshold (NFC-s); and (v) third-country entities (TCEs).
The proposed method of determining whether the clearing threshold for FCs is exceeded or not is however different from that set out under Article 10(2) of EMIR for NFCs which refers to the rolling average position over a period of 30 working days. Instead, and similar to the calculation of the aggregate average notional amount under the EU Margin Rules12, it is the aggregate month-end average position for the months of March, April and May of a given year that determines whether the clearing threshold is exceeded and whether the FC is an FC+ or an FC-. Where the clearing threshold for a particular class of derivatives is exceeded for an FC, the FC would become subject to mandatory clearing for all classes of OTC derivatives, just like currently is the case for NFCs. In contrast and moving away from the current provisions, the proposal now indicates for NFCs that they will only be subject to mandatory clearing in the asset class for which the clearing threshold is exceeded.
In terms of calculating the clearing threshold there is another important difference between FCs and NFCs: where an FC in calculating these positions needs to include all OTC derivative contracts entered into by that FC or by all other entities within the group to which that FC belongs, an NFC will only have to include all the OTC derivative contracts entered into by it or by other non-financial entities within the group to which it belongs. The proposal has not expanded the existing ‘hedging exemption’ for NFCs13 when determining whether the clearing threshold has been exceeded, to FCs and hence they will have to include all such trades in the calculation.
The proposed re-classification of counterparties will very likely be welcomed by financial counterparties with a small derivatives portfolio. Also, it fits in with the recent proposals for a delayed phase-in for some financial counterparties with a limited volume of derivatives activity (the so-called Category 3 counterparties). However, it will require a whole reclassification by the industry of their counterparty population which will have a huge impact. This concern is even more imminent when you realise that most of the changes would already take effect 20 days after publication of the regulation in the Official Journal of the EU and don’t allow any preparation by the industry. The introduction of a new class of counterparties will undoubtedly require a lot more time to prepare for. In its response ISDA has therefore requested an effective date of the amendments which is at least 6 months after entry into force of the amending regulation.
The change in calculation in clearing threshold from the rolling average position over a period of 30 working days to the month-end average position for the months of March, April and May in any year will clearly reduce the operational burden for counterparties although it would also allow counterparties the opportunity to ‘manage’ the outcome of the calculation by artificially keeping the numbers down during the reference dates. No explanation is given for the fact that NFCs do not have to include hedging transactions in their clearing threshold calculations, whereas FCs do.
Finally, one could query the logic behind scoping out NFC+s from clearing asset classes in which they do not exceed the clearing threshold but still requiring them to comply with all other EMIR requirements such as margining those uncleared asset classes. In its response ISDA has raised this as well in the form of some de minimis threshold below which financial counterparties (given the low level of counterparty and systemic risk associated) should not be required to post or receive collateral against derivatives trades if they are below the de minimis threshold in all asset classes. At the same time ISDA has caveated this proposal by pointing out that there are some practical difficulties associated with introduction of this threshold which would require serious consideration, such as:
- sell-side financial counterparties are currently continuing the process of onboarding smaller financial counterparties for variation margin purposes;
- trades with an entity that is a financial counterparty now but would become a financial counterparty below a de minimis threshold at a future date might have to be re-priced;
- how would this proposal interact on a cross-border basis with other margin regimes which do not make this distinction.
Expansion of the category of FCs
The proposal expands the category of financial counterparties with all alternative investment funds (AIFs) as defined in the Alternative Investment Fund Managers Directive as opposed to only those AIFs which are managed by a manager authorised or registered under the Alternative Investment Fund Managers Directive. The result of this is that all AIFs registered under national law and as defined in Article 4(1)(a) of the Alternative Investment Fund Managers Directive14 will be in scope as an FC, where these are currently classified as an NFC. Obviously, this will have the effect of EMIR applying to many more entities than is currently the case.
Another expansion of the category of FCs is the proposal to also include Securitisation Special Purpose Entities (SSPEs) as defined in Article 4(1)(66) of the CRR15, being “a corporation trust or other entity, other than an institution, organised for carrying out a securitisation or securitisations, the activities of which are limited to those appropriate to accomplishing that objective, the structure of which is intended to isolate the obligations of the SSPE from those of the originator institution, and in which the holders of the beneficial interests have the right to pledge or exchange those interests without restriction”.
The proposal to include SSPEs in the category of FCs is unlikely to be greeted with much enthusiasm by the market. Where such vehicles would currently not be subject to clearing under EMIR as NFCs because their own positions would not be such that they would exceed the clearing threshold and they would equally not be part of a group whose non-financial counterparties would make them exceed that threshold, the proposed categorization as FCs may very well change that. As mentioned above, hedging transactions will count towards the clearing threshold for FCs and where securitization vehicles will generally enter into OTC derivative contracts to hedge risks, all such trades will be relevant for the clearing threshold calculations where they were not previously with SSPEs being NFCs and will therefore also impact the margining requirement. Where SSPEs will typically not have any free cash and very limited liquidity, they will not be able to collateralize uncleared OTC trades with any cash collateral or any other eligible collateral under the EU Margin Rules unless they retain cash or rely on any additional third-party liquidity arrangements. It is not clear how this proposal sits with, and questionable to what extent it reflects the ideas underlying, the proposed EU Securitisation Regulation16 which is part of the European Commission’s Capital Markets Union package of reforms and which seeks to make ‘high quality’ securitizations more appealing, restore investor confidence in securitization transactions and contribute to reviving the real economy through increased financing and targeted risk allocation. At the time of publication of this article, agreement had just been reached on this proposal in the trilogue among the European Commission, the Council and the Parliament but still require approval by the Council and the European Parliament in a plenary vote.
Removal of ‘frontloading’ obligation
The European Commission proposes to fully remove from EMIR the ‘frontloading’ requirement of Article 4(1)(b)(ii) of EMIR. This requires Category 1 and 2 FCs to also clear some OTC derivative contracts which were entered into before the actual clearing start date for a particular class in addition to all those OTC derivative trades in that class which were entered into after the clearing start date. This requirement has been much criticized from the start as a requirement that creates significant pricing and market risk management challenges. The general complaint was always that frontloading stood in the way of accurately pricing trades that would be cleared at a future date which would lead to a divergence in pricing and overall market disruption and would necessitate the introduction of documentation solutions requiring negotiation and agreement between counterparties. There were no similar requirements under the US Dodd-Frank Regulations and so ‘frontloading’ under EMIR was always an anomaly.
For the reasons mentioned above it is to be expected that the removal of ‘frontloading’ will be welcomed by the market.
Removal of ‘Backloading’
One of the trade reporting obligations under EMIR requires counterparties to also report to trade repositories historic derivatives trades which existed or were entered into on or after 16 August 2012 but were no longer outstanding on 12 February 2014 when the transaction reporting obligation under EMIR entered into force17. Equally, there has always been strong opposition from the market against this requirement, querying what purpose could be served with having to report transactions which no longer exist but the reporting of which would require a disproportionate effort from market participants in terms of retrieving and sourcing the relevant data. Also, ‘backloading’ would have to be performed using the same data fields and reporting format as used for the reporting of new trades. This would create issues already as many trades would not have UTIs at the time they had been executed and would therefore very unlikely be matched. The implementation of the ‘backloading’ requirement had recently already been delayed with a few more years in the expectation that it would very likely be removed altogether in the context of the review of EMIR.
The European Commission is now finally proposing to fully remove this requirement from EMIR by suggesting an amendment to Article 9 of EMIR such that it applies the reporting obligation only to derivative contracts which: (a) were entered into before 12 February 2014 and remain outstanding on that date; or (b) were entered into on or after 12 February 2014. In the Explanatory Memorandum to the proposal the European Commission justifies this by saying that this ‘will significantly reduce costs and burdens on counterparties and eliminate the potentially insurmountable obstacle of having to report data which may simply not be available without compromising prudential needs’.
Again, this proposal deserves full support. It has never been clear to the market what the purpose of this reporting requirement was from the start. Reporting was the first leg of EMIR which got implemented after EMIR entered into force and there has always been a level of concern in the market that too little time was spent on establishing a cost-efficient and well-balanced process for the transaction reporting. Revisiting this and other elements of this process (see further below) is therefore very welcome.
The European Commission proposes the following further changes to the trade reporting requirements under EMIR:
- Intragroup transactions involving an NFC should be exempted from the reporting obligation. According to the Commission this would significantly reduce the costs and burdens of reporting for those counterparties that are the most disproportionately affected by the requirement, while the resulting very limited loss of data will not significantly affect authorities’ ability to monitor systemic risk in the OTC derivative markets.
- Single-sided reporting on behalf of both parties by central counterparties for exchange-traded derivative transactions. This would greatly simplify reporting of exchange-traded derivatives without adversely impacting the transparency of the market.
- OTC derivative transactions where one party is an NFC not subject to the clearing obligation should be reported by the FC on behalf of both counterparties. This would reduce the burden of reporting for small NFCs for whom this would be a significant burden, without leading to a loss of data.
Although the proposal represents a vast improvement to the EMIR reporting regime on many levels, it effectively still constitutes a dual-sided reporting set-up for OTC derivatives, despite consistent advocacy by the market for single-sided reporting during the last few years. The primary objective of the reporting requirement under EMIR is to provide regulators with increased transparency into OTC derivative markets and, by doing that, to better enable the monitoring and assessment of risks that could pose a threat to the stability of the financial system. A dual-sided reporting regime requires trades to be matched and doubles the number of trade records. As a result it enhances the challenges on aggregation, consistency and implementation and operational costs for the industry. Recent experience has shown that the current matching rates at trade repositories is around 60% with current confirmation rates for most asset classes at or even above 90%. This is an indication that where there is agreement on the economic terms of trades between counterparties, the completion of fields required under the dual-sided reporting set-up results in inconsistencies and low matching rates.
It is widely believed that single-sided reporting can in large part address these flaws: it will significantly simplify the operational complexity associated with dual-sided reporting and produces a more cost effective framework. This is clearly something different than under the current set-up where firms can delegate the reporting obligation to another firm. Apart from having to maintain and reconcile across multiple delegated reporting agreements, firms also face significant on-going costs in fulfilling the obligation to check that trades have been correctly reported to the trade repository on their behalf. Those costs can be avoided in a regime where the obligation to report lies with sophisticated parties.
The proposal under 3 above, which is similar to the reporting framework under the Securities Financing Transaction Regulation (SFTR), is therefore not the solution it would appear to be. It requires FCs to report transactions on behalf of its counterparty, even it has not been able to obtain all the required information from the counterparty and creates a liability for the FC, even where it has no control over the data it receives from its counterparty. Although ISDA submitted a lot of convincing arguments for single-sided reporting in the context of the consultation for the EMIR Review, accompanied by a blueprint for single-sided reporting, these do not appear to resonate with the Commission and it therefore remains to be seen what any further advocacy should focus on.
A separate concern with respect to the proposal – as also identified above for the reclassification of counterparties – is caused by the implementation timeline of this part of the proposal. Where the proposed changes appear to apply when the amending regulation enters into force, counterparties would have no or very little time to prepare themselves by putting in place agreements with counterparties or amend their systems.
Suspension of clearing mandate
The European Commission also proposes a mechanism which allows the Commission, at the request of ESMA, to suspend the clearing obligation for a specific class of OTC derivatives or for a specific type of counterparty where certain conditions are met. The market has previously expressed concern that there is no existing mechanism in the Level 1 text of EMIR to terminate or suspend the clearing obligation within a short period of time. Currently, this would require an amendment to the relevant regulatory technical standards through which the clearing obligation was established and that process may take several months and would not work in a scenario and in market situations which would require that action is taken within a much shorter period of time. Situations which could require such suspension could be the following:
- a deterioration in market liquidity;
- contracts which were previously cleared no longer have the characteristics qualifying them for mandatory clearing;
- a CCP chooses to cease to provide clearing services for a specific class of OTC derivatives and no other CCP is able to clear that class;
- a CCP enters into recovery or resolution proceedings.
Where the market and ISDA on its behalf in the context of the EMIR Review consultation have expressed concerns about the absence of a clearing suspension mechanism, the Commission’s proposal is by all accounts a welcome one. There are some flaws in the proposal however which would require attention. Although the mechanism is intended to trigger short term decisions on a suspension of the clearing obligation, the process by which the Commission has to take this decision may still be too slow in certain circumstances. Also, the process by which ESMA has to make the request for a suspension to the Commission and the Commission then communicates a decision to suspend to ESMA and publishes it in the Official Journal of the European Union, may be too elaborate. Under circumstances ESMA should be able to suspend the clearing obligation itself. The maximum timelines for suspension could also prove to be too restrictive.
The proposal is not clear on what the position is of in scope trades entered into during a period of suspension of the clearing obligation, once that suspension is lifted. There should not be any requirement to clear those trades retroactively and the proposal needs to be clear on that. Equally, the proposal is unclear on whether the derivative transactions entered into during the clearing suspension should instead become subject to the margining requirements as uncleared OTC derivatives. Also, there may be scenarios where the regulators should be able to backdate or forward-date the suspension of the clearing obligation, options which the proposal currently does not provide for.
The ‘FRAND’ Principle
The European Commission proposes some amendments to Article 4 of EMIR which seek to introduce the so-called ‘FRAND’ concept. Under this concept clearing members and clients who provide clearing services, directly or indirectly, are required to provide those services under ‘fair, reasonable and non-discriminatory commercial terms’. The European Commission is empowered to adopt a delegated act to specify the conditions under which commercial terms are considered to be fair, reasonable and non-discriminatory.
This principle is clearly intended to enhance access to clearing as much as possible and should for that reason be applauded. However, until such time as further regulatory technical standards are produced which will specify what are such ‘fair, reasonable and non-discriminatory commercial terms’ it is not clear how clearing members and clients of clearing members are expected to behave and whether and when market participants would be in a position to take action for breach of these principles. Also, it would seem to make sense to have the main ‘FRAND’ principle laid down in the Level 1 text of EMIR and to clarify that it does not seek to introduce an obligation for counterparties to offer mandatory clearing, something the market has always wanted to stay well away from.
Some other proposals
The proposals above are some of the most eye-catching suggestions from the European Commission in the context of the EMIR Review. A few additional changes are the following:
- a further extension by three years of the transitional exemption from the clearing obligation for Pension Scheme Arrangements, which currently benefit from an existing clearing exemption which will run out on 16 August 2018;
- a proposal to clarify that assets covering the positions recorded in an account held by a CCP or a clearing member are not part of the insolvency estate of the CCP or the clearing member that keeps separate records and accounts. This proposal raises the question of how this will sit and interact with national insolvency rules;
- a proposal to have the European Supervisory Authorities submit a common draft regulatory technical standards within 9 months after the entry into force of the Commission’s proposed regulation, specifying the risk-management procedures, including the levels and type of collateral and segregation requirements, required for compliance with Article 11(3) of EMIR. This raises the question of whether it is the European Commission’s proposal that there will be a new European Margin RTS on the horizon;
- a further EMIR Review to be scheduled in three years after the coming into force of the draft regulation.
Implementation time-line and next steps
The proposed regulation sets out different effective dates for different changes, with some entering into force on the twentieth day following publication in the Official Journal of the European Union, some on a date which is 6 months after the entry into force and again some on a date which is 18 months after entry into force. As already touched upon above, this implementation time-line needs some further thought as in some cases it will prove to be overambitious and will not allow the market sufficient time to adapt its infrastructure to the proposed changes. Also, in many cases ESMA is required to submit draft regulatory technical standards to the European Commission by a date which is 9 months after the date of entry into force of the regulation. In view of the typical process regulatory technical standards need to go through, that time-line may be equally unrealistic and cause ESMA to have to compromise on the quality of the end product.
The proposals will now be considered by the European Parliament and the European Council and need their approval before being adopted. The expectation is that this process will be completed by the second half of 2018. Prior to that there will be ample opportunity for the market to express their views and try to influence the outcome of the regulation through a continued process of advocacy.
The proposal addresses a fair number of points which the market has previously expressed its dissatisfaction with and some of the Commission’s suggestions will undoubtedly improve EMIR. At the same time it is unfortunate to see that the request by the wider market for single-sided reporting has not triggered much enthusiasm with the Commission, this despite all the effort that has gone into trying to convince it of the benefits. Also, in terms of the proposed time-line for implementation of the various proposals it would make sense to allow a little bit more time for the submission of regulatory technical standards. One of the reasons for the review is that some of the regulations - the rules on trade reporting come to mind - were a bit of a rush job when they were first put in place and it would be unfortunate if the same would happen now. No doubt there will be a lot of advocacy in the next few months and more changes may be introduced.
- All responses available on https://ec.europa.eu/eusurvey/publication/emir-revision-2015?language=en.
- EMIR Review Report no. 4, ESMA input as part of the Commission consultation on the EMIR Review; 13 August 2015 | ESMA/2015/1254).
- ESRB Report on the Efficiency of Margining Requirements to Limit Pro-Cyclicality and The Need To Define Additional Intervention Capacity In This Area and the ESRB Report on Issues To Be Considered In The EMIR Revision Other Than The Efficiency Of Margining Requirements, both dated 28 July 2015).
- ECB Response to the European Commission’s Consultation on the Review of the European Market Infrastructure Regulation (EMIR), 2 September 2015.
- See also my contribution to Edition 5 of Rocket, the Magazine from the OTC Space “EMIR Review: EMIR revisited or EMIR II?”
- REFIT aims to make sure that EU law remains fit for purpose and delivers the results intended by policy makers in the most efficient and effective way, targeting removing red tape and lowering costs without compromising policy objectives and EU high standards.
- The responses to the consultation, including ISDA’s feedback, can be accessed on: http://ec.europa.eu/finance/consultations/2015/emir-revision/indexen.htm.
- Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 1095/2010 establishing a European Supervisory Authority (European Securities and Markets Authority) and amending Regulation (EU) No 648/2012 as regards the procedure and authorities involved for the authorisation of CCPs and requirements for the recognition of third-party CCPs.
- Proposal for a Regulation of the European Parliament and of the Council on a framework for the recovery and resolution of central counterparties and amending Regulations (EU) No 1095/2010, (EU) No 648/2012, and (EU) 2015/2365.
- Project KISS is an agency-wide review by the Commodity Futures Trading Commission (CFTC) of its operation and oversight program with the goal of identifying areas in which it can simplify and modernize Commission rules, regulations and practices in order to reduce regulatory burdens, remove barriers to the efficient operations of derivatives markets, and foster economic growth.
- Executive Order 13772, Core Principles for Regulating the United Stated Financial System.
- See Article 39(1) of Commission Delegated Regulation (EU) 2016/2251 of 4 October 2016.
- See Article 10(3) of EMIR.
- Directive 2011/61/EU.
- Regulation (EU) No 575/2013 of 26 June 2013 on prudential requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012.
- Proposal for a Regulation of the European Parliament and of the Council laying down common rules on securitisation and creating a European framework for simple, transparent and standardised securitisation and amending Directives 2009/65/EC, 2009/138/EC, 2011/61/EU and Regulations (EC) No 1060/2009 and (EU) No 648/2012.
- See implementing regulation EU 1247/2012.
*This article represents my personal view and should not be taken to represent the official view of UniCredit Bank AG or any of its affiliates.
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