It is over three years now that the European Market Infrastructure Regulation (EMIR) was put in place on 4 July 2012 as Europe’s response to the commitment expressed by the G-20 leaders at the Pittsburgh summit in September 2009 that all standardised OTC derivatives contracts (i) should be traded on exchanges or electronic platforms, where appropriate; (ii) be cleared through central counterparties by end-2012 at the latest; (iii) be reported to trade repositories; and (iv) with non-centrally cleared contracts to be made subject to higher capital requirements. The level 1 text of EMIR provides for a review of the regulation by the European Commission by 17 august 2015. A market consultation on the review of EMIR was completed on 13 August 2015.

It is over three years now that the European Market Infrastructure Regulation (EMIR) was put in place on 4 July 2012 as Europe’s response to the commitment expressed by the G-20 leaders at the Pittsburgh summit in September 2009 that all standardised OTC derivatives contracts (i) should be traded on exchanges or electronic platforms, where appropriate; (ii) be cleared through central counterparties by end-2012 at the latest; (iii) be reported to trade repositories; and (iv) with non-centrally cleared contracts to be made subject to higher capital requirements. The level 1 text of EMIR provides for a review of the regulation by the European Commission by 17 august 2015. A market consultation on the review of EMIR was completed on 13 August 2015.

On 13 August 2015, the first phase of the EMIR Review was completed with a public consultation by the European Commission of all stakeholders on their views and experiences with the implementation of EMIR to date. Although the European legislator probably anticipated in 2012 that EMIR would have been fully implemented and completed by the review date of 17 August 2015 mentioned in Article 85(1) of EMIR and would allow for a full review, the current reality is somewhat different with mandatory clearing and margining of non-centrally cleared OTC derivatives still not in force. The Commission has acknowledged this reality in its 21 May 2015 consultation paper by stating in so many words that its report would “focus primarily on those aspects of EMIR which have been implemented” but equally that it would welcome “views of stakeholders as to any identified issues with respect to the implementation of upcoming requirements”.

First steps in the EMIR Review

Following the publication of the consultation report, a public hearing was held by the European Commission in Brussels on 29 May 2015, presided by Lord Hill, the European Commissioner for financial stability, financial services and capital markets union. The purpose of the open hearing which was run through four topic-picked panel discussions, was to get some initial feedback from the market on their experiences with EMIR to date, what has worked under EMIR and what has not, where EMIR has resulted in unintended consequences and, more importantly, what could be improved and how. Any expectations that the EMIR Review would result in a total overhaul of the EMIR Level 1 text were however immediately thwarted by Lord Hill’s opening speech at the hearing stating that there was no plan to change the fundamental objectives of the regulation. In addition, the consultation paper is very clear on the fact that it is not seeking any views on regulatory technical standards which have not yet been adopted by the European Commission, such as the proposed regulatory technical standards on mandatory clearing of certain interest rate derivatives and the joint draft regulatory technical standards of ESMA, EBA and EIOPA on margining of uncleared OTC derivatives.

So what topics are under review?

In determining the topics to be reviewed in the context of the con- sultation the European Commission was to some extent bound by the items listed in Article 85(1)(a) – (e) of EMIR, which the EMIR Level 1 text made subject to an assessment by the Commission and all of which have been included in targeted questions to stakeholders in Part I of the consultation paper (CCP Liquidity; the position of NFCs; CCP Colleges; Procyclicality; and CCP Margins and Collateral). Part II of the consultation paper then continues with general questions covering a variety of additional topics, some of which will be discussed in further detail below.

A total of 181 respondents submitted their feedback on the consultation. On behalf of its members ISDA also submitted a response to the consultation paper on the basis of extensive discussions with its members through its EU Regulatory Department during the period following publication of the consultation paper. Below follows a summary of ISDA’s feedback on some of the main topics covered in its response which has been published on http://ec.europa.eu/finance/consultations/2015/emir-revision/indexen.htm. The European Commission has announced to publish a summary of the responses received at a later stage.

Indirect clearing

For the purpose of clearing OTC derivatives which have been made subject to mandatory clearing Article 4(3) of EMIR requires a counterparty to become a clearing member, a client, or establish indirect clearing arrangements with a clearing member, provided that those arrangements do not increase counterparty risk and ensure that the assets and positions of the counterparty benefit from protection with equivalent effect to that referred to in Articles 39 (segregation and portability) and 48 (default procedures) of EMIR. The concept of indirect clearing was introduced to enable smaller market participants who are simply unwilling or unsuitable to become a direct clearing member or a direct client of a clearing member access to clearing once clearing will become mandatory for certain classes of OTC derivatives. At the time, regulatory technical standards (EU Regulation 149/2013 of 19 December 2012) were developed specifying the types of indirect contractual arrangements that would meet the requirements of the EMIR Level 1 text.

An initial proposal to make the offer of indirect clearing an obligation for clearing members was removed following strong pushback from the market which rightfully feared that this would cause clearing members to no longer offer any clearing services and to withdraw from the market altogether which obviously would not have been in the interest of clearing. Some of the difficulties of the indirect clearing model have already been identified and discussed in a previous contribution to the OTC Space on 25 September 2013 by Maria Leontiou (“Indirect Clearing. Can it work?”) and in this context I would also refer to a publication by Simon Puleston Jones for FIA in Futures Industry of November 2014 (“Is there a future for indirect clearing?”). ISDA has also on various occasions in the past spoken out to express its members’ concerns with the indirect clearing ruleset.

Although it appears that ESMA has taken the practical issues of indirect clearing into account in designing the indirect clearing setup for exchange-traded derivatives under MiFIR, (RTS 38: Draft regulatory technical standards on indirect clearing), there are specific considerations under EMIR which will stand in the way of these rules working in an EMIR context. In its response on the EMIR Review consultation paper ISDA has set out a list of suggestions which would require attention to create a workable ruleset for indirect clearing under EMIR. Most of these proposals are based on the idea that where in a direct clearing environment a CCP is generally protected by various regulations when taking action on a clearing member default, similar, but currently missing, protections should be made available to clearing members which provide indirect clearing services upon a default of their client, the indirect clearer. A complicating factor in all of this is that the chain of relationships in the world of indirect clearing can be cross-border and cover a multitude of jurisdictions, EU and non-EU, each with its own insolvency regime and the impact of such insolvency regimes, where they apply in various potential default scenarios, may not be compatible with the requirements of Regulation 149/2013. Upon the insolvency of a direct client in an indirect clearing setup, clearing members may for instance not be able to ensure the making of ‘leapfrog’ payments to the indirect client as required by Article 4 (5) of Regulation 149/2013. For that reason, ISDA has suggested that Article 4 of EMIR be amended such that the requirements in the technical standards adopted pursuant to this article shall prevail over any conflicting insolvency and other laws and regulations of an EU Member State that would otherwise prevent any person from fulfilling them. In addition, ISDA has urged ESMA to remove from Article 4 (4) of Regulation 149/2013 the requirement for clearing members to establish robust procedures to manage the default of a client that provides indirect clearing services, such as a credible mechanism for transferring positions and assets to an alternative direct client or clearing member.

Frontloading

The concept of frontloading as set out in Article 4(1)(b)(ii) of EMIR has been in the EMIR Level 1 text from the start and seeks to also make subject to mandatory clearing any derivative contracts which fall within a class that needs to be cleared and were entered into on or after the notification by a competent authority to ESMA of a CCP authorisation to clear a particular class of OTC derivatives and before the date that the mandatory clearing for that class actually takes effect. The market (and ISDA on its behalf in response to previous consultations with respect to draft regulatory technical standards on mandatory clearing of interest rate swaps and credit default swaps) has always been very vocal about its views on frontloading. It creates significant pricing risks as bilaterally traded OTC derivatives are priced differently from trades which are cleared through a CCP and will require a re-pricing adjustment at the point they are frontloaded into a CCP. If this need to re-price a trade has not already been reflected at trade inception – which may well be the case as pricing a trade which will be valued differently at a point in the future can be complicated – one of the parties will suffer a loss once the trade gets cleared. Additional problems arise if firms clear OTC derivatives traded during the frontloading window at CCPs that have not yet been authorised or recognised by the time the clearing obligation enters into effect. Those positions would technically have to be ter- minated and re-opened with CCPs which are recognised/authorised which is likely to cause significant market disruption.

Ability of ESMA to terminate or suspend the clearing obligation

ESMA does not currently have the ability to terminate or suspend the clearing obligation of a class of derivatives as a matter of urgency in a scenario where the circumstances which justified the clearing obligation to come into effect for that class of derivatives have changed dramatically and no longer justify such mandatory clearing. A review by ESMA of the clearing obligation and an ability to terminate or suspend could also be necessary in a situation where a CCP loses its authorisation or recognition under EMIR.

Trade reporting

A key element of the G-20 objectives at the time was to increase transparency in the OTC derivatives markets with a view to better understand and monitor potential risk to the stability of the financial system. The reporting of trades under EMIR which started on 12 February 2014 and is based on a dual-sided reporting mechanism, requires a matching process of data across counterparties and trade repositories and has proven to be very costly and challenging with, currently, poor matching rates across the board. At the same time the operational complexity has turned out to be disproportionately burdensome and has necessitated buy-side firms, which often simply lack the necessary resources to do their own reporting, to rely on delegated reporting by the larger dealers. In the run-up to the deadline of this consultation ISDA consulted its members on their experiences with the trade reporting regime so far and an overwhelming majority expressed a strong preference to redesign it into a single-sided regime. With a view to improving the quality and accuracy of reporting data but at the same time reducing the complexity of the reporting regime, ISDA’s proposal to the Commission in response to the consultation consists of four limbs:

1. NFC- s (NFC minuses) should be fully exempt from the trade reporting obligation;

2. Intragroup transactions for all NFCs should not be subject to the trade reporting obligation;

3. Exchange-traded derivatives should be fully exempt or only be subject to single-sided reporting;

4. In the cleared world the obligation to report under a singlesided reporting regime should reside with the CCP for cleared trades between the CCP and the clearing member and with the clearing member for trades between a clearing member and its counterparties for which it provides access to clearing. In the non-cleared space ISDA has developed a detailed hierarchy to determine which party to a trade should be the reporting party.

Backloading

According to Article 9 (1) of EMIR and the implementing regulation EU No. 1247/2012 of 19 December 2012 the obligation to report OTC derivative transactions to trade repositories applies, inter alia, to trades which were entered into on or after 16 August 2012 but are no longer outstanding after the reporting start date under EMIR of 12 February 2014. The deadline for reporting these historical dead trades is 3 years from the reporting start date but many institutions have not focused on this exercise yet. It is likely that the reporting of these trades will require a significant effort from institutions to retrieve these old data and it is questionable what purpose will be served with that. For that reason there is huge resistance in the market against having to incur additional costs for something that does not appear to serve any purpose and ISDA has therefore expressed as its belief that this backloading requirement should be removed from EMIR.

Article 13 and Article 25 Equivalence assessments

The slow progress in the adoption of positive equivalence decisions both in the context of Article 13 of EMIR for the purposes of avoiding duplicative or conflicting requirements for clearing (Article 4 of EMIR), reporting (Article 9 of EMIR), treatment of non-financial counterparties (Article 10 of EMIR) and risk mitigation techniques for non-cleared trades (Article 11 of EMIR), as well as in the context of Article 25 of EMIR with a view to recognition of non-EU CCPs, is increasingly becoming a concern for market participants. It stands in the way of a regulatory level playing field across jurisdictions and puts the international operations of many institutions at a competitive disadvantage. This topic was also high on the agenda of the latest ISDA AGM in Montreal in April this year and triggered some heated discussions there but the debate continues without any resolution.

Admittedly, there has been some progress on equivalence through technical advice by ESMA to the European Commission on 3 September and 2 October 2013 in respect of equivalence between the regulatory regimes of Australia, Hong Kong, Japan, Singapore, Switzerland, the United States, Canada, India and South Korea and the EU regulatory regime under EMIR in respect of the clearing obligation, non-financial counterparties and risk mitigation techniques for non-centrally cleared OTC derivatives. It is expected that the European Commission will eventually base its potential equivalence decisions for these jurisdictions on this advice. In addition, on 30 October 2014 the European Commission adopted its first equivalence decisions for the regulatory regimes of CCPs in Australia, Hong Kong, Japan and Singapore and in accordance with Article 25 (2) of EMIR ESMA recognised ten third-country CCPs from these jurisdictions.

ISDA and a number of other market associations have in the past already expressed their concerns on the lack of equivalence decisions through a letter to Lord Hill on 22 June 2015 in which it welcomed the recognition of the ten non-EU CCPs mentioned above but equally urged the European Commission and ESMA to work closely together with a view to granting further recognition to non EU CCPs at the earliest possible time. In its response to the EMIR Review consultation paper ISDA has repeated its concerns and has expressed the following views on Article 13 equivalence:

• When EU counterparties trade with counterparties established in, or subject to the rules of, an equivalent jurisdiction, they should be permitted to mutually agree which set of rules would apply to a particular trade between them;
• Article 13 (3) of EMIR should allow for separate equivalence decisions regarding the obligations contained in Articles 4, 9, 10 and 11, instead of one all-encompassing decision and any equivalence assessment should follow an outcomes-based approach (as opposed to a rules-based approach);
• From a procedural point of view any equivalence assessment should not be conditional on third country regulators making an application for a European Commission equivalence determination; and
• The European Commission should be able to make temporary equivalence determinations, specifically in the context of margining of uncleared OTC derivatives, where the absence of any equivalence could potentially result in counterparties having to post margin twice under different rulesets.

In relation to the Article 25 equivalence ISDA has, inter alia, proposed:

• a de-linkage of the CCP recognition under EMIR from the qualifying CCP (QCCP) treatment under the Capital Requirements Regulation (CRR). Under the CRR, a firm may benefit from a beneficial treatment of its exposure to a CCP if such CCP has the status of a QCCP which a non-EU CCP can only get if it is recognised by ESMA under Article 25 of EMIR. This would enable firms to continue clearing at such non-recognised CCP without incurring punitive capital requirements on their exposures to such CCP;
• that EU firms should be able to become clearing member with CCPs which have not yet been recognised under EMIR without incurring burdensome capital requirements if such CCPs comply with the Principles for Financial Market Infrastructures which have been set out by the Committee on Payments and Market Infrastructures and the International Organisation of Securities Commissions.

So what will be the next steps?

Following the feedback from the market, the European Commission will now have to prepare a general report on EMIR which is not expected to be available until later in the year (rather than on 17 August 2015 as set out in Article 85 (1) of EMIR). On the deadline for feedback on the EMIR Review consultation paper, ESMA submitted four reports to the European Commission which are expected to also feed into the general report of the European Commission. These four reports cover such topics as: (i) the use of OTC derivatives by non-financial counterparties; (ii) the efficiency of margining requirements to limit procyclicality; (iii) segregation and portability requirements; and (iv) clearing obligation, trade reporting third-country CCP recognition, EU CCP authorisation and trade repository supervision. Once prepared, the European Commission will submit its report to the European Parliament and the European Council with any appropriate proposals. When all of this may result in changes to the EMIR Level 1 text and when such potential changes will come into effect is difficult to predict at this stage. What is clear though is that some features of EMIR, such as frontloading by Category 1 counterparties, are expected to already kick in before any potential changes to the EMIR Level 1 text on those aspects of EMIR may come into effect.

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