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Carolyn Jackson, partner at Katten Muchin Rosenman UK LLP and a P.R.I.M.E. Finance expert, discusses the recently adopted EMIR REFIT proposal including the key changes that it brings about, the benefits and challenges of these changes, and how practitioners can prepare for it coming into force.
EMIR REFIT is the culmination of a review of the European Market Infrastructure Regulation (EU) 648/2012 (EMIR) that began in 2015. Article 85(1) of EMIR required the European Commission (the Commission) to review EMIR by August 2015 and to submit a report of its findings to the European Parliament and the Council of the EU. Between May and August 2015, the Commission carried out an extensive assessment of the legislation, which resulted in a report, published in November 2016. The Commission concluded that although there was no need for a fundamental change to the nature of the core requirements of EMIR, amendments could be made to some specific areas to eliminate disproportionate costs and burdens on certain over-the-counter (OTC) derivatives counterparties, as well as to simplify the current rules.
EMIR was included within the Commission's 2016 Regulatory Fitness and Performance (REFIT) programme which resulted in May 2017 in a proposal from the Commission for a Regulation amending EMIR (EMIR REFIT) to address the costs, burdens and simplification issues it had identified. The Commission published the EMIR REFIT proposal on 4 May 2017. After a number of iterations, the draft text of EMIR REFIT was adopted by the Council of the EU on 14 May 2019, was signed on 20 May 2019 and published in the Official Journal of the European Union on 28 May 2019. EMIR REFIT will therefore enter into force on 17 June 2019.
The key changes brought about by EMIR REFIT include:
The definition of financial counterparty (FC) has been expanded under EMIR REFIT to capture all EU alternative investment funds (AIFs), irrespective of the location of the alternative investment fund manager (AIFM) and, where relevant, their AIFMs. Under EMIR, only AIFs, irrespective of location, with an AIFM authorised or registered in accordance with the Alternative Investment Fund Managers Directive (AIFMD) fell within the FC definition, allowing for the possibility for some AIFs to fall within the non-financial counterparty (NFC) definition. To date, many non-EU AIFs (and a limited number of EU AIFs) which have non-EU managers not authorised or registered in accordance with the AIFMD have therefore classified themselves as third country entities (TCEs) that would be NFCs were they to be established in the EU. Further, if such non-EU AIFs have an amount of uncleared OTC derivatives below the applicable EMIR clearing thresholds for each asset class, they are exempt from the obligation to clear any OTC derivative subject to a mandatory clearing determination as well as the obligation to post margin on uncleared OTC derivatives and certain reporting obligations on OTC derivatives transactions entered into with EU counterparties. Thus, once EMIR REFIT enters into force, any non-EU AIF with a non-EU manager not authorised or registered in accordance with the AIFMD, will be an FC and required to post margin with FC and NFC+ EU OTC derivative counterparties and may be required to post initial margin, depending on the volume of its OTC derivatives activities. Additionally, as discussed below, there is a limited possibility that such TCE AIFs may also be subject to the EMIR mandatory clearing obligation.
EMIR REFIT introduces the new counterparty classification of a "small financial counterparty" (FC-), for those FCs that are below the EMIR clearing threshold for all five asset classes, with FC+s being those FCs above any one of the EMIR asset class clearing thresholds. An FC- will be exempted from the EMIR clearing obligation but, critically, will remain subject to the risk mitigation obligations, including the obligation to post margin on uncleared OTC derivatives. The determination for whether an entity is an FC+ or an FC- is based on the existing EMIR clearing thresholds for each asset class that currently apply to NFCs. The clearing threshold calculation itself, however, as discussed below, has changed.
EMIR REFIT changes how the EMIR clearing threshold calculation is made. Rather than looking at the 30 working day rolling average of gross notional principal amount outstanding, the calculation will now only be required to be made once a year and will be determined if an entity's aggregate month-end average position for the previous 12 months exceeds any of the applicable EMIR clearing thresholds for an asset class. As under EMIR, the calculation must be made at group level. Under EMIR REFIT, an NFC that exceeds the clearing threshold for one asset class (i.e., an NFC+) will now only become subject to the clearing obligation in respect of in-scope products in that particular asset class, rather than in respect of all asset classes, as is currently the case. However, an FC that exceeds the clearing threshold for one asset class as an FC+ will be subject to the clearing requirement for all in-scope products in all asset classes. As discussed above, non-EU AIFs with non-EU AIFMs that are not authorised or registered in accordance with the AIFMD will become TCE FCs when EMIR REFIT enters into force. However, despite the change in the EMIR clearing threshold calculation, it is unlikely that any such non-EU AIF that is currently below the EMIR clearing thresholds as a TCE NFC- will exceed them under the EMIR REFIT calculation and become a TCE FC+, subject to the EMIR clearing obligation.
Any FC or NFC that exceeds an EMIR clearing threshold on the day that EMIR REFIT enters into force must inform both the European Securities and Markets Authority (ESMA) as well as its competent authority. Thus, EU FCs and NFCs will have to make the clearing threshold calculations on or before 17 June 2019 over the months commencing with June 2018 and ending with May 2019. If however, an NFC or FC chooses not to make the EMIR clearing threshold calculations, they can effectively "opt-up" to NFC+ and FC+ status, respectively, by a one-time notification to ESMA and to its competent authority, stating that it has not made the clearing threshold calculation. Both an NFC and an FC making the "opt-up" declaration will be subject to the clearing obligation in all asset classes.
EMIR REFIT contains some minor
concessions related to reporting, including the following:
The requirement for OTC derivatives
contracts entered into or novated before the effective date of an EMIR
mandatory clearing obligation, i.e., "frontloading" has been removed.
EMIR REFIT introduces an obligation on clearing brokers to provide services on fair, reasonable, non-discriminatory and transparent commercial terms (FRANDT). This builds on existing requirements in EMIR and the revised Markets in Financial Instruments Directive 2014/65/EU, but has created some uncertainty as to the conditions of the new standard.
The Commission is given the power to suspend the clearing obligation for three months, extendable for successive periods of three months up to a total of twelve months, for specific classes of OTC derivatives or a specified type of counterparty. Any such suspension would be extended to the trading obligation under the Market in Financial Instruments Regulation (EU) No 600/2014.
The final transitional exemption for pension scheme arrangements from the EMIR clearing obligation in respect of certain OTC derivatives expired on 16 August 2018. EMIR REFIT extends the exemption for a further two years and empowers the Commission to extend it thereafter twice by one year.
EMIR REFIT contains a recital requiring the mandatory exchange of collateral for variation margin for physically settled FX forwards and physically settled FX swaps to only apply to OTC derivatives transactions between "the most systemic counterparties". Under earlier drafts of EMIR REFIT such counterparties were specified as EU credit institutions and investment firms. Currently, FCs and NFC+s are trading physically settled FX forwards and swaps on an uncollateralised basis on the basis of regulatory forbearance.
For market participants, the changes to EMIR introduced by EMIR REFIT were designed to make compliance under EMIR simpler, easier and less costly, especially for NFCs and FC-s. Many NFCs will benefit from reduced reporting obligations and will no longer be required to clear any OTC derivatives in an asset class in which they have not exceeded the applicable EMIR clearing threshold. The elimination of the backloading and frontloading obligations is potentially beneficial to both NFCs and FCs. FCs that fall within the FC- category will no longer be automatically subject to the EMIR clearing obligation, which will only occur when they have exceeded an EMIR clearing threshold in one or more asset classes. Additionally, EMIR REFIT has introduced clarity on the reporting obligations under EMIR for UCIT managers and AIFMs.
Due to the time it has taken for EMIR REFIT to get from its original proposal by the Commission to actually enter into force on 17 June 2019, there have been a number of timing issues, which European authorities have attempted to solve through regulatory forbearance. Such forbearance is somewhat unsatisfactory for certain market participants, and reflects ESMA's limited abilities to mitigate against regulation that clearly does not meet the intention of European lawmakers. For instance:
The new reporting obligation under EMIR REFIT for FCs when entering into an OTC derivative with NFC-s to report both sides of the transaction to a trade repository and to retain legal liability for both reports is a dramatic shift from the current position and one that may prove unpopular, especially if enforcement action is taken against such FCs. As stated above, FCs currently generally make the required EMIR reports pursuant to a delegated reporting agreement for their NFC- counterparties, however the legal responsibility for the accuracy and timeliness of the reports remains with the NFC-.
While EMIR REFIT enters into force on 17 June 2019, the regulation includes some phase-in periods (for instance, 24 months for FRANDT, 12 months for FCs to report on behalf of NFC-s and 4 months for new FC+s to prepare for clearing which will apply only to in-scope OTC derivatives contracts entered into as of that date and going forward), some of the changes will require changes to existing procedures or the introduction of new processes and contractual arrangements. It is possible that non-EU AIFs that are currently TCE NFC-s will be obligated to post margin on their uncleared OTC derivatives for the first time as of 17 June 2019 and will therefore need to set up internal processes and enter into credit support agreements with their counterparties before that date. Alternatively, even if such TCE NFC-s are currently posting such margin due to their counterparty's risk management requirements, the applicable credit support agreements may not be EMIR compliant and will need to be amended as of 17 June 2019. Any firm that will be an FC+, NFC+ or "opt-up" FC+ or NFC+ will need to notify both ESMA and its competent authority on 17 June 2019 of their status. FCs will need to prepare for being able to report OTC derivatives entered into with NFC-s. Firms should therefore be evaluating which changes to EMIR introduced by EMIR REFIT may affect them and prepare for such changes as soon as possible.
Interviewed by Emma Millington.
The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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