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ESMA recently published a consultation containing long-awaited proposals for the extension of EMIR rules to third country entities (TCEs) in relation to over-the-counter (OTC) derivative transactions. With ESMA requiring responses by 16th September, Betsy Dorudi, a senior manager in PwC’s Financial Services Regulatory Centre of Excellence, highlights the potential impact.
What are the new rules about, in a nutshell?
The proposals aim to clarify the conditions in which EMIR provisions relating to clearing or risk mitigation techniques would apply to OTC derivatives by two non-EU counterparties which have a substantial effect in the EU.
Proposals running nearly a year behind schedule
EMIR applies to financial and non-financial derivative counterparties established in the EU and requires them to comply with three sets of obligations: to clear all derivatives subject to mandatory clearing (art 4) or for non-centrally cleared contracts, to apply risk management processes (art 11) and to report all derivative transactions to trade repositories (art 9).
ESMA published a consultation on 17 July 2013, ‘Draft Regulatory Technical Standards—Contracts having a direct, substantial and foreseeable effect within the Union and non-evasion of provisions of EMIR’, containing proposals to extend the EMIR clearing and non-centrally cleared obligations to transactions between entities established outside the European Union, known as TCEs. While the EMIR primary legislation states the high level principles under which the rules can be extended, stakeholders have waited over a year for a first look at proposals which set out the specific criteria to identify which TCE transactions fall in scope.
ESMA was due to deliver its final proposals to the EC on 30 September 2012, but the European Commission (EC) instructed ESMA to delay development until the EU could coordinate its extra-territorial proposals with US and other international rule makers. Rule makers needed to coordinate key aspects of their extra-territorial regimes. They needed to agree the circumstances in which their extra-territorial rules should apply, to ensure that trading which takes place outside their territorial or other direct jurisdiction, but has a direct effect in their markets, is subject to adequate regulatory standards. They also needed to agree when extra-territorial rules should be dis-applied, if the overlay of extra-territorial rules results in duplicative and conflicting obligations for market participants. Agreement between the US and EU on extra-territorial regimes was critical, as the EU and US are the largest derivatives markets.
Agreement with the US critical
On 11 July 2013, the Commodity Futures Trading Commission (CFTC) and EC published their ‘Path Forward’ statement, announcing agreement on key aspects of their extra-territorial regimes. This accord was the milestone event that allowed the CFTC to publish the remainder of its outstanding extra-territorial legislative package, and for the EU to move ahead with its stalled EMIR extra-territorial rule making. EU and US representatives agreed on extra-territorial scope principles and to work towards achieving mutual recognition of their respective derivatives rules. EMIR rules allow TCEs in third countries with derivatives rules deemed equivalent by the EU to opt to follow the equivalent rules, or EMIR. Both countries acknowledged the importance of equivalence relief for market participants and undertook to work together to provide recognition of reciprocal rules.
During the EU’s extra-territorial rule making delay, the first EMIR compliance obligations for EU derivative counterparties came into force. But TCEs were in regulatory limbo, sitting on the sidelines and wondering when and if they would need to comply with EMIR and how much or how little to participate with their EU group company and client preparations.
The EMIR extra-territorial proposals have arrived and while they are not final, they provide EU derivative counterparties with interests outside the EU and TCEs with clear criteria for analysing the likelihood of being subject to EMIR under the TCE and related anti-evasion principles. In addition, the consultation answers a number of outstanding cross-border perimeter and implementation questions for EU counterparties.
What the proposals address
The EMIR primary legislation states that the clearing and non-centrally cleared derivative obligations apply to transactions between TCEs:
• if the TCEs would be subject to EMIR if they were located in the EU, and
• the transaction has a direct, substantial and foreseeable effect in the Union, or
• where such application is necessary or appropriate to prevent the evasion of any provision of EMIR
The art 9 transaction reporting obligations do not apply to transactions between TCEs, although the EC may rethinks this policy at a later date.
The EMIR primary legislation provides EMIR exemptions for EU central banks and certain public bodies and a three year temporary exemption from the clearing obligation for pension funds. The EU has already moved to exempt US and Japanese central banks and public bodies from EMIR, and may seek to extend these exemptions to other jurisdictions in line with third country equivalence determinations.
The consultation proposals set out the criteria for transactions which fall under the ‘direct, substantial and foreseeable’ and anti-avoidance principles.
Direct, substantial and foreseeable criteria more narrow than anticipated
ESMA proposes that only the following types of TCE-to-TCE transactions fall under this principle:
• Transactions within the EU: all over-the-counter (OTC) derivative transactions between EU branches of TCEs (where the rules of the third country(ies) are not deemed equivalent to EMIR rules). This would capture transactions between the Paris branch of a Kuwaiti bank and the London branch of an Indian bank. However, the rules do not extend EMIR obligations to transactions between the EU branch of a TCE and an EU counterparty, or when it trades with a TCE located outside the EU.
• Transactions outside the EU: all OTC derivative transactions undertaken by a TCE established in a non-equivalent country that is guaranteed by an EU financial counterparty, when the guarantee covers the TCE’s aggregated OTC trading liability for €8bn or more and represents 5% of the EU guarantor’s total OTC derivative trading exposure. The very narrow scope of this criteria was a surprise. The EC could have set out a much broader, more inclusive scope. ESMA decided not to include TCE transactions in contracts which are denominated in Euro and EU currencies, or transactions where the underlying assets, such as commodities, are heavily traded in the EU. ESMA noted that they have taken a pragmatic approach to narrowing the scope to only those which are backed by EU financial counterparties—because EU competent authorities are more likely to be able to supervise and enforce compliance with EU regulated financial services entities.
Evasion factors: the primary purpose test
ESMA has taken its lead from tax anti-avoidance provisions which look through the substance of an arrangement to its purpose. ESMA’s proposed rules look to the primary purpose of the arrangement to determine if it is constructed for legitimate business purposes, or if it is an ‘artificial arrangement’ contrived to circumvent EMIR. Such an arrangement would lack commercial substance or relevant economic justification.
The draft rules include a list of non-exhaustive situations which may indicate artificial arrangements:
• the arrangement or series of arrangements is carried out in a manner which would not ordinarily be employed in what is expected from reasonable business conduct
• the arrangement or series of arrangements includes elements which have the effect of offsetting or cancelling the economic meaning of each other
• transactions are circular in nature
• the arrangement or series of arrangements results in non-application of EMIR but this is not reflected in the business risks undertaken by the entities relating this activity
Examples include passing risk through intra-group transactions to counterparties not subject to EMIR, or arrangements between unaffiliated entities that pass legal risk but not economic risk to the legal counterparties.
What prompted the introduction of the new rules?
EU regulators have developed these rules to safeguard EU financial stability and to capture evasive conduct.
US rule makers lead the charge in introducing broad extra-territorial powers relating to derivative market participants under the Dodd-Frank Wall Street Reform and Consumer Protect Act 2010. They were keenly aware that the AIG bailout (at $85bn the largest private company bailout in US history) was due to the credit default swap activities undertaken by the AIG Financial Products division based in London. Other jurisdictions quickly introduced
extra-territorial principles, to ensure their markets were not going to be regulated first and primarily by the US.
While EU rule makers followed the US’s example and introduced extra-territorial principles in their derivatives rules, I’m not sure that the ghost of the 1995 Barings collapse has ever really gone away. In 1995, the oldest merchant bank in the City of London ceased to exist almost overnight after a £827m derivative trading loss accrued by its Singapore office.
Who will most likely be affected?
TCEs which have:
• EU branch offices which conduct derivatives transactions, and/or
• guarantee arrangements provided by EU entities
EU entities which have business interests related to derivatives transactions which fall outside of EMIR rules need to also assess their derivative interests and arrangements.
What is the predicted timeframe on this?
ESMA has given the market a two-month period for consultation, but has allowed itself only nine days between the end of the consultation period on 16 September 2013 and 25 September 2013, the date it is now due to deliver final recommendations to the EC.
We believe this very short processing period implies that ESMA views these as near-final rules and it is not prepared to negotiate many stakeholder comments. We do not expect significant differences between the version published on 16 July 2013 and the version that will be presented to the EC as final recommendations on 25 September 2013.
The EC, the Parliament and the Council will all then review ESMA’s proposals and are free to request further amendments before endorsement.
These rules are very political. EU legislators could take a pragmatic view and endorse them without haste to bring TCEs into the EMIR fold, or could request amendments to widen the scope of ESMA’s proposals. Once the proposals receive endorsement, they will be published in the Official Journal of the European Union and come into force 20 days after. We believe this could be as early as January or as late as June 2014.
At the same time, EU legislators will be reviewing ESMA’s third country equivalence advice and will bring these recommendations into law about the same time. ESMA is due to deliver its technical advice on third country equivalence to the EC on rules applicable to TCEs by 1 September 2013 for US and Japan, with advice on Australia, Canada, Hong Kong and Singapore equivalence due to the EC by 1 October 2013. The third country equivalence advice will then be reviewed and endorsed by EU legislators, but given its analytical nature may be less likely to be amended during EU legislative review.
How will this be implemented? What changes do Financial Services firms need to make as a result?
EU regulations have direct effect, so they will apply immediately and will not be transposed into EU member state law. For TCEs, this means that by the date the final version takes effect next year, they must have arrangements in place to:
• comply with art 4 clearing obligations which may be in force at that time to clear any transactions subject to EMIR clearing obligations with an EMIR authorised or recognised CCP
• comply with art 11 non-centrally cleared risk management obligations—all of the operational risk management obligations will be in force by 2014 but the obligation to exchange non-centrally cleared margin under EU rules will not likely come into force until 2015.
If TCEs have not already done so in the context of their dealings with EU counterparties, they must establish both their own EMIR classification and then verify the classification of other TCE counterparties. The International Swaps and Derivatives Association (ISDA) published its 2013 EMIR Nonfinancial Counterparty Notification Protocol which TCEs that are classified as either financial and non counterparties can use to affirm their EMIR classification status under ISDA master agreement documentation.
With likely less than a year before they come into effect, EU and TCEs need to commence or revive EMIR implementation analysis and make decisions. The only critical piece that’s missing is the EMIR third country equivalence determinations, which will provide relief to TCEs established in EMIR equivalent jurisdictions.
Betsy Dorudi is a securities and derivatives specialist in the Regulatory Centre of Excellence and supports PwC’s Securities and Derivatives practice. Prior to joining PwC, Betsy worked for over a decade as an in-house lawyer and in regulatory developments roles with US and UK financial services firms. She has advised extensively on asset management, retail investments, and capital markets and derivatives trading issues.
This was first published as a News Analysis piece on LexisPSL Financial Services. The The views expressed by our Legal Analysis interviewees are not necessarily those of the proprietor.
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