New clearing, risk mitigation, and reporting obligations imposed on certain derivative contracts

 
Wednesday 20 March 2013

On 15 March 2013, the first six implementing measures of the European Market Infrastructure Regulation (EMIR) entered into force. Over the next two years, the full EMIR will be implemented. EMIR applies widely to both financial and nonfinancial counterparties to derivative contracts, including energy derivatives. In particular, new clearing and risk mitigation requirements for uncleared trades will apply to over-the-counter (OTC) derivative contracts, and a new reporting requirement will apply to both OTC and exchange-based derivative contracts.

 
Firms entering into derivative contracts should ensure that compliant recordkeeping and valuation measures are in place and that OTC trades are promptly confirmed to counterparties. In the longer term, firms should prepare for the implementation of a full suite of EMIR reporting obligations, further risk mitigation measures, and the entry into force of a clearing obligation for eligible derivative contracts.

 
EMIR creates a new regulatory framework for counterparties to derivative contracts, central counterparties (CCP’s), and trade repositories. EMIR imposes the following three broad categories of obligations on most undertakings established in the European Economic Area (EEA) that enter into derivative contracts:

  1.  
    A clearing obligation for OTC derivatives. This obligation requires all eligible derivative contracts between certain counterparties to be cleared through a CCP. A register of eligible derivative contracts will be made available on the website of the European Securities and Markets Authority (ESMA). In some cases, however, the clearing obligation will have retrospective effect for the period between approval of a CCP for clearing a specific class of derivatives and the date on which the clearing obligation for a particular eligible derivative contract takes effect. In this way, clearing of derivative contracts will be "frontloaded.
  2.  
    Risk mitigation requirements for uncleared OTC derivatives. Pending the authorization of CCP’s, all OTC derivatives that would otherwise be subject to the clearing obligation will be subject to the risk mitigation requirements for uncleared OTC derivatives, insofar as those requirements are in force. After the implementation of the clearing obligation, OTC derivative contracts falling outside the scope of the clearing obligation will remain subject to the risk mitigation requirements. Timely confirmation, portfolio compression and reconciliation, marking-to-market, collateral exchange, and capital requirements are the main categories of risk mitigation techniques.
  3.  
    A reporting obligation for all derivative contracts. This obligation requires all derivative contracts entered into in the EEA to be reported to a trade repository. When phasing-in is complete, details of the conclusion, modification, or termination of a derivative contract must be reported by the end of the following working day but will likely amount to almost real-time reporting. One aspect of the reporting obligation already in force is the obligation on counterparties to keep a record of any derivative contract for at least five years following the termination of the contract.

 
The derivative contracts falling within the scope of EMIR are derived from the Markets in Financial Instruments Directive (MiFID) and include options, swaps, forwards, and contracts for difference. These include foreign exchange derivatives and both cash-settled and physically settled commodities derivatives. The European Commission has confirmed that energy spot transactions do not fall within the scope of EMIR because, like foreign exchange spot trades, they are not derivatives under the relevant provisions of MiFID.

 
Certain EMIR obligations apply only to "OTC derivatives," which are defined as derivative contracts not executed on an EEA-regulated market or an equivalent third-country market. The extent to which the above obligations apply to an undertaking established in the EEA depends on whether the undertaking is a financial or nonfinancial counterparty and, if it is the latter, whether it exceeds certain thresholds. Where one counterparty is established in a third country (TC) (i.e., outside the EEA), the EMIR reporting obligation continues to apply, and transactions that would be subject to the clearing obligation if the non-EEA counterparty were established in the EEA must be cleared. 

 
"Financial counterparties" (FC’s) are broadly defined in EMIR as investment firms authorized in accordance with MiFID; credit institutions authorized in accordance with the Banking Consolidation Directive; insurance, assurance, and reinsurance undertakings authorized in accordance with the First Non-Life Directive, the recast Life Directive, and the Reinsurance Directive, respectively; Undertakings for Collective Investment in Transferable Securities (UCITS) funds and their managers authorized in accordance with the UCITS IV Directive; "institutions for occupational retirement provisions," as defined in the Occupational Pension Funds Directive; and alternative investment funds managed by alternative investment fund managers authorized or registered in accordance with the Alternative Investment Fund Managers Directive. Nonfinancial counterparties (NFC’s) are undertakings established in the EEA that are not FC’s or central counterparties (CCP’s). Qualifying NFC’s are those NFC’s that exceed certain thresholds. Qualifying NFC’s are subject to the clearing obligation and most of the risk mitigation requirements. Nonqualifying NFC’s are not subject to the clearing obligation and are required to comply with a reduced number of risk mitigation requirements for uncleared trades.

 
For the purposes of the thresholds, hedges (understood to be derivative contracts that are "objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity" of the nonfinancial counterparty) are disregarded. Where a clearing threshold for one asset class is reached, an NFC is treated as having reached the clearing thresholds for all other asset classes. Intragroup exemptions from both the clearing obligation and the risk mitigation requirements are available, although there is no exemption from the reporting obligation. 
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