Following an assessment by the European Commission (the Commission) of how the European Market Infrastructure Regulation (EMIR) has been working since it entered into force on 16 August 2012 and the phasing in of its various requirements, an EU regulation[1] that makes targeted modifications to EMIR—known colloquially as EMIR 2.1 or EMIR Refit—enters into force on 17 June 2019. Controversially, some significant regulatory requirements emanating from modifications wrought by EMIR Refit will take effect immediately on 17 June, a mere 20 days after publication of EMIR Refit on 28 May 2019 in the Official Journal of the European Union.[2]
From the buy-side perspective, the key modifications are the expanded definition of a financial counterparty (FC), the exemption for sub-threshold or small FCs and, for EU asset managers only, the application of the trade reporting obligation to the EU manager of the fund, rather than, as now, the fund itself. In addition, in a welcome deregulatory development, EMIR Refit abolishes the contentious backloading aspect of the trade reporting obligation and the frontloading aspect of the clearing obligation.
The Commission assessed EMIR over the summer of 2015, consulting the public and taking into account reports from the European Securities and Markets Authorities (ESMA), the European Systemic Risk Board, and the European System of Central Banks. The Commission then waited on the separate Call for Evidence on the EU Regulatory Framework carried out between September 2015 and January 2016. The Commission found that while no fundamental change should be made to the core requirements of EMIR, EMIR could usefully be amended in certain areas to eliminate disproportionate costs and burdens on some counterparties and to simplify certain rules. At that stage, the EMIR assessment was fed into the wider 2016 Commission's Regulatory Fitness and Performance programme (REFIT), which led to the use of the expression "EMIR Refit" to describe the amending EU regulation that arose from the assessment. However, EMIR Refit is not the product of a comprehensive review of EMIR, as the Commission considers that it is still too early to draw a firm conclusion on EMIR's long-term impacts. This approach makes sense, given the welcome gradual phasing in over several years of its requirements.
FCs under EMIR (prior to EMIR Refit) already include any EU or non-EU alternative investment funds (AIFs) managed by EU alternative investment fund managers (AIFMs) authorised or registered under the Alternative Investment Fund Managers Directive[3] (AIFMD) (but not EU AIFs managed by non-EU AIFMs, which are typically classified as non-financial counterparties (NFC)), as well as EU banks, investment firms, undertakings for collective investments in transferable securities (UCITS), and insurers. EMIR Refit extends the definition of an FC to also include: i) any EU AIF irrespective of the location or status under AIFMD of its manager; and ii) a fund's AIFM if the AIFM is EU-established. Therefore, an EU AIF managed by a non-EU AIFM (which is currently classified as an NFC) will instead be an FC under EMIR Refit. The change to the FC definition will not impact UCITS which already constitute FCs under EMIR.
The classification of an AIF as an FC or NFC is critical since it determines the application of certain EMIR requirements, such as those relating to clearing and margin and other risk mitigation requirements. EU counterparties to AIFs, whether EU or non-EU, must therefore know what classification the AIFs fall into. An FC is under an obligation to centrally clear standardised over-the-counter (OTC) derivative contracts—subject to the new small financial counterparty (SFC) exemption described below—or perform risk mitigation procedures for uncleared OTC derivatives, such as the posting of margin and trade reporting.
EMIR Refit clarifies that AIFs that are securitisation special purpose entities (SSPEs) or established solely for employee share purchase plans (ESPPs) are excluded from the new FC definition and will therefore be classified as NFCs.
In another deregulatory initiative, EMIR Refit helpfully recognises that FCs whose volume of trades falls below specified clearing thresholds qualify as SFCs and should not be subject to the clearing obligation at all. The clearing thresholds for this purpose are the same as those under EMIR that determine whether an NFC is an NFC – or NFC+[4], except that hedging transactions that an FC enters into must be included in the calculation. ESMA recently clarified that if an AIF wishes to rely on the SFC exemption, it must have calculated its aggregate month-end average position for the previous 12 months as at the date EMIR Refit comes into force, 17 June 2019. The SFC exemption reflects the disproportionate costs that smaller counterparties would otherwise bear in order to meet the clearing obligation.
The extended scope of EMIR by the wider definition of an FC is, therefore, partially countered with the introduction of the new SFC exemption, which will reduce the number of counterparties that need to comply with the EMIR clearing obligation. Accordingly, the impact upon funds and their asset managers might not prove to be as significant in practice as it first appears.
While SFCs are exempt from the clearing obligation, they remain subject to risk mitigation requirements such as those relating to margin, confirmation timings, and portfolio reconciliation and compression. FCs who could qualify as SFCs will have the ability to notify ESMA if they have chosen not to run the calculation, so that they remain classified as FCs. As an SFC is still required to comply with margin requirements, asset managers may choose to clear the OTC derivative transactions rather than exchange margin.
The 30-day rolling average determination, currently used to calculate the clearing thresholds for NFCs, has been replaced by an annual determination calculated at the level of the AIF.
Under EMIR Refit, NFCs will only be subject to the clearing obligation for the specific asset classes that exceed the threshold (as NFCs pose less of a systemic risk to the financial system); FCs that exceed the threshold for any asset class will continue to be required to clear all OTC derivatives for all asset classes. However, asset managers that currently fall within the scope of EMIR may find that they no longer need to comply with the clearing obligation due to the introduction of the SFC exemption.
Under EMIR, the trade reporting obligation is one-sided in that it applies only to EU counterparties. While EMIR currently imposes the EMIR reporting obligation on the EU AIF counterparty (whether FC or NFC + or ‑), EMIR Refit instead places responsibility and legal liability for the reporting obligation on the AIFM of the EU AIF counterparty. As of18 June 2020, the AIFM will become responsible for reporting and ensuring the accuracy of the details reported on behalf of the EU AIF. Asset managers will need to ensure that the change of reporting obligation is reflected in the management agreement and any relevant fund documents. However, this is unlikely to have a significant impact where the asset manager is already providing trade reporting services to the AIF.
FCs will become solely responsible and legally liable for reporting trades with NFCs+ on behalf of both counterparties and for ensuring the details reported are accurate. That change is mitigated by the imposition of a new obligation on NFCs to provide their counterparty FC with details of OTC derivatives that the FC cannot reasonably be expected to possess and to take responsibility for its accuracy. Where an FC deals with a non-EU counterparty, the FC will be required to report the value of any collateral posted and the mark-to-market value of each OTC derivative that it has entered into with the non-EU AIF.
EMIR Refit also removes reporting obligations for intra-group trades where at least one counterparty is an NFC because intra-group derivative transactions are primarily used for internal hedging and, therefore, do not contribute significantly to systemic risk. Additionally, the backloading requirement is abolished so that parties will no longer be required to report derivative transactions that were not outstanding on 12 February 2014, the date that the trade reporting obligation under EMIR commenced.
Irrespective of EMIR Refit, EMIR has an indirect impact on non-EU counterparties such as AIFs. Where an EU counterparty trades with a non-EU AIF, the clearing obligation and risk mitigation requirements for uncleared OTC derivatives already provide that the obligations of the EU counterparty are determined by reference to the equivalent categorisation of that non-EU AIF as if it were an EU AIF. Accordingly, following EMIR Refit, non-EU AIFs managed by non-EU AIFMs (who will not be directly covered by the expanded definition of an FC) will prima facie be categorised as equivalent to an FC, a third country FC. Non-EU AIFs may rely on the SFC exemption on the same deemed basis in order to be classified as equivalent to an SFC, a third country SFC, provided that the non-EU AIFs have collected the necessary data for the first clearing calculation, prior to 17 June 2019. This will allow the first calculation to be made on 17 June.
Non-EU AIFs that exceed any one of the clearing thresholds will be required to clear, but not otherwise. The changes under EMIR Refit should not of themselves cause a third-country NFC– to qualify as an FC (as opposed to an SFC) and thereby become subject to the clearing obligation. However, EMIR Refit does provide for delayed implementation for a non-EU AIF that has been re-classified as a third-country entity FC and will have four months to make clearing arrangements after 17 June 2019.
Non-EU AIFs that deal with an EU FC/NFC+ will be required to put margin agreements in place by the time EMIR Refit comes into force. In practice, that process will need to be driven by the EU dealer. Non-EU AIFs must also ensure that they notify their EU counterparties of their new status as either a third-country SFC or FC on the day on which EMIR Refit comes into force to avoid breaching any representation of their former status in current documentation.
Non-EU AIFs that are managed by an AIFM authorised or registered under AIFMD (currently, only EU AIFMs can acquire such status) are already FCs under EMIR and will remain so under EMIR Refit, subject to the SFC exemption and the exclusion for SSPEs and ESPPs.
EU asset managers should reassess any AIFs that they manage in order to establish whether their categorisation changes under EMIR Refit following the expanded definition of FC and, if so, prepare to notify ESMA of their FC or SFC classification on 17 June 2019. EU counterparties to AIFs will want to review any existing representations made by those AIFs as to their counterparty classification post EMIR Refit. Those AIFs and their managers should consider undertaking that analysis at their own initiative and updating their status representations as necessary.
Non-EU AIFs currently categorised as NFC– will probably be impacted, becoming required to post margin on all OTC derivatives entered into with any EU FC or NFC+. Those FCs and NFC+s will in turn need to ensure that their margin agreements are EMIR compliant. This will be difficult to achieve by 17 June 2019, particularly where no margin arrangements are already in place voluntarily.
The industry is unhappy that it has been given just 20 days to meet the requirements flowing from the expanded definition of an FC and is lobbying for regulatory forbearance to be exercised by national regulators for a significant period. The unexpectedly short period is ironic given EMIR Refit was designed to diminish disproportionate burdens and simplify EMIR.
If you have any questions or would like more information on the issues discussed in this Law Flash, please contact any of the following Morgan Lewis lawyers:
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[1] Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 2019.
[2] It is worth noting that the European Parliament's ECON Committee indicated in May 2018 that amendments under EMIR Refit should take effect no sooner than five months after coming into force.
[3] Directive (EU) 2011/61 of the European Parliament and of the Council of 8 June 2011.
[4] The clearing thresholds are €1 billion in gross notional value for each of credit and equity OTC derivatives and €3 billion in gross notional value for each of OTC interest rate derivatives, OTC FX derivatives, OTC commodity derivatives, and other OTC derivatives. However, EMIR Refit empowers ESMA to review the clearing thresholds periodically and update them where necessary.