As a consequence of the European Market Infrastructure Regulation (EMIR), additional rules will apply to companies that enter into OTC derivatives. As a result, the costs and the administrative burden for OTC derivatives will increase.
The new rules for OTC derivatives involve:
For which parties do the EMIR obligations apply?
Whether the obligations under EMIR will apply to a party of a derivative contract depends on the classification of the party as a financial counterparty or a non-financial counterparty.
Non-financial counterparties are all companies resident in the EU, with the exception of central counterparties (legal entities which conclude derivative contracts) and financial counterparties.
Financial counterparties are all entities which hold a licence as an investment company, credit institution, insurer, pension fund, undertaking for collective investment in transferable securities (UCITS) and an alternative investment fund (AIF) which is managed by an AIF-manager.
In case a financial counterparty concludes an OTC derivative with a non-financial counterparty, the financial counterparty is required to execute the rules of EMIR also on behalf of the non-financial counterparty. The financial counterpart can transfer the related costs to the non-financial counterparty.
To which OTC derivatives do the EMIR obligations apply?
The concept “OTC derivatives” includes the following types of contracts:
provided that these are not traded on a regulated market but are concluded on a bilateral basis or via a multilateral trading facility or other trading platform which is not a regulated market.
Financial counterparties have an obligation to clear OTC derivatives.
Non-financial counterparties have a clearing obligation if they enter into OTC derivatives for speculative purposes and the total nominal value exceeds a certain threshold. The clearing obligation only applies where a non-financial counterparty, which exceeds the clearing threshold, enters into an OTC derivative with: (a) another non-financial counterparty which exceeds the clearing threshold; or (b) a financial counterparty.
Non-financial counterparties do not fall within the clearing obligation if they only enter into OTC derivatives which can objectively be established to reduce the risk directly related to the commercial activities or treasury finance activities of the non-financial counterparty or its group. OTC derivatives fall within this non-speculative category if the OTC derivative (either alone or in combination with other derivatives):
Exceeding the threshold
If non-financial counterparties also enter into OTC derivatives for speculative purposes, they have to calculate whether the total nominal value (notional value) of the OTC derivatives they have entered into (i.e. both speculative and non-speculative) exceeds the thresholds laid down in the Implementing Regulations. The thresholds currently proposed for consultation are as follows:
In calculating whether its positions exceed the thresholds, a non-financial party is required to:
If the non-financial counterparty falls within the clearing obligation on the basis of this calculation, it must notify ESMA and the competent supervisor. All OTC derivatives entered into after the clearing threshold has been exceeded will have to be cleared by a central counterparty (to the extent that they have been designated for mandatory clearing by ESMA).
A non-financial counterparty can benefit from the intra-group exemption if it enters into a transaction with another counterparty which is resident in the EU, or in a third country in relation to which the Commission has determined that adequate supervision is exercised there, and:
Entities in non-EU Member States
Entities from non-EU Member States can also be subject to the clearing obligation. The following situations can be derived from EMIR in which such counterparties will be required to meet the clearing obligation:
Risk mitigation techniques for un-cleared OTC derivatives
For all OTC derivatives entered into by a non-financial counterparty which are not cleared by a central counterparty, certain risk mitigation techniques have to be implemented. Appropriate measures and procedures must be in place to measure, monitor and mitigate the operational risk and counterparty credit risk. EMIR therefore requires action to be taken on this point for all non-financial counterparties which enter into OTC derivatives and which have not already taken the measures mentioned above. The risk mitigation techniques will be further elaborated in the Implementing Regulations for which ESMA and the ESAs have already produced proposals. The following measures must be considered in relation to the risk mitigation techniques:
OTC derivatives entered into between group companies which meet certain conditions (including unrestricted transfers of assets between the parties) are excluded from the obligation to take risk mitigation measures under (4 – Collateral Obligations). For group companies that enter into OTC derivatives with each other it is therefore important to see whether one of these exemptions applies.
Entities in non-EU Member States
If derivative contracts are concluded between entities from one or more non-EU Member States which have a significant impact in the EU, the rules concerning risk mitigation techniques and the exemptions from these rules for intra-group transactions apply accordingly.
Reporting and data retention obligation
Finally, EMIR introduces a reporting and data retention obligation. The reporting obligation applies to all derivative contracts and all counterparties. The reporting obligation can be delegated to a third party. The reporting obligation means that counterparties have to report information relating to all derivative contracts concluded (and any change or termination of such contracts) by them to a trade repository. The minimum information which the parties have to report to a trade repository pursuant to this obligation consists of:
ESMA has proposed that the information to be reported should be split into two parts. First, the part with the counterparty information – this part has to be separately reported by each counterparty (or a third party to which the counterparty has delegated this activity). Second, a part containing collective information – this part can be reported by only one counterparty (if the name of the other counterparty is also stated) or a third party to which the notification of information to the trade repository has been delegated (the ‘third party reporting entity’).
In the proposed Implementing Regulations ESMA has also included a table of points which must form part of a transaction report. The table categorises the information in accordance with the above breakdown between counterparty information and collective information. It also indicates what additional information is required for special types of derivatives (e.g. for commodity derivatives the transaction report must also state the name of the commodity group).
The report must be made not later than one working day after the contract is entered into, amended or terminated. EMIR provides that the parties will not be in breach of any contractual (or statutory) duties of confidentiality if they comply with the reporting obligation.
The reporting obligation will apply to derivative contracts which:
A transitional rule applies to the extent that the rules relating to the reporting obligation are still to be developed in the Implementing Regulations. The rules that are included in the Implementing Regulations will come into force on a date to be specified by ESMA in the Implementing Regulations.
Apart from that, counterparties are also required to retain information relating to all derivative contracts concluded by them, and any changes to such contracts, for five years following the termination of the derivative contract.