EMIR Clearing Obligation
The European Markets Infrastructure Regulation (EMIR) Regulatory Technical Standards (RTS) on the clearing obligation for EUR, GBP, USD and JPY interest rate derivatives are now in final form. The RTS entered into force on 21 December 2015 (20 days following the publication on 1 December 2015). Note however that the clearing requirements themselves do not apply immediately but are subject to a phase-in. The obligation to centrally clear certain classes of OTC derivative contracts through a central counterparty (CCP) stems directly from the European Markets Infrastructure Regulation (EMIR) and its main objective is to reduce counterparty risk and systemic risk.
Will you be subject to mandatory clearing?
The clearing obligation applies to all OTC derivatives of a class that is subject to the clearing obligation (initially Interest Ratederivatives are included, foreign exchange, equity and commodity derivatives to follow later) and if it is entered into between any combination of FC and NFC+ parties, given that one or more of the parties involved in the transaction is established in the EEA:
- Two financial counterparties (FCs)
- A FC and a non-financial counterparty which exceeds the clearing thresholds (NFC+)
- Two NFC+s
- A FC or NFC+ and a non-EEA entity that would be subject to the clearing obligation if it would be established in the EEA
What category do you belong to?
The European Securities and Market Authority (ESMA) has decided to phase in the clearing obligation depending on the categories of the counterparties.
The categories are defined in the Regulatory and Technical Standards (RTS) for interest rate derivatives as follows:
Category 1: Counterparties (FCs and NFC+) that are clearing members of at least one central counterparty (CCP) which is authorized to clear any of the Class+ derivatives (class of OTC derivatives subject to the clearing obligation), and whose membership enables clearing of one or more of the relevant classes of derivatives.
Category 2: Financial counterparties (FC) not included in Category 1 (non-clearing members and clearing members not meeting the condition of Category 1), and Alternative Investment Funds (AIF) that are non-financial counterparties above the clearing threshold. Moreover the counterparties must have average gross notional outstanding over a 3-month period following the publication of the RTS (meaning January, February and March of 2016) exceeding EUR 8bn (un-cleared, at group level and for AIFs or UCITS at fund level) OTC derivative contracts.
Category 3: Financial counterparties (FC) and Alternative Investment Funds (AIF) not included in Categories 1 and 2 with a lower level of activity in un-cleared derivatives (i.e. OTC derivative contracts with gross notional outstanding over the 3-month period below EUR 8bn)
Category 4: All non-financial counterparties above the clearing threshold (NFC+) not included in Categories 1, 2 or 3
When will it apply?
The principle is a phase-in for all clearing categories (article 3.1 RTS).
For categories 1 and 2 some frontloading requirements will apply (article 4 RTS). The frontloading requirements mean that the parties are subject to the clearing requirements as of a certain date in the future but also for transactions entered into and which have not been cleared as of such date (retrospective clearing requirement).
If the parties enter into Covered Transactions together and belong to two different categories, the less stringent rules will apply to both parties (article 3.1 last part RTS). For example if a category 1 party enters into Covered Transactions with a category 2 party, the category 2 timing will apply.
In general, mandatory clearing will start on various dates depending on
1) when the relevant classes of OTC derivatives are declared subject to the clearing obligation, and
2) the categories of the counterparties to the derivative transaction.
For an overview of the phase in under the RTS on certain interest rate derivatives as currently published we refer to the below table.
Update: Category 3 might be subject to delay. ESMA asked the European Commission to delay the date from which the clearing obligation takes effect.
If an OTC derivatives transaction is entered into by counterparties in different categories, the date from which the clearing obligation takes effect is the later date. Subject to certain conditions, there is no mandatory clearing for NFC-. Please note that pension funds have been granted an additional exemption from central clearing until 15th August 2017 (or until 2018 if the exemption is re-extended).
Firstly, clearing obligation applies to derivative transactions that are entered into or novated following the start date of the clearing obligation with a possible frontloading. Secondly, clearing is a process by which the OTC derivatives contract of two counterparties is replaced with two separate contracts with a central counterparty. This translates into the CCP taking over each party’s position, and therefore the two original counterparties no longer have a contract with each other, but have it with a CCP (in the end, all clients and banks face the central counterparty, either directly or indirectly). Different models may be used to achieve the clearing of OTC derivatives:
- a market participant can become a clearing member of a CCP (Member Clearing)
- a market participant can become a client of a CCP clearing member (Client Clearing)
- a market participant could also become the client of a clearing member’s client (Indirect Clearing)
Fig 1. Scheme of Direct Clearing and Contracts between Different Counterparties
Dates for mandatory Clearing and Frontloading
As mentioned above, the date from which clearing is mandatory depends on when the relevant classes of OTC derivatives are declared subject to the clearing obligation and on the counterparty classification.
The timing of entering into force of the clearing requirements for the different categories is as follows:
Category 1: 21 June 2016 with a frontloading application as of 21 February 2016 (4-month frontloading).
Category 2: 21 December 2016 with a frontloading application as of 21 may 2016 (7-month frontloading).
Category 3: 21 June 2017. No frontloading obligations apply. Update: this timing might be delayed. ESMA asked the European Commission to delay this date.
Category 4: 21 December 2018. No frontloading obligations apply.
If an OTC derivatives transaction is entered into by counterparties that belong to different categories, the date from which the clearing obligation takes effect is the later of the two. Generally, no mandatory clearing for corporates unless they exceed the clearing thresholds (i.e. counterparties with average gross notional outstanding over a 3-month period exceeding EUR 8bn un-cleared OTC derivative contracts). Note that OTC derivatives used for hedging purposes by corporates are not considered when assessing whether a corporate exceeded the clearing threshold.
Frontloading essentially is an obligation to clear OTC derivative contracts (concluded on a bilateral basis) that were entered into a certain period before the date of entry into force of the clearing obligation.
Category 1 has to frontload those interest rates derivatives they have concluded or novated in the period of four months preceding the respective starting date of the clearing obligation (so between 21 February 2016 and 21 June 2016). Category 2 has to frontload those interest rates derivatives they have concluded or novated in the period of seven months preceding the respective starting date of the clearing obligation (so between 21 May 2016 and 21 December 2016).
Frontloading is not applicable for Categories 3 and 4.
Third (non-EEA) countries
Regarding third (non-EEA) countries (3C), there are three main areas of concern that were identified by ESMA: recognition of third country (non-EEA) CCPs, recognition of third country (non-EU) trade repositories (TRs), and identification of potentially duplicative or conflicting requirements regarding reporting and clearing obligations and risk mitigating techniques under EMIR.
Clearing obligations applies if there is a derivative contract between FC or NFC+ in an EEA and a non-EEA country when the entity would be subject to clearing obligation if it were established in the EEA (as FC or NFC+). Risk mitigation obligations applicable to a non-EEA party will also have a direct effect on the EEA party when they enter into transactions together as the EEA party must comply with EMIR.
Moreover, the clearing obligation and the risk mitigation requirements apply to contracts between non-EU country entities if the contract has a “direct, substantial and foreseeable effect within the EU” or where such “an obligation is necessary or appropriate to prevent the evasion of any provisions of EMIR”. The “direct, substantial and foreseeable effect within EU” is further defined as follows:
- At least one of the counterparties benefits from a legally enforceable guarantee provided by an FC established in the EEA (exceeding a threshold of EUR 8bn equivalent gross notional of un-cleared OTC derivative contracts) or
- The two counterparties enter into the OTC derivative contract via their EEA branches
The reporting obligation does not apply to non-EEA counterparties, however the EEA counterparties still have to disclose information from the non-EEA counterparty and details of the transactions to comply with their own reporting obligation.
Moreover, in order to avoid duplication, ESMA has introduced the following mechanism: if at least one of the counterparties entering into a transaction is established in an equivalent jurisdiction, the provisions of EMIR can be disapplied and third (non-EEA) country provisions applied (EMIR Article 13).
Summary of the scope of application of EMIR to third country entities pursuant to the draft RTS and Article 13 of EMIR:
Financial Products in Detail
The ESMA determines the classes of OTC derivatives that must be centrally cleared. Over time, ESMA will develop various technical standards setting out which relevant classes of OTC derivatives will be subject to the clearing obligation. The main requirements for products to be centrally cleared are their standardization, liquidity and suitability for risk management/modeling. An overview of Regulatory Technical Standards and relevant products can be found at https://www.esma.europa.eu/regulation/post-trading/otc-derivatives-and-clearing-obligation.
On 1 December 2015, the European Commission published Regulatory Technical Standards (RTS) for phased-in mandatory clearing of interest rate derivatives (IRD) in the G4 currency being:
- basis swaps denominated in EUR, GBP, JPY, USD
- fixed-to-float swaps denominated in EUR, GBP, JPY, USD
- forward rate agreements denominated in EUR, GBP, USD, and
- overnight index swaps denominated in EUR, GBP, USD.
For more information about EMIR Clearing, please visit the Q&A section.