EMIR Gearing up for Clearing PART I

EMIR Gearing up for Clearing PART I

Contents EMIR Gearing up for Clearing PART I 01 Annex 1 Who does the clearing obligation apply to? 05 Annex 2 Which trades are subject to the clearing obligation? 09 Annex 3 Exemptions to Clearing 12 Annex 4 Should we gear up for clearing? 13

EMIR Gearing up for Clearing PART I The requirement to clear certain classes of OTC interest rate derivatives through central counterparties appears likely to come into effect from the first half of 2015 with a phased-in obligation to clear starting in the second half of 2015. As a result, derivatives counterparties need to consider the steps which they will have to take to comply with any clearing obligations to which they may be subject under the European Market Infrastructure Regulation (EU 648/2012) ( EMIR ). Non-EU counterparties are amongst those that should consider whether they need to gear up for clearing if they frequently enter into OTC derivatives with EU counterparties who are subject to clearing under EMIR. This briefing is intended to provide an overview of the clearing obligations imposed by EMIR. It will be followed by separate briefings on the structure of client clearing and the legal and practical issues which counterparties should be taking into account when preparing for clearing. WHICH CLASSES OF OTC DERIVATIVES ARE IN THE PIPELINE FOR MANDATORY CLEARING? Interest rate derivatives Interest rate derivatives look set to become the first asset class of OTC derivatives that are subject to the clearing obligation under EMIR. In October 2014, the European Securities and Markets Authority ( ESMA ) published a report containing the final draft Regulatory Technical Standards ( RTS ) on the clearing of interest rate derivatives under EMIR. The European Commission ( EC ) responded to ESMA in December 2014 stating that they intended to endorse the draft RTS, with some amendments. In January, ESMA submitted an opinion and an amended draft RTS (the Amended Draft IR RTS ). Shortly after it has been endorsed, the Amended Draft IR ITS will become effective. Back to basics: For further detail in relation to which trades are considered OTC derivatives for the purpose of EMIR, the process by which classes of derivatives are declared subject to the clearing obligation, and frontloading of existing trades, see Which trades are subject to the clearing obligation? in Annex 2. The position under the Amended IR RTS is that the following four classes of interest rate derivatives will need to be centrally cleared: basis swaps (denominated in Euro, GBP, JPY and USD); fixed-to-float swaps (denominated in Euro, GBP, JPY and USD); forward rate agreements (denominated in Euro, GBP and USD); and overnight index swaps (denominated in Euro, GBP and USD). 01

The date on which the clearing obligation for these classes of interest rate derivatives takes effect is dependent on the type of counterparties that are entering into the derivative contract. The proposed phased-in implementation scheduled for mandatory clearing is as follows: Category 1 clearing members six months after the RTS enter into force; Category 2 financial counterparties and AIFs that exceed a threshold of EUR 8 billion aggregate monthend average outstanding gross notional amount of all non-centrally cleared derivatives (the Counterparty Categorisation Threshold ) 12 months after the RTS enter into force; Category 3 financial counterparties and AIFs that do not exceed the Counterparty Categorisation Threshold 18 months after the RTS enter into force; and Category 4 NFC+ that do not fall into any of the other categories three years after the RTS enter into force. Back to basics: For further detail in relation to counterparty classification including what constitutes a financial counterparty, an AIF and an NFC+, see Who does the clearing obligation apply to? in Annex 1. The Counterparty Categorisation Threshold is to be calculated using the month end average for the three months after the publication of the RTS in the Official Journal (not including the month of publication). Where a derivative contract is entered into between two counterparties in different categories, the date from which the clearing obligation takes effect for that contract will be the later of the two dates applicable to the counterparties. The Amended Draft IR RTS propose frontloading requirements to apply to counterparties in Categories 1 and 2 with the frontloading start date for counterparties in Category 1 and Category 2 set for two months and five months respectively after the RTS enter into force. The minimum remaining maturity as at the date the clearing obligation takes effect of derivative contracts to be frontloaded for both Category 1 and Category 2 counterparties are as follows: 50 years for basis swaps and fixed-to-float swaps entered into or novated before the applicable frontloading start date; 3 years for forward rate agreements and overnight index swaps entered into or novated before the applicable frontloading start date; and 6 months for all the above classes of interest rate derivatives entered into or novated on or after the applicable frontloading start date. 02

INTRA-GROUP EXEMPTION IN RELATION TO COUNTERPARTIES OUTSIDE THE EU It is worth noting that the Amended Draft IR RTS suggested a temporary solution to enable intra-group transactions with a non-eu counterparty in a jurisdiction which has not been granted an equivalence decision by the EC to benefit from the intra-group exemption to clearing by proposing that such non-eu jurisdictions should be deemed to be equivalent for three years after the interest rate RTS is effective or, if earlier, until an equivalence decision is adopted for the relevant jurisdiction. However, ESMA disagreed with the proposed solution, querying its legal basis, and the final RTS for interest rate derivatives is unlikely to be endorsed until ESMA and the EC resolve their differences. See section 3 of Annex 1, and Annex 3 for further information in relation to equivalence decisions and the intra-group exemption respectively. CCPS AUTHORISED IN RESPECT OF INTEREST RATE DERIVATIVES. There are currently five CCPs authorised by ESMA in relation to the interest rate derivatives: LCH. Clearnet Ltd; CME Clearing Europe; Eurex Clearing AG; KDPW_CPP; and Nasdaq OMX Clearing AB. LCH. Clearnet Ltd s SwapClear currently clears the majority of volume in respect of global cleared interest rate swaps (including client-cleared interest rate swaps) with CME Clearing Europe being another market leader in this space. Credit derivatives In July 2014, ESMA produced draft RTS for the clearing of credit derivatives under EMIR. ESMA proposes that European untranched index credit default swaps (for two indices: itraxx Europe Main and itraxx Europe Crossover) which are denominated in Euro should be subject to central clearing. However ESMA has stated that it would delay submission of its final RTS on credit derivatives until the EC s assessment process in relation to the interest rate derivatives RTS has been finalised as the assessment of certain aspects of the interest rate RTS is likely to apply to the credit derivatives RTS. Foreign exchange derivatives In October 2014, ESMA published a consultation paper on draft RTS for the clearing of non-deliverable foreign exchange forwards. Based on the feedback it received, ESMA has announced that it will not be proposing a clearing obligation on the non-deliverable foreign exchange forward classes at this stage as more time is needed to address the concerns that were raised in the consultation. Other asset classes and classes of derivatives Certain CCPs have been authorised to clear certain classes of equity and commodity derivatives but there is no clear indication at present as to when ESMA will produce related draft RTS. 03

WHAT ARE THE CONSEQUENCES OF FAILING TO CLEAR? Individual member states of the EU are to apply their own rules on penalties for a counterparty breaching the rules in EMIR. In the United Kingdom, the Financial Conduct Authority ( FCA ) has the power to impose an unlimited fine on a counterparty for a breach of EMIR. The FCA also has the power to publish a statement that it considers the counterparty to be in breach of a requirement in EMIR. For non-eu counterparties not directly subject to clearing under EMIR but would have been so subject if they were established in the EU, and whose usual counterparties are also subject to clearing in the EU, they run the risk that they may not be able to enter into eligible OTC derivatives trades with their usual counterparties in the EU if they do not gear up for clearing. GEARING UP FOR CLEARING THE LEGAL OBLIGATION All derivatives counterparties, including non-eu counterparties, need to consider whether they are subject to the clearing obligation under EMIR or, if not, whether they may need clearing capabilities to maintain access to their usual derivatives markets. Counterparties should consider: Whether the mandatory clearing obligation applies to them and if any exemptions apply (see Annexes 1 and 3 for more detail); Which classes of OTC derivatives clearing are currently contemplated; and For non-eu counterparties, the potential implications of the mandatory clearing obligation on the ability of their usual counterparties to enter derivatives contracts with them. Please refer to Annex 4 for a flowchart aimed at assisting clients in determining whether they should be gearing up for clearing. For counterparties who need to clear, the options are to become a direct clearing member of a central counterparty or to clear indirectly by entering into a client clearing arrangement with an existing clearing member. As direct membership is unlikely to be feasible for the majority of derivatives counterparties, such counterparties will need to enter into indirect client clearing arrangements. In the next briefing, we will provide an overview of the client clearing structure and key considerations for clients in choosing their clearing member. This will be followed by a third briefing which will cover the legal and operational aspects of client clearing including clearing documentation and key rules. MIRANDA LEUNG T 020 7090 3127 E miranda.leung@slaughterandmay.com MARK DWYER T 020 7090 3139 E mark.dwyer@slaughterandmay.com VICTORIA BARNS-GRAHAM T 020 7090 3771 E victoria.barns-graham@slaughterandmay.com JESSICA BRODD T 020 7090 3137 E jessica.brodd@slaughterandmay.com 04

Annex 1 Who does the clearing obligation apply to? EMIR imposes an obligation on certain counterparties to centrally clear their eligible over-the-counter ( OTC ) derivative contracts through an authorised or recognised Central Counterparty ( CCP ). A counterparty can access central clearing by transacting directly with the CCP or, if the counterparty has no direct relationship with a CCP, indirectly through a principal entity that does have such a direct relationship with a CCP. The clearing obligation applies to financial counterparties. It also applies to non-financial counterparties ( NFC ) who take positions in OTC derivatives which exceed specified clearing thresholds ( Clearing Thresholds ). An NFC+ is an NFC in excess of these thresholds and an NFC- is one below these thresholds. Eligible derivative contracts will only need to be cleared when both counterparties are subject to the clearing obligation, for example, when financial counterparties or NFC+ enter into eligible OTC derivative contracts with each other. 1. FINANCIAL COUNTERPARTIES A financial counterparty is defined under EMIR as an investment firm 1, credit institution 2, insurer 3, undertaking for collective investments in transferable securities ( UCITS ) 4, pension fund 5 or alternative investment fund ( AIF ) managed by an alternative investment fund manager ( AIFM ). 6 AIFs which are financial counterparties It is beyond the scope of this briefing to comment on all areas of uncertainties associated with the application of EMIR. However it is worth noting that in the context of AIFs, it is not entirely clear whether non EU AIFs or AIFMs authorised or registered outside the EU are caught. The Questions and Answers published by ESMA on the implementation of EMIR ( ESMA Q&As ) clarify, amongst other AIF related issues, that EU AIFs and Non- EU AIFs managed by authorised or registered EU AIFMs should be included within the definition of financial counterparty together with EU AIFs and Non-EU AIFs managed by authorised non-eu AIFMs only to the extent they are marketed in the EU with the benefit of a non-eu passport. 1 authorised in accordance with Directive 2004/39/EC 2 authorised in accordance with Directive 2006/48/EC 3 authorised in accordance with Directive 73/239/EC, Directive 2002/83/EC and Directive 2005/68/EC 4 authorised in accordance with Directive 2009/65/EC 5 defined as an institution for occupational retirement provision as defined in Directive 2003/41/EC. 6 in respect of which the AIFM is authorised or registered in accordance with Directive 2011/61/EU 05

2. NON-FINANCIAL COUNTERPARTIES An NFC is any other entity established in the EU other than a financial counterparty or CCP. RTS published by ESMA set out the Clearing Thresholds for the purpose of determining whether a non-financial counterparty is an NFC+. These are as follows: Asset-class of derivative OTC credit derivatives OTC equity derivatives Clearing Threshold in gross notional value (Euro) EUR 1 billion EUR 1 billion OTC interest rate derivatives OTC foreign exchange derivatives Other OTC derivatives (including commodities) EUR 3 billion EUR 3 billion EUR 3 billion An NFC will become an NFC+ if it exceeds any one of these thresholds, after which the consequences of it being an NFC+ will apply in respect of all its OTC derivatives, not just the asset-class where the threshold was exceeded. In calculating its positions for the purpose of the Clearing Threshold, an NFC must include all OTC derivative contracts entered into by the NFC or by other non-financial entities within its group, except those which are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the NFC or of its group (the hedging exclusion ). It is likely that many OTC derivatives entered into by an NFC could fall within the hedging exclusion. 06

The Hedging Exclusion: In the relevant RTS, it states that an OTC derivative contract would fall within the hedging exclusion when, whether by itself or in combination with other derivative contracts, and whether directly or through closely correlated instruments, it meets one of the following conditions: Conditions: (a) it covers the risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the NFC or its group owns, produces, manufactures, processes, provides, purchases, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal course of its business; (b) it covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in paragraph (a) above, resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk; or (c) it qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS) adopted in accordance with Article 3 of Regulation (EC) No 1606/2002. Notes: The RTS notes that the criteria provided for under IFRS can be used by non-eu counterparties even if they use local accounting rules and it is expected that most of the contracts classified as hedging under local accounting rules will fall within the hedging exclusion. It has been clarified in ESMA Q&As that the frequency with which the NFC enters into the OTC derivative is not a relevant criterion and macro or proxy hedging may also satisfy the hedging exclusion. Certain exchange traded derivatives included for Clearing Threshold calculations It is worth noting that guidance from ESMA has made clear, somewhat counter-intuitively, that all trades executed on non-eu exchanges should be regarded as being OTC derivatives for the purposes of the Clearing Threshold calculation, until such time as ESMA clarifies which non-eu exchanges it regards as being equivalent. Since 15 March 2013, EMIR requires any NFC to inform ESMA and its local regulator both when it exceeds the Clearing Threshold and when it no longer exceeds it. If an NFC finds that it does at any point exceed the Clearing Thresholds the obligation to notify is immediate and the NFC has up to four months to begin clearing those OTC derivatives subject to the clearing obligation. A party to an OTC derivatives trade who is a financial counterparty or an NFC+ will want to determine whether their NFC counterparty is an NFC+ (since the trade only needs to be cleared if both counterparties are an NFC+ or a financial counterparty). The International Swaps and Derivatives Association, Inc ( ISDA ) published the ISDA 2013 EMIR NFC Representation Protocol which includes a mechanism for NFCs (and third country equivalents) to amend their ISDA Master Agreements to include a representation as to their status as such. 07

3. THIRD COUNTRY ENTITIES (A) Contracts between an EU counterparty and a non-eu counterparty: The clearing obligation will also apply whenever a financial counterparty or an NFC+ enters into an OTC derivative contract of a class declared subject to the clearing obligation with an entity established outside the EU that would be subject to the clearing obligation if it were established in the EU. While assessing whether a non-eu bank or insurer would be a financial counterparty were it established in the EU is relatively simple, the assessment for other types of financial entities is less straightforward as it requires applying EU laws and legal concepts to a diverse set of funds and management arrangements across jurisdictions. However, counterparties to a transaction may be treated as having complied with the clearing obligation if one of them is established in an equivalent jurisdiction and the counterparties have submitted the transaction for clearing to a recognised CCP within that jurisdiction. The effect of this is significant. In particular, banks, insurance companies, funds or other entities outside the EU which frequently enter into OTC derivatives with a financial counterparty or an NFC+ will need to consider carefully whether they should gear up for clearing as their usual counterparties may not be able to enter into such derivatives with them unless they are able to clear them. (B) Contracts between two non-eu counterparties: In addition, the clearing obligation may also apply to an entity established outside the EU even if it is not contracting with an FC or NFC+ in the EU but (a) the contract has a direct, substantial and foreseeable effect within the EU or (b) such an obligation is necessary or appropriate to prevent any evasion of any provision of EMIR. Under the relevant European secondary legislation, transactions between EU branches of non-equivalent non-eu entities (such as the London branches of two U.S. banks) would be subject to the clearing obligation. Furthermore, this legislation provides that an OTC derivative may be subject to the obligation when a non- EU counterparty is guaranteed, in relation to the OTC contracts entered into by that counterparty, by an EU financial counterparty which covers that non-eu entity for at least EUR 8 billion and is equal to at least 5% of the total OTC derivative exposure of the financial counterparty providing the guarantee. These counterparties will be deemed to be in compliance with the clearing obligation under EMIR if they have submitted the transaction for clearing to a recognised CCP in an equivalent jurisdiction. 08

Annex 2 Which trades are subject to the clearing obligation? 1. IS THE TRADE OTC? The clearing obligation only applies to trades that are executed OTC. EMIR defines an OTC derivative to mean a derivative contract, the execution of which does not take place on an EU regulated market as defined in accordance with Directive 2004/39/EC ( MiFID ) or on a third country market that is considered as equivalent to an EU regulated market. 2. IS THE TRADE A DERIVATIVE CONTRACT? EMIR clearing (and reporting and risk mitigation) requirements apply to derivative contracts. Article 2(5) of EMIR defines a derivative contract as a financial instrument set out in points (4) to (10) of Section C of Annex I to MiFID. In broad terms, therefore, the following are derivatives for the purposes of EMIR: (A) derivative contracts relating to securities, currencies, interest rates or yields; (B) derivative contracts relating to commodities (although some physically settled OTC commodity derivatives which are entered into for commercial purposes (meaning not for speculative purposes) are outside of the scope of EMIR); (C) derivative contracts for the transfer of credit risk; (D) contracts for difference; and (E) derivative contracts relating to climatic variables, freight rates, emission allowances or economic statistics. The position regarding foreign exchange forwards is complicated, in that current UK regulator guidance states that foreign exchange forwards (including non-deliverable foreign exchange forwards) are not financial instruments under MiFID if they are entered into for commercial purposes and therefore are not derivatives for the purposes of EMIR. Under this UK guidance, EMIR would not apply to foreign exchange forwards. However, ESMA disagrees with this conclusion and considers foreign exchange forwards to be within the definition of derivatives for the purposes of EMIR. The question of whether OTC physically settled commodity forwards fall within the definition of a derivative contract also remains somewhat unsettled. ESMA consulted on the adoption of guidelines to ensure a consistent classification and is expected to publish its final report soon. 09

3. HAS THE CLASS OF DERIVATIVE BEEN DECLARED SUBJECT TO THE CLEARING REQUIREMENT? Clients will only need to start clearing trades once ESMA has declared that the clearing obligation should apply to that particular class of derivative contact. Although EMIR sets out two approaches for determining the classes of derivatives that should be subject to the clearing obligation, it is the approach described below which has been adopted so far. The clearing obligation will apply to a class of OTC derivatives where: (A) a CCP is authorised in the EU (or, if it is established outside the EU, recognised by ESMA) to clear that class of OTC derivatives; (B) ESMA has determined that the class of OTC derivatives should be subject to the clearing obligation (as it is required to do within 6 months of being notified of a CCP being so authorised) and has produced an RTS specifying how the clearing obligation will apply to that class of derivatives; and (C) the RTS proposed by ESMA has been endorsed by the EC. In the RTS, ESMA is required to specify (i) the date or dates from which the clearing obligation takes effect, including any phase-in periods and the counterparties to which the obligation applies; and (ii) which OTC derivative contracts that have been entered into before the date from which the clearing obligation takes effect will also become subject to the clearing obligation (by virtue of the minimum remaining maturity specified in the draft RTS) (see section 4 of this Annex in relation to frontloading ). Once ESMA has published the draft RTS, the EC must decide whether to endorse them. Once endorsed, the Parliament and Council have one month to approve the RTS which then becomes effective 21 days after its publication in the Official Journal ( OJ ). ESMA maintains a Public Register for the Clearing Obligation which includes not only a list of CCPs that have been notified to it as having been authorised to clear but also the asset-classes and classes (within those asset-classes) of OTC derivatives that each CCP has been authorised to clear. The register shows certain CCPs have been authorised to clear certain interest rate derivatives, credit derivatives, foreign exchange derivatives, equity derivatives and commodity derivatives so far. Once the relevant final RTS in respect of a class of OTC derivatives is published in the OJ, this will also be reflected in this register. 10

4. DOES THE CLEARING OBLIGATION APPLY TO EXISTING TRADES AS WELL AS NEW TRADES? The clearing obligation will apply to OTC trades: (A) entered into from the date which the clearing obligation takes effect with respect to the relevant class; and (B) in respect of certain counterparties, certain trades entered into before this date ( frontloading ). The latest position on frontloading is that certain financial counterparties will be obliged to clear existing derivative contracts which: (A) are entered into (i) on or after the frontloading start date (which will be a date falling a certain number of months after entry into force of the relevant RTS); and (ii) before the date on which the clearing obligation takes effect; and (B) at that date, have a remaining maturity higher than the frontloading threshold specified in the relevant RTS. See section of the briefing headed Interest rate derivatives for (i) the proposed phased-in clearing implementation schedule for various categories of counterparty, (ii) the categories of financial counterparty that frontloading will apply to and (iii) the proposed frontloading start date with respect to such counterparties in relation to clearing of certain interest rate derivatives. 11

Annex 3 Exemptions to Clearing There are two main exemptions to the clearing obligation as set out below. THE PENSIONS EXEMPTION Pension fund arrangements are subject to a three year transitional exemption from clearing in respect of OTC derivative contracts that are objectively measurable as reducing investment risks directly relating to the financial solvency of the pension scheme arrangement. The transitional exemption also applies to entities established for the purpose of providing compensation to members of pension scheme arrangements in case of default. The intention behind this exemption is to provide time for CCPs to develop technical solutions for the transfer of noncash collateral to meet margin calls as pension scheme arrangements generally minimise their cash holding and invest in long-term high yield assets thus, requiring them to hold cash or liquid assets to meet the collateral requirements could significantly reduce this investment return. The EC has recommended, in a report published in February 2015, that the exemption which was due to expire in August 2015 is to be extended for a further two years. IORPS and the Pensions Exemption It should be noted that there is a potential mismatch between the scope of derivatives that institutions for occupational retirement provisions ( IORPS ) are allowed to enter into and the scope of the pension exemption in Article 89 of EMIR. Article 18(1) of Directive 2003/41/EC provides that IORPs may enter into derivative instruments insofar as they contribute to a reduction of investment risks or facilitate efficient portfolio management. The range of derivatives which fall within this scope (including those employed for efficient portfolio management) may be wider than the range of derivatives which are objectively measurable as reducing investment risks directly relating to the financial solvency of the pension scheme arrangements. THE INTRA-GROUP EXEMPTION In respect of intra-group transactions, the parties may apply for an exemption from the clearing obligation. For the intra-group exemption to apply, whether to an NFC or a financial counterparty, both counterparties must be within the same group, included in the same consolidation on a full basis and are subject to appropriate centralised risk evaluation, measurement and control procedures. Further, both counterparties must either be in the EU or if not, they must be established in a country in respect of which the EC has adopted an equivalence decision (see section 3 of Annex 1). In the case of a financial counterparty, an additional requirement applies as the other counterparty within the group must be either a financial counterparty 7, a financial holding company 8, a financial institution 9 or an ancillary services undertaking 10 subject to appropriate requirements. Insurance Groups and the intra-group exemption It is worth noting that in respect of insurance groups, they may find it more difficult to utilise this exemption than the banking groups especially if intra-group transactions are entered into between an insurer and a holding company which acts as the treasury function for the group given that such holding company may not qualify as one of the types of institutions referred to above. 7 according to Article 2(8) 8 according to Article 2(18) 9 according to Article 2(17) 10 according to Article 2(19) 12

Annex 4 Should we gear up for clearing? This flowchart is aimed at assisting clients in determining whether the clearing obligation applies to them. Are we a financial counterparty? No Are we an NFC+? No Are we a non-eu Yes Yes Does the Pensions Exemption apply? No Does the Intra-group Exemption apply? Yes counterparty that would be a financial counterparty or NFC+ if established in the EU? Yes Yes No Do we trade with a financial counterparty or NFC+? No need to clear OTC derivative transactions objectively measurable as reducing investment risks directly relating to financial solvency No need to clear the relevant intra-group OTC derivative transactions (subject to regulatory approval) Yes No Clearing obligation applies to eligible OTC derivative contracts. Transaction to be submitted for clearing by an authorised CPP in the EU. Option to submit transaction for clearing by a recognised CCP in an equivalent jurisdiction, where at least one counterparty is established in an equivalent jurisdiction. Yes Yes No Does our contract with another non-eu counterparty have a direct, substantial and foreseeable effect within the EU? No Is it necessary or appropriate for our contract with another non-eu counterparty to be cleared to prevent any evasion of any provision of EMIR? No Clearing obligation does not apply 13

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