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Background to UK EMIR
UK EMIR came into existence on 31 December 2020 at the end of the transitional period after the UK left the EU. At this point, the UK became a "third country" from the perspective of the EU and EU Member States became "third countries" from the perspective of the UK.
The European Union (Withdrawal) Act 2018 brought UK EMIR into existence in the UK's domestic law following EU law ceasing to apply in the UK.
The 'on-shoring' process set out in this Act worked by taking a 'snapshot' of EU EMIR, as it applied on 31 December 2020. The UK Government made some small changes to allow UK EMIR to work effectively and certain functions were transferred from EU authorities to UK authorities. However, none of these changed the substantive requirements of UK EMIR.
UK EMIR and EU EMIR exist in parallel and are independent from each other. Importantly, changes made to EU EMIR after 31 December 2020 do not automatically carry over to UK EMIR. The UK is also free to depart from EU EMIR. This has led to divergences appearing between the two regimes, which can be difficult to keep track of.
Who is in scope of the UMRs?
As the UK and EU UMRs are distinct regimes, counterparties need to understand when each regime will apply to them. Whilst the current differences between the UK and EU UMRs are mostly incremental, over the medium to long term this may not remain the case.
The UK and EU UMRs directly apply to financial counterparties ("FCs") and non-financial counterparties ("NFCs") that exceed the clearing threshold ("NFC+"). However, the territorial scope of these definitions differs.
Under UK EMIR, FCs and NFCs are generally limited to counterparties established in the UK, whereas under EU EMIR they are generally limited to counterparties established in the EU. Funds, branches and guarantees provide exceptions to this general rule.
Funds can be brought territorially into scope of the UMRs by virtue of either the location of the fund vehicle or the fund manager.
The presence of a branch is not generally sufficient to bring an entity territorially within scope of the UK or EU UMRs, even when transacting out of that branch. However, this will not be the case where an EU branch transacts with the EU branch of another non-EU entity or where a UK branch transacts with the UK branch of another non-UK entity, due to the "direct, substantial and foreseeable effect" test.
Also, the EU UMR apply to a non-EU party because of the "direct, substantial and foreseeable effect" test where an EU FC guarantees a certain amount of that non-EU party's OTC derivative liabilities. The UK UMR similarly apply to a non-UK party where a UK FC guarantees its OTC derivative liabilities.
These exceptions can lead to both the UK and EU UMRs directly applying to a party in respect of the same transactions.
In addition, UK parties also need to indirectly comply with EU UMR when trading with an EU counterparty and EU parties similarly need to indirectly comply with UK UMR when trading with a UK counterparty. Again, this can lead to both UK and EU UMRs applying in respect of the same transactions.
Meaning of "OTC derivative"
The concept of an "OTC derivative" is key to many of the obligations in UK EMIR and EU EMIR. This includes the calculations to determine which phase of the initial margin rules a party will fall into and whether a party exceeds any of the clearing thresholds and is therefore subject to the clearing obligation.
Both regimes define an OTC derivative to be a derivative contract that is not concluded on either:
(i) a regulated market; or
(ii) a third-country market that is "equivalent" to a regulated market.
However, each regime has its own definition of a "regulated market" and recognises different third-country markets as equivalent.
Under UK EMIR, a "regulated market" is a "recognised investment exchange" that is not an "overseas investment exchange". Examples include the London Stock Exchange, the London Metal Exchange and ICE Futures Europe.
The UK on-shored existing EU equivalence decisions, so the UK recognises various markets in Australia, Canada, Japan and Singapore as equivalent. The UK has also adopted its own equivalence decisions that recognise regulated markets in the EEA and many key exchanges in the USA as equivalent .
Under EU EMIR, a "regulated market" is a multilateral system (other than a MTF or OTF) authorised in accordance with MiFID II. Examples include Eurex and Euronext.
The EU has adopted equivalence decisions in respect of certain markets in Australia, Canada, Japan, Singapore and the USA. Importantly, the EU does not currently recognise any UK markets as being equivalent.
So, for example, a derivative traded on a UK exchange would be seen, under EU UMR, as an OTC derivative.
As a result, the UK and EU regard different transactions as "OTC" and so counterparties will need to be clear which of their transactions are OTC under each regime and which are exchange-traded.
Exemptions for certain FX and equity transactions
After much delay, EU UMR were amended on 18 February 2021 so that physically-settled FX forwards and swaps are only subject to mandatory VM requirements where both parties are "institutions" (essentially either a deposit-taking institution or a systemically-important investment firm – although noting that the UK and the EU have slightly different definitions of "systemically important") or a third country equivalent. All other physically-settled FX forwards and swaps are exempt from the VM requirement.
This amendment was not on-shored into UK UMR as it was implemented after 31 December 2020. However, the FCA and the PRA have since amended UK UMR to introduce an equivalent exemption to maintain parity with the EU UMR.
Both EU UMR and UK UMR also have separately extended the exclusion of single-stock equity options and equity index options from the VM and IM requirements until 4 January 2024.
ISDA is currently lobbying for the single-stock and equity index options exemptions to be made permanent under both EU and UK UMRs as other jurisdictions do not require mandatory margining of these products.
Equivalence of third-country UMRs
UK EMIR and EU EMIR each provide a mechanism to avoid duplicative or conflicting rules where one party to a derivative is subject to a third-country regulatory regime. This is called "substituted compliance".
Substituted compliance allows a UK or EU party to comply with its UMR obligations (as well as certain other obligations) by complying with the UMR regime applicable to its counterparty. Without substituted compliance, both counterparties would need to need to comply simultaneously with their respective UMR regimes.
However, substituted compliance under EU EMIR and UK EMIR requires the adoption of an equivalence decision with respect to the relevant third country regime. The UK and EU now recognise different third-country regimes as equivalent.
Under UK EMIR, the UK on-shored EU equivalence decisions that were effective on 30 December 2020, so the UK recognises certain regulatory regimes in Japan and the USA as "equivalent". The UK has also made an equivalence decision in respect of the EEA but, crucially, the scope of this decision is very limited and does not allow a UK entity to rely on substituted compliance for EU UMR.
Under EU EMIR, the EU has adopted equivalence decisions in respect of certain regulatory regimes in Australia, Brazil, Canada, Hong Kong, Japan and the USA. Importantly, the EU does not currently recognise UK UMR as being equivalent.
Parties will therefore need to be aware of which jurisdictions (and which specific regulatory regimes in that jurisdiction) are considered equivalent under UK EMIR and/or EU EMIR when attempting to rely on substituted compliance.
On 7 December 2022, the European Commission published a proposal for a regulation to amend EU EMIR (so-called "EMIR 3.0"). In connection with proposed reforms to the intragroup exemption regime, there is a proposal for deleting the entirety of the provisions of EU EMIR that enable substituted compliance . It is not clear at this stage whether the extent of this change is intentional or if an alternative mechanism will be added to avoid EU parties having to comply with multiple margin regimes. The EMIR 3.0 proposed changes do not apply to UK EMIR.
Eligible collateral types
The types of collateral that are eligible are broadly consistent between UK and EU UMR, but there are now some divergences in relation to shares or units in collective investment schemes.
EU UMR allow shares or units in UCITS as a form of eligible collateral. However, shares or units in a UK UCITS are no longer "UCITS" for these purposes and so are not eligible.
UK UMR allow shares or units in UK UCITS as a form of eligible collateral, which excludes EEA UCITS. The on-shoring process introduced a transitional regime that temporarily allowed EEA UCITS, which has been extended until 31 March 2023.
The FCA and the PRA amended UK UMR on 12 December 2022 to expand the range of eligible collateral types to include units and shares in non-UK funds that satisfy certain conditions. These conditions include:
(i) the fund must be subject to supervision and regulation at least equivalent to that applicable to a UK UCITS (importantly, this "equivalence" assessment must be performed by each counterparty as part of its periodic review of its collateral arrangements; it will not be assessed via equivalence decisions);
(ii) the units or shares must have a daily public price quote; and
(iii) the fund is limited to investing in cash, cash-equivalent instruments and government (and similar) debt securities.
The fund can also invest in other funds which meet the above conditions.
Once the transitional regime expires, EEA UCITS will need to meet these conditions to continue to be eligible as collateral under UK UMR.
Aggregate average notional amount calculation for umbrella funds
UK UMR and EU UMR allow umbrella funds to calculate their aggregate average notional amount ("AANA") by treating each sub-fund as a distinct entity and then calculating the AANA at the sub-fund level. This is subject to conditions relating to the segregation of sub-funds and the absence of cross-collateralisation / cross-guarantees (which are typically satisfied).
This treatment is only permitted under UK UMR where the umbrella fund is either a UK UCITS or an AIF managed by a UK-authorised AIFM. Likewise, under EU UMR this approach is only available for a UCITS authorised under the UCITS Directive or an AIF managed by an AIFM authorised in the EU under AIFMD.
UK UMR provides transitional relief in respect of EU UCITS and AIFs managed by EU AIFMs. However, this transitional relief for EU UCITS is set to expire on 31 March 2023 (the transitional relief for EU AIFMs expired on 31 March 2022). Parties subject to EU UMR when trading with a non-EU umbrella fund, or a non-EU umbrella fund with a non-EU manager, are similarly affected. However, there was no transitional relief under EU UMR, and so this position has applied since 31 December 2020
The transitional relief would suggest that, without it, a non-UK umbrella fund, or a non-UK umbrella fund with an non-UK fund manager, will need to determine the fund's AANA at the umbrella level when facing counterparties subject to UK UMR. This would result in more funds crossing the EUR 8 billion threshold and being brought into scope for the IM requirements under UK UMR. However, it is not clear how the UK or EU UMR regimes are applied to entities which would be the equivalent if established within the regime's perimeter and the position is unchanged under both regimes as to umbrella funds established further afield, such as Singapore. We suspect that they calculate their AANA's at the sub-fund level in any case and, if that is correct, then there would be no divergence between UK and EU UMR.
Initial margin model approvals
EMIR REFIT amended EU EMIR on 17 June 2019 and, amongst many other things, made provision for regulatory technical standards for the validation of IM models used by a party to calculate its IM requirements.
A consultation paper on these draft regulatory technical standards was published on 4 November 2021. The consultation closed on 4 February 2022 but without further regulatory response. However, a number of trade associations (including ISDA and SIFMA) have been critical of the proposals, warning that they set too high a bar and would deter the use of IM models, including industry-standard models like ISDA SIMM.
EMIR 3.0 contains a proposal to remove the provision that would allow for RTS on the validation of IM models, so it can be assumed that there is little likelihood of such RTS coming into force.
The FCA and the PRA have a similar power to adopt RTS on this issue, as EMIR REFIT was on-shored. However, the FCA and the PRA have not begun any consultations on validation of IM models and it does not feature as part of the FCA's November 2021 or May 2022 Regulatory Initiatives Grids. It is not therefore clear at this stage whether the UK will implement similar rules for UK counterparties or, if so, what those rules might look like.
Transitional period for application of UMRs
The FCA and the PRA amended UK UMR on 12 December 2022 to introduce two separate transitional periods where parties come into scope of UK UMR for the first time.
The first transitional period applies where UK UMR apply for the first time due to a change in the netting status of the non-UK party's jurisdiction (e.g., the jurisdiction’s status changes from one where netting is not enforceable to one where netting is enforceable). This transitional period will last for 12 months and applies from the point the UK party concludes that netting will be enforceable in the applicable jurisdiction.
The second transitional period applies in all other circumstances where UK UMR apply for the first time. This transitional period will last for 6 months or until the end of the calendar year (whichever period is longer). This could apply where there is a change in status of an entity from NFC- to NFC+ (e.g., due to increased non-hedging derivatives activity or a change in its group structure) or from NFC- to FC.
There is already a similar implementation period where an entity comes into scope through exceeding the AANA threshold of EUR 8 billion.
A transitional period will not, however, apply where a party merely enters into a new trading relationship with a counterparty that is already within scope of UK UMR. UK UMR would apply immediately to that relationship. In this case, the parties are not able to start trading until UK UMR-compliant documentation and arrangements are in place. As a result, establishing new trading relationships could be more time-consuming and documentation-heavy where the relationship is subject to the requirement to exchange initial margin.
With the number of firms and regions implementing the margin requirements increases, the expectation is that these events will occur more frequently.
EU UMR do not have any transitional period. Under EMIR 3.0, there is a proposal for a 4-month transitional period when a NFC changes from NFC- to NFC+. Other than that, EU UMR will continue to apply immediately once a counterparty comes into scope.
Intragroup exemptions from UMR
The EU is proposing amendments to simplify the rules for exemptions from EU UMR for intragroup transactions. These amendments will be made via EMIR 3.0. ISDA is currently lobbying for similar amendments to be made to the equivalent rules under UK EMIR. A separate article will consider the UK EMIR and EU EMIR regimes for intragroup transactions in more detail.
If you would like to discuss the implications of this article, or UK EMIR or EU EMIR more generally, please get in touch with your usual Fieldfisher contact or a member of the derivatives team.