In Europe, we now have what are expected to be the final rules for the margining of uncleared swaps under EMIR as well as the rules for the mandatory clearing of certain OTC derivatives. These are each contained in separate Regulatory Technical Standards or RTS.
The earliest clearing obligation applicable to certain types of interest rate derivatives applies from 21 June 2016. This only affects what is known as Category 1 firms – i.e. those which are clearing members of the CCPs which clear those products. The clearing obligation for these products is extended to apply to Category 2 firms from 21 December 2016. Category 2 firms include (a) all financial counterparties (FCs) and (b) alternative investment funds which are non-financial counterparties whose OTC derivatives are over the EMIR clearing threshold (so-called NFC+s), in each case with uncleared OTC derivatives in excess of EUR 8 billion. Other FCs and other NFC+ alternative investment funds will be Category 3, whose obligation to clear arises later. As a consequence, at the latest from 21 December 2016 (and possibly by as early as 21 June 2016) all FCs and NFC+s which are alternative investment funds (and non-EU equivalents trading with EU counterparties) will need to declare their status in order to trade these products in the market, NFC+s which are not alternative investment funds are Category 4 and are not subject to any volume-based threshold with respect to their clearing obligations which arises later still.
Similarly, the final uncleared swaps margin rules only start to apply from 1 September 2016. As a result, from that date all FCs and NFC+s (and non-EU equivalents trading with EU counterparties) will need to declare their status in order to trade any OTC derivatives, as the requirements to post initial margin are dependent on the notional amount of uncleared OTC derivatives. The compliance start dates for the margining of uncleared swaps are as indicated on these timelines.
The assessment periods for determining the dates for compliance with both sets of rules have already begun. All FCs and NFC+s (and those who would be FCs and NFC+s if established in the EU) need to make a self-assessment of their trading volumes for one or both sets of rules.
Whether an FC or NFC+ is above or below the relevant threshold for the September 2016 implementation date for the exchange of initial margin for uncleared swaps is to be determined based upon the aggregate average month end notional amounts for uncleared OTC derivatives for March, April and May 2016. This level is referred to as an entity's "AANA", short for "average aggregate notional amount", and is required to be calculated on a group basis.
Whether an FC or NFC+ which is an alternative investment fund (and non-EU equivalents trading with EU counterparties) is a Category 2 or, a Category 3 entity for the purposes of the earliest EU clearing obligation is to be determined based upon that entity's AANA for January, February and March 2016.
NFCs have for some time had to make a similar determination in order to establish whether they are NFC+ or NFC- for the purposes of their obligations under EMIR. Whilst the AANA assessment now required is different (it is not a continuous assessment; there is no carve out for hedging transactions; and it is only uncleared OTC derivatives which are included), some of the issues which faced NFCs are also relevant to the determinations which FCs and NFC+s now have to make.
In the same way as NFCs were previously required to represent their status (as an NFC+ or NFC-), FCs and NFC+s are now going to have to start to declare their AANA status from the relevant start dates, even if they are very light users of OTC derivatives. In order to carry out an assessment, every FC or NFC+ which may enter into an OTC derivative will need to consider the following questions:
What is an "OTC derivative"?
For the purposes of EMIR, an "OTC derivative" is any instrument which is a derivative under MiFID and which is not traded on a regulated market (as defined in MiFID) or on a third country market considered equivalent to a regulated market in accordance with the new Article 2a of EMIR (as inserted by the Securities Financing Transactions Regulation).
As of today there are no non-EU equivalent markets for this purpose so that all derivatives traded on a non-EU exchange are currently treated as OTC derivatives for the purposes of EMIR. Equivalence decisions are expected soon, so that what is included as an OTC derivative will have to be revisited.
At the boundaries, there are slightly different definitions of what constitutes a "derivative" across EU Member States given that MiFID was implemented locally by individual EU Member States, resulting in variances across the EU in what is considered a "derivative". We saw this issue with FX transactions when trade reporting under EMIR was introduced.
Whilst a harmonious definition of what constitutes an OTC derivative should be in place when MiFID2/MiFIR is finally implemented, as of today there is still significant regional variance within the EU.
Although the impact of these different interpretations across the EU has significantly lessened with the delayed phasing in of the margining requirements for uncleared FX transactions, the issue is still "live" as regards the AANA calculation, in which FX forwards have to be incuded.
What is an "uncleared" OTC derivative?
This distinction does not arise in the context of an NFC+ versus NFC- assessment as that includes all OTC derivatives (cleared and uncleared). However, it does arise in the context of the AANA assessment.
In terms of what "uncleared" derivatives are, the question arises as to whether this refers to derivatives "not cleared anywhere at all" or "not cleared by an authorised EU CCP or a recognised third country CCP". The rules are not clear on this point and it may be that this issue will only be clarified by a future ESMA Q&A. We would suggest that the second of the two interpretations is more likely to be the one which ESMA will adopt (and is the more conservative) but the rules can quite easily be interpreted to mean "not cleared anywhere", whether in the EU or not.
The lack of clarity on this issue is significant and, for the moment, it is recommended that parallel calculations are conducted.
What constitutes a "group"?
The AANA has to be calculated on a group basis, which begs the question as to what is meant by "group" for these purposes. When NFCs were making their status assessment, there was some uncertainty (given the definition of "group" in EMIR) as to whether "group" meant only the EU group or the world-wide group. In its earlier Q&A on the NFC+/- assessment, ESMA clarified that group meant the world-wide group wherever the ultimate parent is located.
Separate funds of a manager or sub-funds of an umbrella fund will not form a group for EMIR purposes provided they are bankruptcy remote from each other.
How are intra-group transactions counted?
As with the NFC +/- status assessment, intra-group trades are to be included in the relevant calculation. The final rules for margining of uncleared swaps clarified that, for AANA calculation purposes, only one leg/side of an intra-group transaction should be included. Although this is consistent with the US standard, it contrasts with the NFC +/- status assessment, where both legs of a non-exempt intra-group transaction are counted.
The rules which mandate the earliest clearing of interest rate swaps are silent on this issue but the same position as under the final rules for the margining of uncleared swaps can be assumed to apply also to the clearing obligation calculation.
What is meant by "notional amount"?
Certain types of derivative, including options and commodity derivatives, do not have notional amounts. Other derivatives have variable notional amounts. In its earlier Q&A on the NFC+/- assessment, ESMA gave guidance on how to make the calculation in these situations, which would be equally applicable to the AANA calculation.
It is important that any EU entity which transacts uncleared OTC derivatives is able to demonstrate to its national competent authority (such as the FCA in the UK) that it understands the calculations that it is required to make in order to determine the extent of its obligations under EMIR.
In practice this will mean having documented procedures in place, appointing a person responsible for ensuring that the calculations are made and maintaining records of the calculations and data used.
Whilst there has been a great deal of global convergence in terms of regulatory implementation of the BCBS-IOSCO framework for margin requirements for non-centrally cleared derivatives (March 2015), inevitably there are differences between the AANA assessments which have to be made under different regulatory regimes. It is possible that entities will need to be able to determine their AANA under multiple regimes in order to maintain existing trading relationships.
This sister publication describes the equivalent requirements under the US regimes.
Publication of status
ISDA has published an EMIR Classification Letter for the purposes of certifying status for the purposes of the EMIR clearing obligations. This will be required by 21 December 2016 and certain counterparties may insist on it following the July 2016 start date, even though there is no volume based threshold at that time.
ISDA will also shortly be publishing a form of self–disclosure letter which will facilitate the publication of counterparty status for the purposes of margining of uncleared swaps. However, as it stands, this does not provide advice or guidance on how to carry out the calculations. It is merely a communication portal.
The initial AANA assessment period will determine whether or not September 2016 compliance is required under the final rules for the margining of uncleared swaps. Going forward, in the EU, an annual assessment of the AANA needs to be made for these purposes based upon the average of the March, April and May aggregate month end notional amounts and any change in status will be effective from the following January.
For the purposes of the clearing obligation implementation dates a one-off determination of AANA only is needed for each class of OTC derivatives which is subject to mandatory clearing (as there will be a separate RTS for each class of OTC derivative for which the clearing obligation is introduced).
Asset manager issues
As usual, asset managers have additional issues to consider.
For managed account clients, the manager will likely not have visibility to all the client's positions and the client may not understand the calculations which the manager is asking it to confirm, especially across various different regimes which are based upon the location of the counterparty that the manager has decided to trade with.
The clients could be potentially subject to AANA calculations under a whole range of different regimes, not all of which may even be familiar to the manager. Even with its own EU fund range, it may manage funds which are subject to a different definition of OTC derivative under MiFID with respect to FX forwards.
And lastly there is the issue of how to make available each client's status to the market and who has responsibility for that.
For further advice on the status determinations which are required to be made by all market participants, please get in touch with your usual contact in the Derivatives Group.
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