EMIR intra-group margin rules for OTC derivatives – time-limited exemptions may now get a last-minute extension
Locations
When it expires, many entities that trade OTC derivatives with non-EU / non-UK affiliates risk having to exchange margin and to lock up large quantities of assets in EMIR-compliant segregated custody accounts held at third-party custodians. Although industry bodies have been lobbying for an extension to this expiry date, it is only now that the European Commission appears to be taking steps to allow for this.
However, the steps needed to implement this extension have not yet been started – and the time that these steps will take may mean that a separate, post-Brexit, UK extension is also needed to avoid the problems that a failure to extend will cause.
The issues
Many firms have been relying on the temporary EU waiver – technically a “derogation” – for intra-group derivatives with non-EU / non-UK (ie, “third-country”) affiliates in order to avoid covered entities needing to exchange variation or initial margin for their intragroup uncleared OTC derivatives. The derogation is due to expire on 21 December 2020.
If the derogation were not to be extended, any affected entities would have only a short period of time to set up the segregated initial margin arrangements that will be needed. If these arrangements are not put in place, an affected entity would have to cease trading OTC derivatives with any affiliate that is in a third country where there is no EU or UK “equivalence” decision (see below).
Intra-group transactions between an EU or UK affiliate and a third-country affiliate that is established in a jurisdiction for which no equivalence decision has been adopted are exempt from the EMIR initial and variation margin rules. This is, though, only on a time-limited basis (and still requires specific approval from the relevant competent authorities). This derogation, for where there is no equivalence decision, expired on 4 January 2020 and is currently subject to 'regulatory forbearance' pending the imminent adoption of an amendment to formally extend the derogation until 21 December 2020.1
Equivalence decisions have only been adopted for USA2 and Japan3. All other third-country jurisdictions – including Switzerland, Hong Kong and Singapore – are considered to be not equivalent, even though many other jurisdictions have implemented uncleared margin rules in line with the standards set by BCBS and IOSCO. All uncleared OTC derivatives between covered entities – ie, financial counterparties (FCs) and non-financial counterparties over the relevant threshold (NFC+s) – and third-country equivalent affiliates established in any of those non-equivalent jurisdictions would therefore have become subject to mandatory initial and variation margin from 21 December 2020.
Without any extension, firms would have needed to start assessing their intra-group trading arrangements and preparing for the exchange of initial and variation margin by putting the necessary documentation, systems and infrastructure in place.
A number of trade associations, who are looking to extend the derogation, sent a joint letter to the European Commission (EC) and the EU supervisory authorities on 30 April 2020 to request that:
(i) the necessary equivalence decisions are adopted for all jurisdictions that have implemented margin rules in line with the BCBS and IOSCO framework; and
(ii) the derogation is extended for a further 3 years.
It is only very recently that the EC has instructed the EU supervisory authorities to extend the derogation – although only for 2 years. Given the timescales needed for the necessary RTS to be drafted, published and go through the scrutiny process, it is not expected to be completed before the end of 2020 (although presumably the encouragement for national authorities to forbear from enforcing would continue pending adoption of the extension).
Brexit impact
However, Brexit complicates this. Once the current Brexit transition period has expired (currently expected to be 31 December 2020), and if there is no EU / UK agreement to the contrary, the extension to the derogation will not automatically form part of UK law because it will happen after exit day. There is no indication yet as to what attitude the UK government would take towards an equivalent extension that matches and follows the EU's.
There is also the further question of whether – even if these extensions take effect – the EU and the UK will take the necessary steps to find each other's margin regimes as "equivalent" to allow for affected groups to seek more permanent intra-group margin exemptions.
The clearing obligation
These issues do not affect just margin. They are equally applicable to the clearing obligation for OTC derivatives. The same lack of equivalence decisions will result in in-scope intra-group transactions between FC+s / NFC+s and third-country equivalent affiliates becoming subject to mandatory clearing. This will trigger the need to have EMIR-compliant clearing arrangements in place as well as having to post variation and initial margin up to the CCP. Again, this could affect firms from as early as 21 December 2020.
Unlike margin, though, and despite a number of trade associations having sent a joint letter to the EC and ESMA on 2 June 2020 which, as with the letter on margining referred to above, asked that the necessary equivalence decisions are adopted and that the derogation is extended for a further 3 years, there is currently no indication that an extension will come.
For so long as this letter goes unanswered, firms ought to be assessing their intra-group trading arrangements and, where needed, preparing to put in place the necessary clearing arrangements in the event the derogation is not extended.
If you would like to discuss the implications of this alerter or the EMIR uncleared margin rules or the clearing obligation more generally, please get in touch with your usual Fieldfisher contact. View the Finance team.