With its intense focus on the OTC derivatives markets, it feels like the exchange-traded world has come to the European Market Infrastructure Regulation ("EMIR") party both relatively late in the day and unnoticed. However, it seems likely that exchange-traded products are going to be impacted much earlier than their OTC counterparts. This briefing highlights the key issues and recent developments which impact the exchange-traded market.
FOA Clearing Module
To many participants in the market, it has only became apparent relatively recently that existing exchange-traded and futures documentation might not be EMIR compliant. The legal issue which has caused such non-compliance relates to the implications of Article 39(4) and Article 39(9) of EMIR. When read in conjunction, these EMIR provisions (arguably) require clearing members to ensure that trades cleared through one CCP close-out net at the client/clearing member level separately from trades cleared through another account at that CCP or at another CCP. This separation is not reflected in current futures documentation.
In October, the Futures and Options Association (the “FOA”) published its "FOA Clearing Module" which is designed to enable firms to clear exchange-traded transactions using their existing FOA Clearing Agreements.
Like its big brother, the ISDA/FOA OTC Clearing Addendum, the FOA Clearing Module has been prepared to apply generically across all CCPs and thereby avoid the need for clients to sign prescribed set of terms for each CCP at which its transactions are cleared.
A key feature of the FOA Clearing Module is the introduction of new provisions catering for “netting sets” (the creation of which have been driven by the separate account structures envisaged by EMIR). This new feature provides for separate close-out amounts to be determined for each CCP service which is being utilised to clear derivative transactions of a client. This new "netting set" concept differs from netting provisions in existing industry derivative documentation which provide for a single close-out amount to be determined across a client's entire portfolio regardless of the product or CCP at which the trades have been cleared at.
In light of the changes which have been made to the FOA netting provisions, drawdown netting opinions are currently being sought by the FOA to confirm the effectiveness of the new netting mechanics and to confirm that the relevant close-out and netting language remain effective for the purposes of Basel III (as implemented in the EU by the Capital Requirements Regulation and fourth Capital Requirements Directive (“CRR”)).
In addition, the FOA Clearing Module (in the same vein as other industry derivative documentation have recently done) introduces FATCA language to address the potential effects on derivative transactions of the Foreign Account Tax Compliance Act provisions of the Hiring Incentives to Restore Employment Act of March 2010 (“FATCA”), with the effect that a payor is not required to gross up any payments to which any FATCA withholding tax applies.
The changes proposed in the FOA Clearing Module will be required to be implemented into documentation used by most futures brokers except perhaps, those who only undertake a single product category through a single CCP. Even some of those may need to make changes to their documentation in order to separate exchange-traded derivatives from OTC positions in those limited markets if exchange-traded and OTC derivatives are covered by the same futures terms.
Being that the decision on the classes of OTC derivative contracts which will be subject to mandatory clearing will unlikely be made before the summer of 2014, exchange-traded products will be impacted by EMIR much earlier than such OTC products. Since CCPs will likely start to be authorised during the first quarter of 2014, the clearing of exchanged-traded products following the authorisation of such CCPs will need to immediately comply with the separate account structures described above.
FOA Disclosure Statement
Article 39(7) of EMIR requires both clearing members and CCPs to publicly disclose the levels of protection associated with the segregation models which they offer and provide, the costs associated with such levels of protection and the legal implications relating to the levels of segregation.
To ensure a consistent level of disclosure by clearing members and thereby allow clients to more easily compare offerings, the FOA have published the "Clearing Member Disclosure Document" to assist in complying with Article 39(7) (albeit firms will still be required to publicly disclosure their own costs for offering each level of segregation).
The reporting obligations in Article 9 of EMIR extend to all derivative contracts, both OTC and exchange traded contracts. While many in the market had been preparing for reporting of OTC derivatives to commence from early 2014, there had for some time been an expectation that reporting obligations in respect of exchange-traded contracts would be postponed until January 2015 to allow time for EMIR and MiFID reporting regimes to be reconciled.
Those expectations were dashed in November, when the European Commission rejected ESMA's proposals for the delay. With a number of trade repositories now registered by ESMA, and the reporting start date for all classes of derivatives set for 12 February 2014, the market has had little time to prepare for EMIR reporting of exchange-traded products.
The EMIR reporting obligations do not just extend to new transactions, but also require backloaded reporting of all contracts traded from 16 August 2012 – including those that have already matured. This can be a particular challenge in the exchange-traded market, where large volumes of short dated contracts have been traded since August 2012.
Non-EU "regulated markets"
Whilst probably most feel they have a grasp of what constitutes an "OTC derivative" for the purposes of EMIR, what may not have dawned on a number of market participants is that due to the way in which the term has been defined in Article 2 of the regulation, it may be the case that certain exchange-traded products actually have to be treated as "OTC derivatives".
Article 2 of EMIR provides that to the extent a derivative is executed on a "regulated market" (within the meaning of MIFID) or on a "…a third party market considered as equivalent to a regulated market…", then it does not constitute an OTC derivative contract.
A problem emanates however where an entity enters into a derivative on a non-EU exchange which has not been recognised as equivalent to a MIFID regulated market. Whilst Article 19(6) of MIFID envisaged the European Commission publishing a list of those third party markets/ exchanges which are equivalent to "regulated markets", to date, no publicly available list has been made available. Accordingly (and somewhat perversely), until such list of third party exchanges is published, any derivative product executed on a non-EU exchange needs to be treated as an "OTC derivative" for EMIR purposes.
The requirement to treat such exchange-traded derivatives as EMIR OTC derivatives could have adverse implications for "non-financial counterparties" in particular. The definition of "OTC derivatives" is relevant to a number of provisions throughout EMIR, including for the purposes of determining whether a non-financial counterparty has exceeded the clearing threshold. As has been confirmed by ESMA in its EMIR "Questions and Answers", all derivative contracts executed on non-EU exchanges must be taken into account for the purposes determining whether the clearing threshold has been exceeded. Having to take into account such non-EU exchange traded derivatives could cause a non-financial counterparty to fall into the "NFC+" category and therefore have to represent as such to its counterparties. Furthermore, by virtue of being an NFC+, such entities will also be subject to the clearing obligations set out in Article 4 of EMIR as well having to comply with the more stringent risk mitigation obligations set out in Article 11 of EMIR in relation to those OTC derivative contracts which are not cleared by a CCP.
Having been largely under the radar for a number of banks, brokers and clients, EMIR is going embrace the exchange traded world with a "big bang". Whilst both clearing members and clients will likely have the best part of 2014 to finalise their clearing documentation for OTC products, participants operating in the exchange-traded sector are going to have to act quickly in the first quarter of 2014 if they want to ensure their transactions are reported in time and can continue to be cleared by those CCPs which obtain EMIR authorisation.