Urgent need for NFCs and smaller FCs to determine their EMIR status due to EMIR REFIT
On 28 May 2019, the regulation known as EMIR REFIT was published in the Official Journal of the European Union. EMIR REFIT amends certain aspects of EMIR. The bulk of the amendments come into force 20 days after publication – i.e. on 17 June 2019.
One of the key changes needs urgent attention. EMIR REFIT creates a new regime for determining who is in-scope for the clearing obligation. This applies to financial counterparties ("FCs") as well as non-financial counterparties ("NFCs"). Importantly for NFCs, this also determines whether they are subject to the mandatory margin regime and certain other enhanced requirements under EMIR which apply to NFC+s.
The issue is compounded due to the indirect effect on non-EU funds which will now be regarded as equivalent to an FC and so will potentially be subject to the clearing obligation and will be subject to the mandatory margin requirements for uncleared OTCs when trading with EU banks and brokers.
Both FCs and NFCs (as well as their non-EU equivalents who trade with EU banks and brokers) need to take steps now to ensure that they are ready to determine whether they are in-scope for the clearing obligation on the day that EMIR REFIT comes into force on 17 June.
There is a potential indirect impact for banks and brokers with clients and customers who are impacted, even if they are not.
Under EMIR today, the determination of whether an NFC (or a non-EU entity which is equivalent to an NCF and which trades with an EU bank or broker) is subject to the clearing obligation is effected by calculating the rolling average of its notional positions in OTC derivatives (and those of other NFCs in the global accounting group of which the NFC is a member) over a 30 working day period. Strictly speaking this determination is continuous and could trigger the obligation to clear on any day looking back at the previous 30 day period.
The test is applied to each relevant asset class and there are separate thresholds which apply to each class (i.e., EUR 1 billion for credit and equity derivatives and EUR 3 billion for interest rate, commodity and other derivatives). However, once any threshold is exceeded then the NFC is an NFC+ for all purposes and must either clear or exchange margin for all classes of OTC derivative.
Post-EMIR REFIT the determination of whether an NFC is subject to the EMIR clearing obligation will be based instead on the aggregate month-end average position in OTC derivatives for each asset class for the previous 12 months. Those averages will be compared against the clearing thresholds for the relevant asset class, which have not been changed. Unlike under EMIR today, however, NFCs that exceed any of the clearing thresholds will be subject to the clearing obligation only for the asset classes for which the threshold has been exceeded. However, this will still result in NFCs being classed as NFC+s for all other purposes so they are then in-scope for mandatory margin for all uncleared OTCs of all classes.
Once the threshold is exceeded an NFC+ will have to clear relevant OTC derivatives four months later and will immediately become subject to the enhanced risk-mitigation techniques, including the mandatory margining rules.
Whilst on the face of it this seems helpful for NFCs because the calculation is only required to be made once per year, if an NFC does not make the determination it will automatically be considered to be an NFC+. The initial calculation has to be undertaken on (or at least "as of" and close to) 17 June. Although the obligation on an NFC is only to report to ESMA and its national competent authority if it determines that it is an NFC+, the severity in terms of implication of being an NFC+ means that an NFC will want to be able to demonstrate that it understood and actually undertook the determination.
Whilst previously NFCs may have taken a broad-brush approach to the determination where they were clearly well below the clearing threshold, this approach may be less safe going forwards.
For those NFCs which are part of a wider corporate group and where there are intra-group transactions, ETDs and hedging transactions, they should take great care to make sure that they properly understand how to make the determination and that they have collected in the necessary information from all NFCs within their group as to their month-end derivative positions and related exposures they were hedging over the previous 12 months.
There are a number of nuances of the calculation that NFCs need to understand as considered later in this alert.
As currently, OTC derivatives entered into by other NFCs in the same group will be included in the calculation (counting both ends of intra-group transactions for this purpose) and transactions used for hedging and treasury management purposes (as determined in accordance with Article 10 of Commission Delegated Regulation (EU) No. 149/2013) are excluded.
EMIR REFIT introduces a new sub-category of counterparty, the 'small financial counterparty' ("SFC" or "FC-"). FC-s can exempt themselves from the clearing obligations (but not the other EMIR requirements which apply to FCs, including the mandatory margining rules) by determining that they are an FC-. If they do not make that determination, they will not be able to benefit from the exemption as they will be considered to be an "FC+".
The introduction of the FC- category of counterparty means that for the first time FCs will need to determine whether they are subject to the clearing obligation.
Due to another change introduced by EMIR REFIT, non-EU funds managed by non-EU managers will also now be equivalent to an FC, whereas previously they had been equivalent to an NFC. This is due to a change in the definition of financial counterparty in EMIR which states that all AIFs established in the EU are now FCs, even if not managed by an AIFM. So all non-EU funds will be subject to the clearing obligation when trading with EU banks and brokers unless they can establish that they are equivalent to an FC- and they will be subject to the mandatory exchange of margin effective from 17 June 2019 (at least as regards variation margin and possibly initial margin) when trading with EU banks and brokers.
The calculations necessary to make this determination are similar to the calculations which apply to determine whether an NFC is an NFC+ or NFC-. The calculation is made by calculating the aggregate month-end average position for the previous 12 months in all OTC derivatives in each asset class and comparing that to the relevant clearing threshold for the relevant asset class. An FC whose average in any asset class exceeds the applicable threshold will be an FC+ and be subject to the clearing obligation across all asset classes, not just those for which it has exceeded the threshold. The thresholds themselves are the same as those which apply to NFCs.
There are some important differences from the NFC equivalent calculation. First, all OTC derivatives will be included in the calculation, regardless of whether they are for hedging purposes. Secondly, the scope of group entities that are captured is widened to include all FCs within the group as well as NFCs. Due to these differences, it is possible that FCs in a group may be above the clearing thresholds whilst NFCs are below them.
Although this calculation is technically optional and will only need to be performed once every 12 months, with the initial calculation needing to be performed on the day EMIR REFIT comes into force – i.e., 17 June -.an FC that fails to perform the calculation will automatically be considered to be an FC+ and will remain so until it is able to demonstrate to its national competent authority that it no longer exceeds any of the clearing thresholds.Although the calculation is required at group level for FCs which are funds, sub funds are looked at without references to other sub-funds as long as they are segregated.
Although these new requirements have no direct impact on larger banks and brokers in the EU who trade derivatives, they will affect their clients and customers.
NFCs, in particular, are perhaps unlikely to be aware of the EMIR REFIT changes and so NFC-s (and their non-EU equivalents) could inadvertently be classified as NFC+s if they do not undertake the new calculation.
Larger banks and brokerages should therefore consider alerting their clients and customers to these changes so they can both benefit from them but also not trip up given the potential for an NFC to suddenly and inadvertently become an NFC+.
Similarly non-EU funds which are not managed by an AIFM will be subject to mandatory managing under EMIR effective from 17 June 2019 and may also be subject to the clearing obligation unless they undertake the calculation and establish that they are equivalent to an FC-.
After 17 June it will not be possible for an EU bank or broker to trade with these new FC equivalents unless EMIR compliant margining arrangements are in place.
We would strongly suggest that EU banks and brokers should read the rest of this alert.
There are some subtleties to the required calculations. NFCs (and equivalents) ought to be aware of these already so this might just be a reminder. For FCs (and equivalents) these calculations will be new and they are not the same as the AANA calculation which determines the threshold when initial margin has to be posted.
For new FC equivalents who were previously NFC equivalents they need to understand the differences between the NFC and FC calculations.
OTC derivatives. EMIR defines an 'OTC derivative' to be any derivative contract that is not executed on a regulated market (as defined in Article 4(1)(21) of MiFID II) or a third-country market that has been deemed equivalent to a regulated market in accordance with Article 2a of EMIR. It includes both cleared and uncleared OTC derivatives as well as certain exchange traded derivatives.
The term 'derivative contract' is defined by reference to points (4) to (10) of Section C of Annex I to MiFID II and captures a very broad range of derivatives. However, there are some variations in the manner in which the MIFID II definition of "derivative contract" has been implemented in different EU Member States which raises the question as to which to apply in some cases. The implementation of MiFID II in January 2018 saw an increased level of harmonisation across the EU as to what constitutes a 'derivative', particularly in relation to physically-settled FX transactions. However, the possibility nonetheless exists of minor regional implementation differences in terms of what constitutes an OTC derivative within the scope of EMIR.
ESMA maintains a list of regulated markets on its website as well as a list of third country markets that have been deemed equivalent. So far certain major exchanges in the USA (e.g., CBOE, CME, CBOT, ICE Futures) have been deemed equivalent along with others in Australia, Canada, Japan and Singapore. Outside these exchanges even exchange-traded derivatives need to be included in the calculations as these are regarded as "OTC" for EMIR purposes.
If and when the UK leaves the EU on a "no deal" basis, UK regulated markets (e.g., the Main Market of the LSE, AIM and LME) will cease to be considered regulated markets for the purposes of EMIR and will not be considered as third-country equivalents unless equivalence decisions are adopted. As such, any derivatives concluded on those markets may need to be treated by counterparties established in the EU27 as OTC derivatives for the purposes of EMIR at that time.
Intra-group transactions. Where an OTC derivative contract is entered into on an intra-group basis, both ends of the transaction will need to be counted towards the threshold calculation, but subject to the hedging exemption for NFCs.
Hedging transactions. With respect to the NFC calculation only, derivatives entered into for hedging and treasury management purposes may be excluded but, other than micro-hedges which qualify for hedge accounting treatment under IFRS) it is not possible to establish whether an OTC derivative is hedging an exposure at the time without also looking at the exposure being hedged at the time (ie at the end of the relevant month in the period of determination). This is not always a simple matter and special consideration needs to be given to macro hedges, pre-hedges and so on. If an exposure is more than the hedge, only part of the notional of the derivative is excluded from the calculation. An NFC needs to be able to demonstrate that it has undertaken the appropriate analysis to be safe.
Notional amounts. Certain types of derivative either do not have notional amounts or it is not easy to ascertain what the notional amount should be for these purposes. Other derivatives have variable notional amounts. In its Q&A on the NFC+/- assessment, ESMA gave guidance on how to make the calculation in these situations.
For further advice on the status determinations which are required to be made under EMIR post-REFIT, please get in touch with your usual contact in the Derivatives Group.