EMIR Update - ESMA Publishes Finalised Technical Standards

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October 2012EMIR Update - ESMA Publishes FinalisedTechnical StandardsIntroductionThe European Securities and Markets Authority (“ESMA”) published on 27September its technical standards and final report on EMIR, 4 days beforethe deadline in EMIR of 30 September 2012. This follows its consultation onits technical standards under EMIR, launched on 25 June 2012, and itsdiscussion paper issued in February this year. The technical standards havenow been submitted to the European Commission for them to consider with aview to adopting by the end of the year, in time for the obligations underEMIR to become effective in 2013.Much of the detail in EMIR for the market to comply with their obligations wasleft to ESMA to develop in technical standards, and so their publication is abig step forward in the EMIR implementation process. However, whilst thedetail provided in the technical standards should help place marketparticipants in a position where they are better able to prepare themselves tocomply with their obligations under EMIR during the course of next year, noneof the key questions such as which products must be cleared and when, willbe answered until at least the middle of next year.Although the market was only given 6 weeks to respond to the consultationon the technical standards, the market rose strongly to the challenge, andthese efforts have not been in vain: a number of helpful changes to the drafttechnical standards have been made. In particular, ESMA has to someextent backtracked on its proposals in the consultation paper to impose amandatory obligation for clearing members to facilitate indirect client clearingarrangements, this is no longer mandatory, and will come as a relief to theindustry.ContentsKey aspects of theconsultation paper: . 1Still to come and timetable 3Technical Standards onclearing obligation, riskmitigation and exemptions 5Indirect clearingarrangements. 5Clearing obligationprocedure . 5Non-financial counterparties. 6Clearing thresholds . 7Intragroup transactionsexemption . 7Risk mitigation – Timelyconfirmation . 8CCP requirements . 8Reporting . 10UK implementation . 12Key aspects of the consultation paper: Indirect clearing: ESMA has removed the mandatory obligation forclearing members to facilitate indirect clearing arrangements thatappeared in the draft technical standards, as well as relaxing in anumber of respects provisions in its technical standards that apply tothose clearing members that do choose to facilitate indirect clearingarrangements – significantly the obligation to “port” assets andobligations of an indirect client has been watered down to putting inEMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 20121

place “a credible arrangement” for transferring such assets andpositions. The clearing member obligation to manage directly thepositions of indirect clients for at least 30 days following the failure of aclient, has also been removed. Register: the technical standards provide that ESMA will publishinformation on its register when it has received notification of a productfor clearing. Hedging contracts: ESMA relaxed the view it took in the consultationpaper as to the types of hedging contracts that it considers nonfinancial counterparties may exclude when calculating their positionsfor the purposes of the clearing threshold, and has amended thetechnical standards to provide that portfolio hedging is permitted andOTC derivative contracts that offset hedging contracts can also beexcluded. Intra-group exemption: although the really key information regardingcriteria to assess the applicability of the exemption is yet to bepublished, the technical standards do clarify information that must beincluded in an application to a regulator for approval to use theexemption – for example, a legal opinion is no longer mandatory unlessthe regulator specifically asks for one. Clearing thresholds: ESMA confirms that gross notional and not netmark-to-market values should be used when calculating the clearingthresholds. This is on the basis that the gross notional amount is afigure that is simpler to calculate and monitor. Extra-territorial provisions: these are yet to be published in technicalstandards. Authorisation of CCPs: ESMA notes that EMIR provides for a 6month notification period following the adoption of technical standardsfor CCPs to comply and re-apply under EMIR. CCP staffing: ESMA’s view is that CCPs should have their owndedicated staff (e.g. such as Chief Compliance Officer, Chief IT officeretc) rather than relying on staff employed by parents. However,sharing of resources is not banned provided it is carried out inaccordance with EMIR’s outsourcing provisions. Third country CCPs: ESMA confirms that the purpose of informationto be provided by third country CCPs to ESMA when applying forrecognition is so that ESMA can confirm how the third country rules areimplemented in practice and not to duplicate the equivalencyassessment on the third country legislation that will be performed bythe European Commission under EMIR. Margin: the paper provides that CCPs in respect of initial margins shallhave confidence levels of: 99.5% for OTC derivatives and 99% forother financial instruments, although in respect of OTC derivativecontracts there is some flexibility to allow CCPs to prove to theEMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 20122

regulators that a lower confidence interval is permitted depending onthe risk profile of the contract. Default waterfall: CCPs must hold dedicated own resourcesequivalent to 25% of the CCP’s total capital resources. Exposure and collateral reporting: despite push back from theindustry ESMA imposes exposure and collateral reporting obligations. Start date of reporting obligations: ESMA has opted for a phase in ofreporting obligations per asset class. Interest rate derivatives andcredit derivatives should be reported first, with other asset classes tofollow 6 months later. Counterparties have 90 days after a traderepository has been registered before reporting must begin.Still to come and timetableAlthough these technical standards represent the bulk of the detail that isrequired under EMIR for participants to comply with their obligations (otherthan, of course, the really key information such as which products are to becleared), there are still other gaps that are yet to be filled in further technicalstandards, including: regulatory technical standards that provide further detail on contractsconsidered to have a “direct substantial and foreseeable effect in theEU” or cases where it is “necessary or appropriate to prevent theevasion of any provision of EMIR” – this will provide much neededclarity on the extra-territorial effect of EMIR; joint regulatory technical standards (ESMA and EBA) on risk mitigationtechniques for OTC derivatives that are not cleared by a CCP, to bedeveloped jointly by ESMA together with European Banking Authority(“EBA”) and European Insurance and Occupational Pensions Authority(“EIOPA”). This is to include exchange of collateral (margins forbilateral transactions) to cover the exposures arising from thosetransactions and certain details on intra-group exemptions. guidelines or recommendations on interoperability between CCPs by31 December 2012.An approximate timetable for the key obligations under EMIR is set out below,(subject to assumptions set out below).Reporting: For credit default swaps and interest rate swaps, based on theassumption that 1 April 2013 is the earliest date for a trade repositoryto be registered and approved to receive data on credit default swapsand interest rate swaps (“Report Date”).-entered into on or after 16/08/12 and outstanding on the ReportDate, July 2013;EMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 20123

-outstanding on 16/08/12 and outstanding on the Report Date,October 2013;-outstanding on, or entered into on or after 16/08/12, but notoutstanding at the Report Date, July 2016.For other asset classes, based on the assumption that 1 October 2013is the earliest date for a trade repository to be registered and approvedto receive data on asset classes other than credit and interest rate (the“Second Report Date”):-entered into on or after 16/08/12 and outstanding on SecondReport Date, January 2014;-outstanding on 16/08/12 and outstanding on the Report Date,April 2014;-outstanding on or entered into on or after 16/08/12, but notoutstanding at the Report Date, January 2017.Collateral reporting for a transaction is extended by a further 6 months.Clearing: Clearing obligations could apply from the middle of 2013 at the earliest– this is based on the assumption that 1 June 2013 is the earliestpossible date that a CCP could be authorised under EMIR; that homeregulators notify ESMA that they have authorised a CCP to clear OTCderivative contracts at the beginning of 2013 when the technicalstandards are in force, and that the Commission endorses technicalstandards for the contracts to be cleared shortly after (and ESMA doesnot take the full 6 months permitted under EMIR to develop thetechnical standards). Note that the more realistic timetable for theclearing obligation to apply is probably the 3rd quarter of 2013.Note however, that since the publication of the technical standards on riskmitigation techniques on exchange of collateral and extra-territorial provisionshas been delayed, it will be some time before the industry will be in a positionto be able to identify extra-territorial contracts that should be cleared, as wellas exchange segregated collateral on non-cleared contracts (the FSA oneminute guide on EMIR states that the risk mitigation technical standards willbe published in the first half of 2013).1Although some comfort can be taken from a recital to EMIR that confirmsthat any obligation in EMIR that is to be accompanied by technical standardsshould only apply from the date on which the technical standards take effect,we understand that the Commission takes the view that since recitals onlyoffer guidance as to interpretation, they do not override a clear obligationwithin the body of the regulation itself. Firms should therefore consider theextent to which they are able to comply with these particular obligations underEMIR, if at all, in the absence of these technical standards. For example,whereas firms should be in a position to comply with the provisions relating to1Recital 93 of EMIREMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 20124

portfolio compression from the beginning of 2013, since the technicalstandards relating to these obligations have been published, the extent towhich firms will be able to comply with risk mitigation requirements relating tothe exchange of segregated collateral is questionable.Technical Standards on clearing obligation, risk mitigationand exemptionsIndirect clearing arrangementsEMIR provides for indirect clearing arrangements as a method of complyingwith the clearing obligation, and ESMA was tasked with drafting technicalstandards to specify the type of indirect clearing arrangement that meet theconditions specified in EMIR. The conditions, broadly, are that thearrangements do not increase counterparty risk and that the assets andpositions of a counterparty entering into such an arrangement benefit fromequivalent protections to the segregation and portability protections for directclients.The reference to indirect clearing arrangements was added at a relatively latestage in the legislative process. In response to feedback that indirect clientclearing is still developing, ESMA opted for an approach in the consultationpaper where it aimed to set out minimum standards without being overlyprescriptive. Broadly, ESMA proposed requiring many of the provisions inEMIR regarding client clearing, including segregation and portabilityrequirements, to move down a level to cover indirect clearing arrangements.However, ESMA received a large volume of responses from a wide range ofthe market, the overwhelming majority of which expressed concerns thatsome of the proposed requirements would be unworkable in practice andpotentially counterproductive.Therefore, ESMA has removed the mandatory obligation for clearingmembers to facilitate indirect client clearing arrangements, as well as makinga number of other substantial modifications to its technical standards forthose clearing members that do choose to facilitate indirect clearingarrangements. For example, ESMA has removed the obligation for theassets and positions of an indirect client to be ported following the failure of aclient, and instead has provided in the technical standards that client clearingmembers must put in place “a credible arrangement” for transferring indirectclients assets and positions of indirect clients to an alternative provider ofindirect clearing services. In response to strong criticism, ESMA has alsoremoved from the technical standards a requirement to manage directly thepositions of indirect clients for at least 30 days following the failure of a client.Clearing obligation procedureESMA provided detailed provisions on the clearing obligation procedure in itsconsultation paper, particularly regarding the information that must bereported to ESMA under the “bottom up” process (where a home regulatornotifies ESMA when it has authorised a CCP to clear a class of derivatives).EMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 20125

ESMA has now agreed to publish information related to the notification of aproduct for clearing to ESMA. This is in response to requests from the marketto be notified at the earliest opportunity that a new product may becomeeligible for clearing, so steps can be taken in readiness for this.Non-financial counterpartiesESMA’s technical standards in respect of non-financial counterparties mustestablish which derivative contracts are “objectively measureable as reducingrisk directly related to commercial activity or treasury financing activity”, andtherefore do not have to be included when a non-financial counterparty iscalculating whether its OTC derivative positions exceed the clearingthresholds, referred to as the hedging definition.In response to feedback, ESMA has relaxed its view as to what it considersfalls within the scope of this exemption and has amended the technicalstandards to provide that: portfolio hedging is permitted and that OTC derivative contractsoffsetting hedging contracts would also qualify as hedging - this is inrecognition that some counterparties carry out hedging on a macrobasis, and also to ensure that all transactions when taken together thatrelate to hedging activities are captured within the exemption; OTC derivative contracts that relate to employee benefits such as stockoptions fall within the exemption - ESMA has reversed its policy in thisrespect, as in the consultation paper it took the view that they did notfall within the exemption. This is in response to feedback that often thenon-financial counterparty incurs a liability related to the expected cashflow or the delivery of shares that could be covered by an OTCderivative contract and should be viewed as part of the counterparty’snormal activity; the scope of the hedging definition has been amended to captureactivities that are in the normal course of business instead of just dayto day activities - the wording “ordinary course of business” has beenreplaced with “normal course of business”; OTC derivative contracts that cover risks related to the acquisition of acompany by a non-financial counterparty fall within the exemption, onthe basis that it would be considered part of the “normal” course ofbusiness of that non-financial counterparty; credit risk is covered in the scope of the exemption, as ESMA takes theview that managing credit risk is reducing a risk directly related tocommercial or treasury financing activity of a counterparty.ESMA has also provided some guidance that whilst it finally considers itinappropriate to reference local accounting rules in the technical standards forthe purpose of the hedging definition, most of the contracts classified ashedging under local accounting rules would in any event fall within theexemption.EMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 20126

Clearing thresholdsESMA proposed in the consultation paper to set the clearing thresholds perasset class, and 5 in total were put forward: credit derivatives, equityderivatives, interest rates, FX and commodity. The thresholds operate so thatwhen one threshold is breached for an asset class the non-financialcounterparty is subject to the EMIR clearing obligation in respect of allclasses of derivatives into which it enters. The consultation drafts of thetechnical standard have been amended so that the thresholds apply to OTCcontracts (whereas in the consultation drafts they applied to all derivatives).Although ESMA has relied on the Bank of International Settlements publisheddata and that provided by regulators and some non-financial counterparties toset the value of the clearing thresholds, there is insufficient data for ESMA tohave a complete view of the OTC derivatives market. In light of this, ESMA isproposing a phase-in approach whereby it will set clearing thresholds at alevel that can be adjusted once more data is available. It is intended that thethresholds will also be reviewed on a regular basis.The technical standards confirm that thresholds will be set by reference to thegross notional amount of the OTC derivative contracts, as opposed to marketvalue, which had been suggested by market participants and the EuropeanSystemic Risk Board. Clearing thresholds are therefore set at a “high” level.This is to accommodate non-financial counterparties that may not havesophisticated IT systems to calculate net exposure.Intragroup transactions exemptionIntragroup transactions exemptions are available in two contexts in EMIR: asan exemption from clearing requirements and as an exemption from the riskmitigation techniques requirements that apply to non-financial counterpartiesin respect of non-cleared transactions. Two sets of technical standards arerequired in respect of the intragroup transactions exemptions: to assess the applicability of the exemption; and to stipulate the information that must be provided to the competentauthority when a counterparty wishes to rely on an exemption.(Counterparties that wish to use the intragroup exemption in respect ofthe clearing obligation must apply to their regulator for approval, asmust non-financial counterparties that wish to use the exemption inrespect of the risk mitigation requirements where relevant groupmembers are located in other EU states or third countries).The really key technical standards that will set out the criteria to assess theapplicability of the exemption (and in particular the legal and practicalimpediments to the prompt transfer of own funds or repayment of liabilitiesbetween parties) are to be developed jointly by the EBA, EIOPA, and ESMA,to be published in a joint consultation at a later date.In the final report in respect of the notification requirements ESMA hasrelaxed some of the information requirements to make the process lessburdensome. For example:EMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 20127

counterparties need not now provide details of intragroup credit limits,on the basis that those groups that have them are likely to changethem regularly; counterparties do not have to provide a legal opinion to the regulatorunless the regulator specifically asks for one – this was in response tocriticisms that this would be an expensive requirement t

EMIR Update – ESMA Publishes Finalised Technical Standards – 27 September 2012 1 October 2012 EMIR Update - ESMA Publishes Finalised Technical Standards Introduction The European Securities and Markets Authority (“ESMA”) published on 27 September its technical standards and final report on EMIR, 4 days before

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