The financial markets now has clarity on some of the areas the EMIR REFIT programme and in particular, some of the changes as they pertain to small financial counterparts, CCP clearing among pension funds and trade reporting requirements. In this Q&A, Pauline Ashall, Partner at Linklaters in London, offers us a review of the recently announced changes. This interview is based on the podcast interview, which you can listen to here or via the DerivSource iTunes channel.
Q. Can you give us a brief overview of the background to the EMIR Refit and the current status?
A. EU legislation usually contains a provision for the European Commission to review how it’s operating in practice, and to report to the European Parliament and Council on possible changes. In the case of EMIR, the Commission’s review has led to 2 separate legislative proposals. These are generally referred to as EMIR REFIT and EMIR 2.2 (which relates to regulation of CCPs). Today’s discussion will just cover EMIR REFIT.
The EMIR REFIT Regulation is so called because it is part of the Commission’s Regulatory Fitness and Performance, or REFIT, Programme. The aim was to make targeted amendments to EMIR, to make compliance more proportionate and less onerous, especially for non-financial counterparties, or NFCs.
The draft Regulation amending EMIR to make the REFIT changes is now in near to final form following a number of trilogue meetings among representatives of the Commission, Parliament and Council. Final political agreement was reached at a meeting on 5 February, though further technical meetings are taking place this month to finalise some details such as phase-in periods. The latest draft text of the Regulation on which the political agreement was reached has now been released, and what I want to cover is based on that text, not all of which is yet in agreed form.
Q. What is the expected timetable going forward?
A. The Regulation is expected to be formally adopted in March or April. It will then be published in the Official Journal (probably in May or June) and come into force 20 days later. However, some of the changes won’t take effect immediately but are to be phased-in over a period of time. This is particularly important for the changes relating to reporting of transactions.
Q. Isn’t this timing problematic? Some of the issues that REFIT is meant to address are already live.
A. It was originally thought that, as the EMIR REFIT changes were less controversial than those relating to regulation of CCPs, the REFIT changes could be made quite quickly. However, it’s nearly 2 years since the REFIT proposal was first published and the delay in finalising it has caused problems. For example, REFIT will extend the EMIR exemption from clearing for pension schemes – but that exemption already expired last August. So in the meantime pension schemes and their counterparties are relying on informal statements from the European Supervisory Authorities that they don’t expect national regulators to prioritise compliance with the clearing obligation for pension schemes. This is usually referred to as “regulatory forbearance”. This informal regulatory forbearance is rather unsatisfactory from a legal perspective, but is the best that can be achieved as the European Supervisory Authorities don’t have formal power to grant waivers, along the lines of the no-action letters issued by the CFTC in the U.S.
There are various other examples of regulatory forbearance being granted pending EMIR REFIT coming into force, that I’ll mention later.
Q. I understand that a particularly topical example of regulatory forbearance relates to the backloading obligation. Can you explain this?
A. Yes, this is the requirement under EMIR to report, to a trade repository, historic transactions that were in place when EMIR came into force but were no longer in place when the reporting obligations were phased-in. This obligation is being repealed by REFIT. However, the obligation came into force yesterday (12 February)! But at the end of January, the European Securities and Markets Authority issued a statement indicating that it expected national regulators to show forbearance in enforcing the obligation, pending REFIT coming into force. The FCA in the UK has confirmed that it will do so. Therefore, in practice, there is no need for these historic trades to be reported.
Q. What about the other changes in REFIT on reporting of transactions?
A. As for the other changes on reporting – the general intention was to make things easier for NFCs. Whether the changes do so is another matter.
First, there will be an exemption from reporting of intra-group transactions involving a NFC, if certain conditions are met. While this is helpful in principle, the conditions are quite stringent and not all NFCs will be able to rely on them. The conditions are that both counterparties must be subject to consolidation and centralised risk management, and the exemption is not available if they have a parent undertaking that is a financial counterparty. It’s necessary to notify your national competent authority if you want to rely on this exemption.
Second, in the case of transactions between a financial counterparty and a small NFC (a NFC-), the FC will, after a phase-in period, become responsible and legally liable for reporting both sides of the transaction to a trade repository.
This is a big change from the current position. In practice, FCs often do agree to make reports for a NFC, but they do this as a delegate of the NFC without taking on legal liability for the accuracy of the reports. And the NFC will usually appoint a single FC to make reports for it, which reports will be made to a single trade repository. This is very different from a NFC- relying on each FC that it transacts with to report the transactions with that FC, which may involve reports being made to a range of different trade repositories.
Financial counterparties have substantial concerns about this change. ISDA advocated moving from dual-sided reporting to a requirement for single-sided reporting, so that only the financial counterparty would make the report, but it would report a single data set, and not be responsible for reporting on behalf of its counterparty. However, FCs will instead be responsible for accurately reporting both sides of the transaction. The NFC- will need to provide the FC with details about the NFC- that the FC cannot reasonably be expected to possess.
From the point of view of NFC-s, the changes are perhaps not so helpful either. As I’ve already mentioned, NFC-s will already have arrangements in place to report transactions. Even if they are willing for FCs to be responsible for reporting future trades, NFC-s will probably need to maintain the ability to make their own reports (directly or via a delegate), to cater for transactions where the counterparty is not a FC, and the exemption for intra-group transactions does not apply. For example, transactions with non-EU banks. There are provisions in REFIT that contemplate reports being made on behalf of NFC-s by financial counterparties outside the EU, but this is dependent on various equivalence determinations that are not yet in place, so those provisions can’t be relied on any time soon.
NFCs may also prefer to continue with their current reporting arrangements even for transactions with FCs. They will be allowed to do so, but they would have to notify this to every FC that they transact with.
In a number of respects, REFIT just postpones issues on reporting to a later date – it requires the Commission to carry out a further review into the reporting of exchange-traded derivatives under EMIR and MiFIR respectively.
Q. How does REFIT affect the scope of mandatory clearing for derivatives?
A. By way of background, the clearing obligation is still being phased-in for Category 3 FCs and for NFC+s.(Category 3 FC means FCs with uncleared derivatives portfolios of less than EUR 8 billion)
The problem with rolling out the clearing obligation for these counterparties is that the volume of their clearable contracts generally, or in a particular asset class, may be quite small. So they face difficulties in finding clearing members willing to take them on as clients. And indirect clearing is not a solution, as indirect clearing models aren’t really operating in the OTC derivatives area. Therefore, the clearing obligation for Category 3 FCs has already been deferred, to June of this year.
Under EMIR REFIT there will be a new exemption from the clearing obligation for small FCs. Small FCs for this purpose does not mean all Category 3 FCs, but only FCs whose derivative portfolios don’t exceed any of the clearing thresholds that have been set for determining whether a NFC is a NFC+ or a NFC-. The threshold for interest rate derivatives is EUR 3 billion and for credit derivatives is EUR 1 billion.
In calculating whether the thresholds are exceeded by an FC, there is no carve-out for hedging contracts – all OTC derivatives need to be taken into account, at group level.
This exemption for small FCs is very welcome, but there were concerns that such FCs wouldn’t be in a position to take advantage of this exemption before the clearing obligation starts to apply to them in June. The exemption may not be in force by then, or small FCs will not have been able to run the calculations necessary to demonstrate that they fall below the thresholds. So ESMA has indicated that regulatory forbearance should be available i.e. FCs that expect to be able to rely on the small FCs clearing exemption should not be required to start clearing derivatives pending the exemption becoming available.
Turning to NFC+s – currently, if a NFC is an NFC+ because it exceeds the clearing threshold for one class of derivatives, it needs to clear all classes of derivatives that are subject to mandatory clearing. Following the REFIT changes, a NFC+ will only be subject to the clearing obligation with respect to the relevant asset class for which the clearing obligation is exceeded. So if it exceeds the threshold for credit derivatives but not interest rate derivatives, it will only need to clear credit derivatives. As the requirement for NFC+s to clear interest rate products came into force on 21 December, regulatory forbearance has again been granted, so NFC+s that don’t exceed the threshold for clearing interest rate products don’t need to clear such products, pending the REFIT changes coming into force.
Q. What about the clearing obligation and pension schemes?
A. As for pension schemes, some of them will be small FCs, so able to rely on the exemption from clearing for small FCs. For larger pension schemes, REFIT will provide further transitional relief from the clearing obligation, potentially for a maximum period of 4 years. REFIT requires work to be carried out to try and resolve, before the transitional relief expires, the practical difficulties that pension funds currently face in clearing derivatives. This mainly relates to the need to hold liquid assets to post as margin.
Q. Any other changes relating to mandatory clearing?
A. There are also some changes applying to clearing members and CCPs. Clearing members that provide clearing services to clients are concerned about the new obligation to provide their services on fair, reasonable, non-discriminatory and transparent terms. What this means in practice will be spelled out in more detail in delegated legislation to be made by the Commission, and the new obligation will therefore be phased-in.
Finally on clearing – there will be new provisions allowing the obligation to clear a particular type of derivative to be suspended in certain exceptional circumstances, for periods of 3 months at a time. up to a maximum of 12 months. If the clearing obligation is suspended, the trading obligation under MiFIR for the relevant derivative can be suspended as well. This is a welcome change.
Q. What about margining for uncleared derivatives – are there any changes in this area?
A. As regards margining of uncleared derivatives, the main “issue” that needs to be addressed is that the margin rules under EMIR cover a broader range of products than are covered by the margin rules in other parts of the world. In other words, they cover FX forwards and swaps and, when the current derogation expires in 2020, will cover equity options and index options as well.
The application of the margin rules to FX derivatives was due to come into effect at the beginning of January last year. Separate from the EMIR REFIT review, draft technical standards were published in December 2017, to carve-out certain FX forward transactions from the scope of variation margining. This applies to all transactions except those where both parties are credit institutions or investment firms. It is not clear to me why the Commission has not yet adopted those technical standards. The industry is relying on regulatory forbearance for the time being to avoid margining of those transactions, pending the technical standards coming into force.
The REFIT Regulation itself just adds a new recital to EMIR acknowledging the need for international consistency as regards the scope of margining requirements with respect to FX forwards and swaps, and other classes of derivatives. It remains to be seen whether this will lead to exemptions being introduced in future for equity options and index options, before the current derogation from margining expires.
As part of REFIT, there was a proposal by the European Parliament to exempt NFC+s from margining uncleared transactions in asset classes where the clearing threshold is not exceeded. However, this has not been agreed. I don’t think this is particularly significant, as there are not many NFC+s, and they will already be posting and receiving margin on their uncleared derivatives transactions.
There will be a new requirement for regulators to validate the procedures that firms have in place to comply with the margining requirements. This will include validation of initial margin models used by firms.
Q. What about the implications of Brexit for EMIR REFIT?
A. If a withdrawal agreement is agreed, with an implementation period to the end of 2020, as EMIR REFIT is phased-in during that period, it will apply in the UK as if the UK was still a member of the EU.
In the event of a no-deal Brexit, only EU legislation that is in force and applying as at exit day will be onshored as part of UK law under the European Union Withdrawal Act. Therefore, If the UK leaves the EU at the end of March without a withdrawal agreement, EMIR will be onshored, but without the EMIR REFIT changes.
There is a separate piece of legislation, The Financial Services (Implementation of Legislation) Bill, giving the Treasury power, after exit day, to bring into force various pieces of EU legislation that are currently in progress but not yet in force – and these include EMIR REFIT.
In practice, I expect that the UK would, following a no-deal exit, choose to enact the EMIR REFIT changes. The Treasury has said that “domesticating [REFIT] will ensure that UK firms do not suffer competitive disadvantage in comparison to EU firms”.
Q. Are there any other aspects of EMIR REFIT you think are relevant to mention to our readers?
A. Overall, I think that EMIR REFIT is something of a missed opportunity.
There were a number of proposed amendments, particularly from the European Parliament, that have not been included in the final compromise. Some of these were changes for which the derivatives industry had lobbied, such as an exemption from EMIR for all central banks, not just those central banks that have been approved by the Commission by delegated act.
And in some respects, REFIT just provides for more work to be undertaken, with a view potentially to further changes in the future. For example, on reporting, and on a possible exemption from the clearing requirement for post-trade risk reduction exercises such as compression. ISDA had advocated for this exemption to be adopted now.
So while the REFIT changes will require firms to overhaul their existing practices, particularly as regards reporting of derivatives and classification of counterparties, the benefits of the exercise, including for non-financial counterparties, don’t seem all that great.
Q. If you were to give a rating personally on EMIR REFIT with 1 being poor and 10 being excellent, what rating would you give it?
A. I think 5 or 6. I think it is helpful in a number of respects but it doesn’t go as far as it might have done. And I think that the changes on reporting, which is certainly very unpopular with the industry, are also likely to really not to achieve what they were intended to do.
