International In-house Counsel Journal

Vol. 7, No. 26, Winter 2014, 1

International In-house Counsel Journal ISSN 1754-0607 print/ISSN 1754-0607 online

EMIR : A Landmark Regulation With Far-Reaching Impacts On The

EU Derivatives Business

FRÉDÉRIC DE BROUWER

Senior Legal Counsel, Société Générale, France

Like the Dodd-Frank Act in the US, EMIR will largely reshape OTC derivatives1

markets in Europe. Beyond the costs of the reform, among others the

requirement of collateral for non-cleared transactions, EMIR constitutes a major

operational challenge for derivative markets actors: IT investment, adaptation of

back and middle office processes, and important amendments to the legal

documentation. As there are still a significant number of regulatory

interpretation questions left unanswered, in-house lawyers are requested to

validate some uncertain assumptions. They must also act beyond their usual role

of advisers ; they have to demonstrate organization and project management

skills, notably for the legal re-documentation phase of the project.

The European Union adopted on 4 July 2012 a new regulatory framework on OTC

derivatives, i.e. the Regulation on OTC derivatives, central counterparties and trade

repositories2 (the so-called “EMIR

3” Regulation).

EMIR is the European translation of the commitment made at the Pittsburgh G20 Summit

in September 2009 in the aftermath of the financial crisis of 2008 to have all standardized

OTC derivatives cleared through a central counterparty. The massive use of OTC4 traded

bilaterally is usually seen by regulators as a major contributing factor to the financial

crisis. Clearing by central counterparties was seen as a way to monitor systemic risks by

pooling the risks among the central counterparties’ clearing members.

Like its foreign equivalents such as the Dodd-Frank Act in the US, EMIR imposes

essentially three types of obligations to derivative operators:

A Clearing Obligation of so-called « standard » derivatives for financial

counterparties and non-financial counterparties above one of the clearing

thresholds ;

Risk Mitigation Measures for transactions not eligible to the clearing

obligation, among others the exchange of collateral ;

A Reporting Obligation of all OTC and listed derivatives to trade repositories.

Whilst six Commission Delegated Regulations of 19 December 20125 came to

supplement the EMIR Framework Regulation and whilst the first obligations of EMIR

*The views contained in this Article are exclusively the personal views of the author. 1 The phrase OTC "over-the-counter" can be used to refer to financial products such as derivatives, which are

traded between dealers outside of an exchange. 2 Regulation (EU) No 648/2012 of the European Parliament and the Council, EU Official Journal, 27 July 2012,

L 201 3 European Market Infrastructure Regulation 4 Over the Counter 5 Regulation (EU) No 148/2013 on the minimum details of the data to be reported to trade repositories; Regulation (EU) No 149/2013 on

indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk

mitigation techniques for OTC derivatives contracts not cleared by a CCP; Regulation (EU) No 150/2013 specifying the details of the

application for registration as a trade repository; Regulation (EU) No 151/2013 specifying the data to be published and made available by

2 Frédéric De Brouwer

have entered into force respectively on 15 March6 and 15 September

7 2013, there are still

a number of regulatory interpretation questions and a number of operational issues to be

solved. Moreover, whilst cross-border or extraterritorial aspects of EMIR are slowly

being clarified8, rules on collateral requirements must still be adopted at European level

9.

Contrary to Dodd-Frank in the US, EMIR does not contain rules on execution (e.g.

suitability). Such rules were to some extent already provided in MIFID10

and they will be

revisited and extended in MIFIDII (or the so-called “MIFIR”), which should not enter

into force before 2017. Pursuant to MIFIR, OTC trades will have to be executed on

electronic platforms (“OTFs”, the equivalent of the so-called “SEFs” in the US).

It is also important to note that EMIR has unexpected impacts on other regulations such

as the Capital Requirements Regulation (“CRR”, the latter applies the EMIR exemption

categories)11

. Hence, EMIR has a direct impact on the regulatory capital to be allocated

by European banks by January 1, 2014.

I. The product scope of EMIR

EMIR applies to all derivatives listed in Annex 1 Section C (4) to (10) of MIFID12

. This

is an extensive list that includes options, futures, swaps, forward rate contracts and other

derivatives related to:

Securities, currencies, interest rates/yields, other derivatives, financial

indices or financial measures which may be settled physically or in cash;

Commodities that must be settled in cash or may be settled in cash at the

option of one of the parties;

Commodities that can be physically settled provided they are traded on a

regulated market and/or an MTF;

Commodities than can be physically settled, not mentioned in MIFID

section C(6) , not being for commercial purposes, which have

characteristics of other derivatives;

Instruments for the transfer of credit risk;

Financial contracts for differences related to MIFID instruments,

currencies, interest rates or other financial indices;

Options, future, swaps, forward rate contracts and any other derivatives

related to climatic variables, freight rates, emission allowances or inflation

rates or other official economic statistics (cash settlement option) and

assets, rights, obligations, indices and measures not otherwise mentioned.

Spots are commonly not qualified as derivatives.

trade repositories and operational standards for aggregating, comparing and accessing the data; Regulation (EU) No 152/2013 on capital requirements for central counterparties; Regulation (EU) No 153/2013 on requirements

for central counterparties. 6 Daily Mark-to-Market valuation, timely confirmations 7 Portfolio reconciliation, dispute resolution, portfolio compression 8 Draft regulatory technical standards are expected following the ESMA consultation paper of 17 July 2013 on

contracts having a direct , substantial and foreseeable effect within the Union and non-evasion of provisions of EMIR. ESMA website www.esma.europa.eu 9 An ESMA consultation followed by draft regulatory technical standards is still expected. IOSCO (The

International Organization of Securities Commissions) and the Basel Committee on Banking Supervision released on 2 Sept. 2013 their Final Report on Margin Requirements for non-centrally cleared derivatives. 10 Directive 2004/39/EC of the European Parliament and of the Council of 21 April 2004 on markets in financial

instruments, EU Official Journal 30 April 2004, L 145 11 Regulation (EU) No 575/2013 of the European Parliament and the Council of 26 June 2013 on prudential

requirements for credit institutions and investment firms and amending Regulation (EU) No 648/2012 12 Ibidem

Emir 3

In the UK, some FX forwards, i.e. deliverable currency forwards, are not “future” and

therefore are not included in MIFID scope. Hence they should be logically excluded from

EMIR scope as well. On the opposite, other Member States usually include these

currency forwards in MIFID scope. A harmonisation of MIFID scope by ESMA appears

essential to ensure a consistent implementation of EMIR across the EU. In turn, such EU

convergence is a pre-requisite of any convergence exercise with third countries such as

the US where FX forwards and swaps, for instance, are excluded from the clearing

obligation.

Whereas OTC derivatives as per MIFID scope are subject to all EMIR obligations, the

Reporting obligation will cover both OTC and Exchange Traded Derivatives.

II. The classification of counterparties in the scope of EMIR

A. Financial counterparties versus non-financial counterparties

One of the first and major challenges of the new regulation for entities subject to EMIR

consists of classifying properly their counterparties which fall in the scope of the

regulation. The classification of counterparties is necessary in order for entities concerned

to comply with their own obligations under the regulation. Indeed, different rules apply

depending on the status of the counterparty (financial counterparty (FC), non financial

counterparty above one of the clearing thresholds (“NFC+”) and non-financial

counterparties below all clearing thresholds (“NFC- “)). Financial counterparties and

non- financial counterparties above one of the clearing thresholds are in principle subject

to stricter requirements than non financial counterparties below all the clearing

thresholds.

The definition of financial counterparties (“FC”) is straightforward in the regulation. It

concerns investment firms, credit institutions, insurance, assurance and reassurance

undertakings, UCITS and their asset managers where applicable, institutions for

occupational retirement and alternative investment funds13

.

Entities which do not fall in the definition of financial or central counterparty are to be

categorized as non financial counterparties by default provided that they qualify as an

undertaking14

.

As far as the distinction between non financial counterparties (NFC) below (NFC-) or

above (NFC+) the clearing thresholds is concerned, the task is more difficult. Non-

financial counterparties are divided between those which exceed and those which do not

exceed one of the clearing thresholds of 1 or 3 billion euros in gross notional value15

.

OTC trades which are objectively measurable as reducing risks directly relating to the

commercial activity or treasury financing activity of the non financial counterparty (the

so-called « hedging ») are excluded from the calculation of the clearing thresholds16

. The

calculation of the threshold must be made on a worldwide consolidated basis17

. Since 15

March 2013, non financial counterparties which cross one of the clearing thresholds must

notify ESMA immediately18

.

It is not possible for a financial institution to determine with certainty whether its non

financial counterparties are below or above the clearing thresholds as the financial

institution is not aware of the derivative positions held by its counterparties with other

13 Art. 2 (8) 14 Pursuant to EU Antitrust Law, an entity is an undertaking if it performs some form of economic activity 15 1bn EUR for credit and equity derivative contracts and 3bn EUR for interest rate, foreign exchange ,

commodity and other OTC derivative contracts (Art. 11 Regulation (EU) No 149/2013 ) 16 Art. 10.3 Regulation (EU) No 648/2012 17 Ibidem 18 Art. 10.1 (a) Regulation (EU) No 648/2012

4 Frédéric De Brouwer

counterparties. In addition, non-financial counterparties have only an obligation to notify

their domestic regulator and the European Securities and Markets Regulator (ESMA) -

not their counterparties - if they exceed one of the clearing thresholds19

. There will be no

public access of such information. In its Q&A, ESMA clearly allocates responsibilities

between FCs and NFCs concerning the classification of the latter : NFCs are obliged to

determine their own status against the clearing thresholds whilst FCs must obtain status

representations from their NFC counterparties on which they can rely unless they are in

possession of information which clearly demonstrates that those representations are

incorrect20

. For NFCs outside of the EU, the ESMA approach is a different one. As

ESMA is conscious that it will be impossible to force a non - EU NFC to classify itself, it

considers that in case of doubt, FCs will have to treat NFCs as NFCs+21

.

Special Purpose Vehicles (SPVs) and other conduits must be examined case by case in

order to determine whether they fall under the financial or non financial counterparty

category.

Financial counterparties are also concerned by this obligation : they have to identify all

non financial counterparties that fall into their worldwide consolidated perimeter and

should one of their affiliated NFCs alone or jointly with the other NFCs of the group

cross one of the clearing thresholds all the NFCs of the group will be impacted. As many

financial groups have numerous non-financial SPVs and other vehicles, conduits or

entities, such task of identification and classification is a real challenge.

Another challenge will be to keep up-to-date with the proper classification of

counterparties. How shall a financial entity know whether one of its non-financial

counterparties has changed its status from NFC- to NFC+ or the opposite ? The ISDA

Protocol on NFC Representation22

imposes on ISDA counterparties which have adhered

to the Protocol to notify their adhering counterparties of such changes but there is

unfortunately currently no mechanism of systematic (or automated) notification

planned23

.

B. Exemptions

There are a number of exemptions - partial or full - under EMIR, which concern the

broad category of sovereigns.

Full exemptions concern the European Central Bank, the Central Banks of the twenty-

eight EU Member States as well as the debt management agencies of the same24

. The

Commission has extended this exemption to the central banks and debt management

agencies of the US and Japan25

. The Bank of International Settlements (BIS) is also fully

exempted26

.

19 Ibidem 20 ESMA Q&A, 22 Oct. 2013, OTC Answer 4, p. 13. The Q&A was updated for the last time on 20 December

2013 21 ESMA Q&A, 22 Oct. 2013, OTC Answer 13, p. 20 & 21 22 www.isda.org 23 Some providers (e.g. Markit, NotiFide) are developing status management and notification systems but their

success will depend on the level of industry (mostly the buy-side) take-up 24 Art.1.4. (a) Regulation (EU) No 648/2012 25 As per Art. 1.6 Regulation (EU), No 648/2012, Commission Delegated Regulation (EU) No 1002/2013 of 12

July 2013, EU Official Journal, 19 Oct. 2013, L. 279/2. Central Banks and Debt Management Agencies of Australia, Canada, Hong Kong and Switzerland are also being considered by

the Commission for exemption .But no decision was made yet. 26 Art. 1.4. (b) Regulation (EU) No 648/2012

Emir 5

Other entities are partially exempted from EMIR, i.e. all obligations except reporting :

multilateral development banks pursuant to a limitative list27

, public sector entities owned

by the central government and benefiting from an explicit guarantee from the central

government28

, the European Financial Stability Forum (EFSF)29

and the European

Stability Mechanism (ESM)30

.

Whereas lists of public entities benefiting from an explicit guarantee from the State were

expected, only a very limited number of Member States seem to have decided to publish

such lists31

. Without such lists, the only way for financial institutions will be to rely on

the declarations of their counterparties.

How to treat other sovereigns (municipalities, regions …) ?

There is still a significant amount of uncertainty on how sovereigns such as

municipalities or regions should be treated. These sovereigns are neither explicitly nor

implicitly included or excluded from EMIR. It is not clear whether the European

legislator aimed to fully exclude these entities from the scope of the Regulation. Let us

not forget that some municipalities have had important exposures to derivatives before

the outset of the financial crisis in 2008. But then under which EMIR category would

they fit ? They cannot be qualified as financial counterparties and they do not fall in any

of the exemption categories except maybe the one of “public sector entity” for some of

them, although this is questionable. The only category left where they could perhaps fall

is the NFC category. But can a region or municipality be qualified as an undertaking in

the sense of the EMIR definition of « NFC »32

? Pursuant to European antitrust case law,

an undertaking is an entity which performs a commercial or economic activity. Some

regions or municipalities could sometimes be qualified as doing so but this would be

rather unusual.

There is much confusion about the real status of these sovereign counterparties under

EMIR (some of them have taken a clear stance of exemption), which leads to uncertainty

as to whether for instance risk mitigation measures must be applied to them. In its

updated Q&A of 18 December 201333

, the Commission aims to clarify the treatment of

municipalities. Pursuant to the Commission, municipalities can be totally or partially

exempted: they would be fully exempted if they can be qualified as “Union public bodies

charged or intervening in the management of the public debt” in the sense of Article 1 (4)

(a) of EMIR34

and they would be partially exempted (i.e. they would still be subject to the

reporting obligation) if they fulfil all the conditions of “public sector entities” benefiting

from explicit guarantee arrangements from the government under Article 1 (5) (b) of

EMIR. The Commission goes on by stating that municipalities which do not fall under

either of the two abovementioned exemptions are to be considered as non financial

counterparties provided that they are undertakings, i.e. that they perform an economic

activity in the sense of Article 2(9) of EMIR. However, in its clarification of the notion of

“undertaking”, the Commission states that “The exercise of public authority or powers

would not be considered as an economic activity. In this respect, where authorities

emanating from the State act in their capacity as public authorities they would not be

considered undertakings”35

. Is a municipality emanating from the State ? I would think it

27 Art. 1.5 (a), Regulation (EU), No 648/2012 28 Art. 1.5 (b) Regulation (EU) No 648/2012 29 Art. 1.5 (c) Regulation (EU) No 648/2012 30 Art. 1.5 (c) Regulation (EU) No 648/2012 31 Germany seems to be one of these Member States 32 Art. 2(9) Regulation (EU) No 648/2012 33 Question 15 34 I am not convinced that a municipality can be qualified as such 35 Question 14

6 Frédéric De Brouwer

does. Hence, I would tend to think that most of the municipalities would be exempted

from EMIR but this is not entirely clear and we can regret that the Commission has not

clarified better. What about other sovereigns such as Regions, for instance? I would think

that the same rules as for municipalities should apply.

III.The clearing obligation

Standard OTC contracts (i) between financial counterparties, (ii) between financial

counterparties and non-financial counterparties above one of the clearing thresholds and

(iii) between non-financial counterparties above one of the clearing thresholds will be

subject to a clearing obligation. Such clearing obligation should enter into force at the

earliest mid 201436

for an important part of IRS and CDS concluded between financial

counterparties (some FX products should come next). The industry has requested ESMA

to go into a sufficient level of granularity in order to lift as much as possible uncertainty

on whether any sub-asset class is subject to mandatory clearing. Such granularity is also

key for the application of the frontloading obligation (see infra). Non-financial

counterparties will in principle benefit from a postponement (phase-in) of the

obligation37

. Some small financial institutions may perhaps be granted some time to

adjust to the new clearing obligation as well, but this remains to be seen. The entry into

force of the clearing obligation will be gradual asset class per asset class. In practice,

Member States’ regulators will notify ESMA of their decision to authorize a CCP to clear

a certain asset class and ESMA will have up to six months and the European Commission

up to three months to confirm the eligibility of the product to mandatory clearing (the so-

called « bottom-up » approach)38

. In its decision, ESMA will take into account the

following criteria:

the degree of standardisation of the contractual terms and

operational processes of the relevant class of OTC derivatives;

the volume and liquidity of the relevant class of OTC derivatives ;

the availability of fair, reliable and generally accepted pricing

information in the relevant class of OTC derivatives.

The clearing thresholds of 1 or 3 billion EUR39

are calculated in gross notional value. The

derivative contracts concluded for hedging purposes are excluded from the calculation of

the thresholds, i.e. derivatives operations which represent a contribution which is

objectively measurable as reducing risks directly relating to the commercial activity or

treasury financing activity of the non-financial counterparty or of that group, when, by

itself or in combination with other derivatives contracts, directly or through closely

correlated instruments, it meets one of the following criteria40

:

it covers the risks arising from the potential change in the value of assets,

services, inputs, products, commodities or liabilities that the non-financial

counterparty or its group owns, produces, manufactures, processes,

provides, purchases, merchandises, leases, sells or incurs or reasonably

anticipates owning, producing, manufacturing, processing, providing,

purchasing, merchandising, leasing, selling or incurring in the normal

course of its business ;

36 Pursuant to the current ESMA timetable. The end of 2014 seems to be a more realistic date though. 37 Pursuant to a Declaration from Commissioner Barnier of 7 Feb. 2013, non-financial counterparties will

benefit from a three year phase-in of the clearing obligation 38 Art. 5 (2) Regulation (EU) No 648/2012 39 Art. 11 Regulation (EU) N°149/2013 40 Art. 10 Regulation (EU) No 149/2013

Emir 7

it covers the risks arising from the potential indirect impact on the value of

assets, services, inputs, products, commodities or liabilities referred to in

point (a), resulting from fluctuation of interest rates, inflation rates, foreign

exchange rates or credit risk ;

it qualifies as a hedging contract pursuant to International Financial

Reporting Standards (IFRS) adopted in accordance with Article 3 of

Regulation (EC) N° 1606/2002 of the European Parliament and of the

Council.

The clearing obligation shall apply to eligible derivative contracts between (i) two

financial counterparties, (ii) between a financial counterparty and a non-financial

counterparty above one of the clearing thresholds, (iii) between two non-financial

counterparties above one of the clearing thresholds, (iv) between a financial counterparty

or a non-financial counterparty above one of the clearing thresholds and an entity

established in a third country that would be subject to the clearing obligation if it were

established in the Union, and finally (v) between two entities established in one or more

third countries that would be subject to the clearing obligation if they were established in

the Union, provided that the contract has a direct, substantial, and foreseeable effect

within the Union or where such an obligation is necessary or appropriate to prevent the

evasion of any provisions of this Regulation. A current point of concern for a number of

EU financial firms is the risk of having some of their guaranteed non-EU subsidiaries

falling into the scope of EMIR41

.

Intra-group transactions are excluded from the clearing obligation if they meet a certain

number of conditions. Counterparties must belong to the same group, they must be

included in the same consolidation perimeter and they must be subject to appropriate

centralized risk evaluation, measurement and control procedures42

. It must be emphasised

that intra-group transactions are counted in the calculation of the clearing thresholds.

They are subject to a prior notification or authorization procedure for respectively

operations concluded between two counterparties established in the EU and between one

counterparty established in the EU and the other counterparty in a third country43

.

A temporary exemption of 3 years is granted to pension funds44

. It remains to be seen

whether some non-EU pension may effectively benefit from such temporary exemption45

.

The frontloading obligation

EMIR shall impose on counterparties to clear not only the trades they have entered into

as from the starting date of the clearing obligation for a particular asset class but also the

trades with a minimum remaining maturity on that particular asset class from the date of

notification by the national competent authority to ESMA that a CCP is authorized to

clear that particular asset class46

. This frontloading obligation, which is specific to EMIR

(it does not exist in the Dodd-Frank Act), will be a source of uncertainty for a period of

time up to 9 months or more47

, i.e. the period of time under which ESMA and then the

Commission have to take a decision on the eligibility to mandatory clearing of the asset

class as well as the effective starting date of the obligation and the minimum remaining

41 ESMA consultation paper of 17 July 2013 on contracts having a direct , substantial and foreseeable effect

within the Union and non-evasion of provisions of EMIR, p. 9 - 12 42 Art. 3 Regulation (EU) No 648/2012 43 Art. 4.2 (a) (b) Regulation (EU) No 648/2012 44 Art. 89.1 Regulation (EU) No 648/2012 45 It seems that ESMA may grant an exemption to non-EU pension scheme arrangements (Art 89.2 Regulation

(EU) No 648/2012) 46 Art. 4.1 (b) (ii) Regulation (EU) No 648/2012 47 With a potential phase-in, the period of uncertainty could be longer

8 Frédéric De Brouwer

maturity of the derivative contracts48

. The frontloading uncertainty period will be creating

two kinds of risks: economic and operational. Economic risks are materialized by the

price differential between collateral and capital charges in a bilateral trade and collateral

and capital charges in a trade cleared at a CCP. Operationally, risks are not the same in a

pure OTC bilateral trade context and in a CCP context.

Even though the level of uncertainty should be somewhat limited due to the fact that it is

public knowledge that IRS and CDS will be the first asset classes to be subject to

mandatory clearing, the extension of the obligation to some sub-asset classes49

may be

less obvious and hence some uncertainty may arise for these sub-asset classes. ESMA has

implicitly acknowledged in its Discussion Paper on the Clearing Obligation of 12 July

2013 that it might use the remaining minimum maturity durations to play down the

frontloading obligation50

.

Besides the fact that operators in derivative markets will have to identify all trades of a

particular asset class from the date of notification from the national competent authorities

to ESMA for potential clearing at a later date, they may have to protect themselves

contractually against the effects of an inaccurate pricing of the transaction by inserting in

their master agreements a clause pursuant to which there would be a possibility to

renegotiate the price of the transaction and failing to agree such a renegotiated price, to

terminate the transaction. A draft ISDA standard clause offers two contractual options: a

clearing assumption and a non-clearing assumption, with a price renegotiation and a

termination clause. The objective of the clause is to allow counterparties to re-negotiate

the price of the transaction and to terminate the transaction failing an agreement on such

re-negotiation. The clause has so far not been published by ISDA as a large number of

firms deem it too complex.

Let us also note that the uncertainty caused by the frontloading obligation should be even

longer for non-financial counterparties than for financial counterparties because of the

likely postponement (phase-in) of the effective clearing obligation for them.

The frontloading obligation and the uncertainty it creates is causing some amount of

unfortunate confusion among dealers.

It is hoped by the industry that ESMA will reduce as much as possible the period of

uncertainty of the frontloading obligation. In view of the potential entry into force of the

first frontloading obligation relatively shortly51

, quick positive signals from ESMA would

be welcome.

IV. Risk mitigation techniques

EMIR provides five types of operational and counterparty risk mitigation techniques52

:

the daily mark-to-market valuation

the timely confirmations

the reconciliation of portfolios and dispute resolution

the portfolio compression

the exchange of collateral

48 Art. 5 .2, & 5.3 & 5.4 & 5.5 Regulation (EU), No 648/2012 49 It could be the case of inflation swaps, for instance, for which CCPs have little clearing experience 50 ESMA Discussion Paper on the Clearing Obligation under EMIR, 12 July 2013 , p. 44, para 135 51 EuroSwaps at NASDAQ OMX could be first in line

52 Art. 11 Regulation (EU) No 648/2012

Emir 9

Financial counterparties and non-financial counterparties above the clearing thresholds

are subject to stricter risk mitigation measures than non-financial counterparties below

the thresholds.

Whilst the daily mark-to-market and the timely confirmations obligations entered into

force on 15 March 2013, portfolio reconciliation, dispute resolution and portfolio

compression rules became effective on 15 September 2013. Collateral requirements

should enter into force gradually from December 2015.

Risk mitigation techniques apply to non-European counterparties where at least one of

the counterparties is established in the EU53

.

Daily Marked to market valuation

Financial counterparties and non-financial counterparties above the clearing thresholds

are required to mark-to-market on a daily basis. We should not expect this to be an issue

for financial institutions as this is already largely applied.

Timely confirmations

The timely confirmation rules are requiring significant adjustments from the financial

industry. The new timing requirements vary depending on the asset classes and

counterparties concerned: they are shorter for financial counterparties and non financial

counterparties above the clearing thresholds than for non financial counterparties below

the clearing thresholds. The new rules shall become stricter across all asset classes after

28 February and 31 August 2014, i.e. imposing D+1 or D+2. The generalization of

electronic confirmation platforms will help complying with these new requirements.

Portfolio reconciliation and dispute resolution

Since 15 September 2013, counterparties in OTC derivative transactions must have in

place portfolio reconciliation and dispute resolution arrangements. Portfolio

reconciliation frequencies depend on the status of the counterparty (financial, non-

financial below or above the clearing thresholds) and the number of outstanding

transactions between the counterparties. The reconciliation has to be daily, weekly,

quarterly or annually. The first quarterly and annual reconciliations have to be performed

respectively by December 15, 2013 and March 15, 201454

. Like other risk mitigation

measures in general, portfolio reconciliation rules apply extraterritorially to non-

European counterparties when at least one counterparty is established in the EU55

.

As EMIR requires that counterparties agree in writing (or other equivalent electronic

means)56

their portfolio reconciliation arrangements, there has been a lot of debate in the

industry on the form of such written arrangements. Whereas some actors seem to be

willing to materialize these arrangements in amendments to master derivatives

agreements, a number of actors have taken a less formalistic view of exchanging ad hoc

forms setting the operational reconciliation arrangements. ISDA itself has published a

Protocol on Portfolio Reconciliation, Dispute Resolution and Disclosure57

to which

several thousand of counterparties have already adhered to.

The entry into force of portfolio reconciliation rules mid-September 2013 marked the first

move on what could become a significant industry re-documentation exercise.

53 ESMA Q&A, 22 October 2013, OTC Answer 12, p. 20 54 ESMA Q&A, 22 October 2013, OTC Answer 14, p. 21 55 ESMA Q&A, 22 October 2013, OTC Answer 12, p. 20 56 Art. 13.1 Regulation (EU) No 149/2013 57 www.isda.org

10 Frédéric De Brouwer

Important progress was achieved across the Atlantic last July when the US and the EU

agreed to recognize the equivalence of risk mitigation measures of Dodd Frank and

EMIR58

. In practice, it means that EU counterparties trading OTC derivatives with US

counterparties are free to choose the application of either DFA or EMIR Rules. For those

counterparties who chose to apply EMIR rules, ISDA published a Top Up Agreement to

bridge between Dodd Frank Protocol 2 and the EMIR Protocol on Portfolio

Reconciliation59

. A number of US counterparties have decided to sign this Top Up

Agreement.

EMIR also requires that counterparties agree dispute resolution procedures regarding the

recognition or valuation of the contract and the exchange of collateral between

counterparties with a specific process for disputes not resolved within five business

days60

. Finally, financial counterparties will have to report to their home regulators

disputes between counterparties for an amount or a value higher than EUR 15 million and

outstanding for at least 15 business days61

.

Portfolio compression

Counterparties having 500 or more outstanding OTC derivative contracts with each other

must perform a compression feasibility exercise at least twice a year62

. It is important to

emphasise that this obligation is a feasibility exercise obligation, not an obligation to

effectively compress the portfolios. However, counterparties falling into the scope of

such obligation will have to make sure that they are able to justify their decision not to

perform a compression exercise63

. Appropriate internal procedures must therefore be in

place.

As EMIR does not distinguish between bilateral and multilateral compression, there is

nothing which allows counterparties to consider that only multilateral compression must

be performed, notwithstanding the fact that the value of bilateral compression to reduce

counterparty risks is questionable. Regulators have reminded in that respect that risk

mitigation rules have been enacted mostly to mitigate operational, not counterparty risks.

Exchange of collateral

The Basel Committee on Banking Supervision and IOSCO published on 2 September

2013 their Final Report on Margin requirements for non-centrally cleared derivatives

pursuant to which financial firms and systematically important non-financial entities will

have to exchange collateral when they trade derivatives not eligible to clearing64

. In the

EU, all financial counterparties and non-financial counterparties above the clearing

thresholds that engage in non-centrally cleared derivatives will have to exchange initial

and variation margin commensurate to the counterparty risks arising from such

transactions.

The Report proposes a gradual phase-in period to allow market participants to adjust to

the new requirements. The requirement to collect and post initial margin on non-centrally

cleared trades would be phased-in over a four-year period, beginning in December 2015

with the largest, most active and most systematically important derivatives markets

participants.

58 EU-US political agreement of 11 July 2013 on the recognition of equivalence of risk mitigation measures

under EMIR and Dodd-Frank 59 www.isda.org 60 Art. 15.1 Regulation (EU), No149/2013 61 Art. 15.2 Regulation (EU),No 149/2013 62 Art. 14.1 Regulation (EU) No 149/2013 63 Art. 14.2 Regulation (EU) No 149/2013 64 www.bis.org

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The proposed framework exempts physically settled foreign exchange (FX) forwards and

swaps from initial margin requirements. The same exemption applies under Dodd-Frank.

European rules are not yet known; it is hoped that they will be in line with the

international standards, with no gold-plating.

Collateral requirements could represent a very significant cost and be detrimental to some

non standardized derivatives business.

There was some doubt in the industry on whether risk mitigation measures had to be

applied with European central banks (including the ECB). The European Central Bank

has indicated in a Communication of 12 September 2013 that this was not to be the case

following a confirmation that it obtained from ESMA.

V. The Reporting obligation

All derivative contracts – OTC and listed – will have to be reported to trade repositories65

from 12 February 2014. The reporting will have to be made at D+1, i.e. no later than the

working day following the conclusion, modification or termination of the contract66

. The

implementation of this obligation requires a significant number of IT developments.

Firms will have many difficulties to be ready for listed products by mid-February 201467

.

Pursuant to the so-called “backloading rule”, all derivative contracts concluded since 16

August 2012 (i.e. the date of entry into force of the Level 1 Regulation) and all contracts

concluded before 16 August 2012 and still outstanding on that date68

will have to be

reported.

Although individuals and non-EU entities are not per se subject to the reporting

obligation, their data will have to be reported to the trade repositories by their EU

counterparties.

One important aspect to look at in the context of reporting are the banking secrecy and

personal data regulations. Whilst Article 9.4 of EMIR protects the reporting counterparty

against any potential breach of any restriction on disclosure of information (by law or

contract), such protection works only vis-à-vis European counterparties. Vis-à-vis non-

EU counterparties69

, European counterparties ought to make sure that they do not breach

local confidentiality constraints. In some jurisdictions, bank secrecy laws are subject to

criminal and/or heavy regulatory sanctions. ISDA has published two Protocols which

should help complying in that respect, i.e. the EMIR Protocol on Portfolio Reconciliation,

Dispute Resolution and Disclosure70

and the Reporting Protocol. Both Protocols provide

a confidentiality waiver clause but whilst the confidentiality waiver of the EMIR Protocol

concerns EMIR only, the confidentiality waiver of the Reporting Protocol concerns any

OTC regulation - including EMIR and Dodd Frank - that prescribes reporting obligations.

For non-European entities not adhering to any ISDA Protocols, ad hoc confidentiality

waivers will have to be requested when the prior consent is a pre-condition for the

reporting of counterparty data, which is most often the case.

65 Trade repositories must be registered with ESMA (Art. 55, Regulation (EU) No 648/2012). So far, six trade

repositories were registered on respectively 7 and 28 Nov. 2013: DTCC, KDPW, Regis-TR, UnaVista, ICE, CME. 66 Art. 9 Regulation (EU) No 648/2012 67 ESMA had recommended to postpone the reporting start date of exchange traded derivatives to 1 January 2015 but this recommendation was turned down by the Commission on 7 November 2013. 68 Art. 9.1 (a) & (b) Regulation (EU) No 648/2012 69 Also vis-à-vis EU counterparties which trade with non-EU branches of EU counterparties in countries which

impose strict banking secrecy constraints. 70 The insertion of a disclosure provision in the Portfolio Reconciliation Protocol creates unfortunate significant

confusion in the industry because the provision is not linked to portfolio reconciliation but to reporting.

12 Frédéric De Brouwer

As allowed by EMIR (Art.9), some financial firms will offer reporting delegation service

solutions to their clients, which may find it too burdensome and costly to report

themselves directly. These financial firms will have to be particularly careful to exclude

liability for such service.

VI. EMIR and extraterritorial rules

Like Dodd Frank in the US, EMIR contains a number of extraterritorial provisions. A

non-EU entity trading with a counterparty established in the EU shall be subject to EMIR

if it would be subject to the clearing obligation were it be established in the EU. Even

when the two legs of the transactions are outside of the EU, i.e. the two counterparties are

established outside of the EU, EMIR may apply when the derivative contract has a direct,

substantial and foreseeable effect within the Union. Hence some guaranteed non-EU

subsidiaries of EU parent financial firms could fall into the scope of EMIR71

.

The extraterritorial reach of EMIR has already created some harsh reaction from some

entities outside the EU. Some of these entities were indeed very surprised to receive

communications from their European counterparties stating that they would have to

comply with portfolio reconciliation requirements.

The extraterritoriality of EMIR is mitigated by the possibility for the Commission to

assess the equivalence of foreign legal, supervisory and enforcement arrangements72

.

When the Commission recognises the equivalence of the OTC legal or regulatory

framework of a third country, counterparties to an OTC derivative trade can choose to

apply either the rules of the third country or EMIR rules. A first positive step was

achieved by the EU-US agreement of 11 July 2013 on the equivalence on risk mitigation

measures. The Commission is expected to conduct a review of a number of jurisdictions,

starting with the major G-20 jurisdictions. We should expect progress to be made next

year, first hopefully with the US, and then other major markets should follow.

Another area of recent progress is the application filed by a significant number of non-EU

CCPs to ESMA in order to obtain EU recognition. Entities using clearing services of

third country CCPs which have applied for recognition to ESMA by the deadline of 15

September 2013 are allowed to continue clearing at such CCPs until ESMA renders its

decision within a maximum of 180 working days from the submission of a complete

application73

. European firms are not allowed to clear themselves or through their local

branches at third country CCPs which have not applied for ESMA recognition by 15

September 2013 whereas local subsidiaries can do so. This distinction between branches

and subsidiaries of European entities was made very clearly by the Commission in its

Q&A of 8 February 2013 (updated on 18 December 2013)74

. The prohibition to clear at

not recognised non-EU CCPs applies not only to derivative products, but also to

securities products75

.

It is crucial that the Commission achieves mutual recognition agreements with the

regulators of the major G20 countries in order to move towards convergence of

regulation and supervision of OTC derivatives markets. Failing to achieve these

71 The guarantee must be above two quantitative thresholds: more than 8bn EUR gross notional of OTC

derivatives and more than 5% of the total OTC derivative exposure of the EU financial firm 72 Art. 13 Regulation (EU) No 648/2012 73 Art. 25 and Art . 89.3 & 4 Regulation (EU) No 648/2012 74 Part III.3 75 Part III.3

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equivalence agreements, in particular in Asia, could strongly jeopardize the business of

European firms in Asia76

.

VII. The Re-documentation hassle

EMIR will probably have a very significant impact on paperwork and contractual

documentation. Every financial firm is adopting its own approaches and policies on this,

some being more formalistic or legalistic than others. Can we just put ourselves in the

shoes of our non-financial counterparties receiving from their banks numerous letters,

communications and probably later master agreement amendments? A large number of

corporate, small financial institutions or asset managers have little or no clue at all of

what EMIR requires. Hence, a high level of pedagogy and fluent communication is key

on the part of financial firms for which EMIR is “just” another Regulation to digest and

implement. Don’t communicate too much but communicate well! Keep it simple should

be the leitmotiv!

That being said, is a systematic large scale re-documentation of the stock of existing

master agreements necessary? All major financial institutions have thousands of

counterparties with which they trade OTC derivatives; there are also several types of

master agreements used to document these transactions: ISDA, the European Federation

of Energy Traders (EFET) Master Agreement, the French Banking Federation (FBF)

Master Agreement, the German Rahmenvertrag, and other local derivative master

agreements.

ISDA Protocols77

will help but they would generally work for ISDA counterparties only78

and only a limited number of counterparties would usually adhere to them.

The approach of a number of financial institutions will be to try to avoid renegotiating

master agreements when it is not absolutely necessary. This is the case for instance when

there is no other impact than what the Regulation provides. A significant number of

financial institutions deemed for instance not necessary to amend master agreements to

include a provision on portfolio reconciliation which would have stipulated exactly the

same thing as what is provided in the Regulation. On the opposite, when counterparties

need to be protected against any adverse business impact arising out of an obligation

under the Regulation, the insertion of a proper clause in the master agreement may be

necessary. This is the case for example of frontloading where counterparties may be

willing to protect themselves in the contract against the pricing differential of a trade

during the period of uncertainty imposed by the Regulation (difference between the cost

of collateral for a bilateral trade and the cost of collateral of a trade cleared at a CCP).

The solution would be to insert a price renegotiation and termination clause. The same

may be true for clearing: counterparties may deem necessary for instance to protect

themselves against the risk of a trade being rejected by a CCP or a clearing broker.

With the clearing obligation coming closer, it is urgent to agree some market

convergence position on contractual re-documentation. So far, the move has come mostly

from some corporate clients and asset managers who have taken the initiative to propose

to their financial counterparties to re-negotiate their master agreements. The problem is

76 The AsiaPac Regional Committee of IOSCO expressed strong concerns about the EU equivalence process for

CCP recognition , which is seen to be too one-sided (Letter of 22 November 2013 to the European

Commission) 77 To date, ISDA has published two EMIR Protocols: the NFC Representation Protocol and the Portfolio

Reconciliation, Dispute Resolution and Disclosure Protocol. We can add the Reporting Protocol which covers

EMIR and any other OTC Regulation. 78 Although ISDA has stated that some of the Protocols (Not the NFC Representation Protocol) are contract

agnostic, it is unlikely that a large number of counterparties not being under an ISDA will adhere to these

Protocols

14 Frédéric De Brouwer

that the amendment requests which are tabled are partial, i.e. they are handling one EMIR

topic at a time, meaning that further amendments of the master agreements will probably

be necessary. This is not an optimal way of proceeding. In view of the number of

counterparties and contracts at stake, some form of contract standardization seems to be

the only solution. ISDA Protocols will help but are definitely not sufficient. Other

contract templates such as the LCH Swapclear Execution Standard Terms for Client

Clearing79

and the ISDA-FOA Client Cleared OTC derivatives Addendum80

(for those

counterparties who offer client clearing services to their clients) may be useful as well.

In-house lawyers have a very important role to play in this process. Here more than being

pure legal advisers, they must demonstrate project management as well as innovation

abilities.

VIII. Conclusion

Like Dodd-Frank in the US, EMIR will radically change the derivatives business model.

It is too soon to predict the precise impact of these changes. One of the consequences of

EMIR could be to drive a significant portion of derivatives to market standardization.

Future will tell.

In such a landmark reform, in-house lawyers have a crucial role to play. Beyond their

traditional advising role, they are requested to demonstrate project management skills and

propose innovative solutions. Beyond, they are invited to help develop new business

solutions in the context of a totally new regulatory environment.

***

Frédéric de Brouwer has been in Bank Regulatory Affairs for almost 15 years . Before

joining SocGen in 2005 , he was Legal Counsel of the European Banking Federation, the

organization representing banks in Brussels. He spent 4 years as Head of European

Regulatory Affairs in SocGen and then became Head of Legal & Compliance in Tokyo

and Deputy General Counsel Asia. He is now back in Paris and is the Lead Lawyer for

the EMIR Project.

Société Générale Group serves 22.5 million customers in France and worldwide. In

France, the bank operates two complementary distribution networks, namely Société

Générale and Crédit du Nord. Beyond France, its retail banking arm is present in 30

countries . Société Générale has a strong corporate & investment banking arm. It is one

of the major European financial groups.

79 www.lchclearnet.com 80 www.isda.org