EMIR 2.1 July 2018 EXECUTIVE SUMMARY

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1 EMIR 2.1 July 2018 After almost a year of discussion, on 12 June 2018 the European Parliament approved a revised proposal put forward by the European Commission to amend the terms of EMIR 1. The revised proposal, aimed at reducing costs and simplifying certain rules under EMIR, is likely to mean at least some good news for most market participants, although others may be disappointed that the proposal did not go further. EXECUTIVE SUMMARY EMIR 2.1, as it has become known, is the first of two proposals to amend EMIR put forward by the European Commission in 2017 as part of the Commission's Regulatory Fitness and Performance programme. EMIR 2.1 is intended to reduce certain of the burdens and costs associated with complying with the requirements of EMIR. EMIR 2.2, a separate amendment not covered in this note, deals with amendments to the way in which central counterparties are supervised under EMIR. On 11 June 2018, EMIR 2.1 was debated in plenary by the European Parliament which voted the next day to adopt the proposed regulation. The next stage of the legislative procedure will see EMIR 2.1 debated in trilogue between the European Parliament, the Council and the Commission, with discussions planned to start in July Most entities will welcome that the mandatory exchange of collateral as variation margin in respect of physicallysettled foreign exchange rate (FX) forwards and physically-settled FX swaps, will only apply to transactions between the most systemically important counterparties (such as banks and investment firms). This formally brings the variation margin requirements of EMIR in respect of these transactions in line with their treatment in other major jurisdictions, such as the US. Managers of alternative investment funds will need to assess whether the broadening of the definition of financial counterparty (to include all alternative investment funds (AIFs) established in the European Economic Area (EEA) will result in funds managed by them becoming subject to the EMIR clearing and margining requirements where they were not before. Pension schemes will not be required to clear their over-the-counter (OTC) derivatives transactions for at least a further two years. However, they should note that the European Parliament has made clear that the extension of the exemption for pension schemes from complying with the clearing obligation will not be permanent. A best efforts obligation will be imposed on industry stakeholders to find a workable solution to the difficulties that pension schemes face in centrally clearing OTC derivatives transactions. These difficulties stem from pension schemes' limited holdings of cash and the high cost, and risk of inefficiencies, resulting from converting assets into cash for use as collateral. As we near the end of the legislative process, this note tracks the changes to the initial proposals summarised in our EMIR 1.5 note (the "July 2017 Note"), which can be viewed here, and considers the implications entities will face when EMIR 2.1 comes into effect. 1 The European Market Infrastructure Regulation on OTC derivative transactions, central counterparties and trade repositories (Regulation EU 648/2012).

2 BROADENING OF THE DEFINITION OF FINANCIAL COUNTERPARTY PROPOSAL The definition of financial counterparty (FC) in Article 2(8) of EMIR includes AIFs if they are managed by an alternative investment fund manager (AIFM) authorised or registered under the Alternative Investment Fund Managers Directive (AIFMD) 2. In practice this currently means only AIFs managed by AIFMs established in the EEA. The definition of FCs in Article 2(8) of EMIR will be broadened to include: (i) AIFs established in the EEA 3 in their own right, as well as (ii) AIFs managed by an EEA AIFM, except if that AIF is related to an employee share purchase plan. AIFs At the time of our July 2017 Note, it was anticipated that the definition of FC would be broadened to include all AIFs (whether managed by an AIFM established in the EEA or not). The scope of this amendment has since been narrowed in order to prevent any purported extra-territorial reach whereby third-country AIFs would be caught within the scope of EMIR and potentially subjected to conflicting legal requirements. The revised proposal has the effect of broadening the definition of FC to include all AIFs which are established in the EEA in their own right, whether or not they are managed by an AIFM authorised or registered under AIFMD. There is a highly specific carve-out for AIFs related to an employee share purchase plan. Currently, EEA AIFs that are not managed by an AIFM authorised and registered under AIFMD are categorised as non-financial counterparties (NFCs). This means, provided that they remain below the clearing thresholds (summarised in our July 2017 Note), that they are not required to exchange collateral as margin or mandatorily to clear any OTC derivatives transactions. Under the new regime, EEA AIFs will be re-classified as FCs, and (subject to the other changes in relation to "small financial counterparties" described below) will be required to comply with more onerous obligations under EMIR. Please refer to our July 2017 Note for further detail on the implications of a re-categorisation from NFC to FC. SSPEs Previously, it was anticipated that the definition of FC would be amended to include securitisation special purpose vehicles (SSPEs). This has been dropped following industry concerns that it would lead to a significant increase in costs and additional operational issues for SSPEs. The effect of the latest proposal is that SSPEs will remain in the category of NFCs as recognised in the EU Securitisation Regulation 4. This reflects the fact that SSPEs neither carry the risks nor have the same financial and operational capacities as financial institutions. CARVE-OUT FROM THE VARIATION MARGIN REQUIREMENTS FOR PHYSICALLY-SETTLED FX FORWARDS AND SWAPS Currently, FCs, NFCs above a clearing threshold (NFC+s) and third country entities (TCEs) that would be an FC or an NFC+ if established in the EEA, when facing an FC or an NFC+ counterparty, are required to exchange collateral as variation margin in respect The mandatory exchange of collateral as variation margin in respect of physically-settled FX forwards and physically-settled FX swaps will only apply to transactions between credit institutions and 2 Directive 2011/61/EU of the European Parliament and of the Council of 8 June EMIR was incorporated into the EEA Agreement in As such, all references to "Union" in EMIR should be read as references to the "EEA" (being all EU member states plus Iceland, Norway and Liechtenstein). On this basis, we have interpreted references to "Union" in the amending regulation as intending, in due course, to be references to the "EEA". However, application of EMIR 2.1 in the non-eu EEA states will ultimately depend on its incorporation into the EEA Agreement. 4 Regulation (EU) 2017/2402 of the European Parliament and of the Council of 12 December

3 of physically-settled FX forwards and swaps. However, a period of regulatory forbearance from the FCA has meant, in practice, that this requirement has not been enforced in the UK in relation to forwards (however the terms of the forbearance did not expressly extend to swaps) and no penalties have arisen for non-compliance. investment firms (these being perceived to be the most systemically important counterparties). On 3 January 2018, physically-settled FX forwards and swaps were intended to come within scope of the variation margin requirements. Following intense industry pressure, and in anticipation of such transactions being carved out of those requirements under EMIR 2.1, the European Supervisory Authorities (ESAs) advocated a period of regulatory forbearance in relation to funds (however the terms of the forbearance did not expressly extend to swaps) to avoid market disruption. The developments in EMIR 2.1 bring the variation margin requirements for physically-settled FX forwards and swaps in line with the treatment of such transactions in other jurisdictions (including the USA, Japan, Canada, Singapore, Australia and Hong Kong). This harmonisation of the rules across jurisdictions is intended to ensure a level playing field in the foreign exchange market. We expect that this will be welcomed by FCs and NFC+s that have historically traded physically-settled FX forwards and swaps on an uncollateralised basis and will be able to continue to do so. NEW CATEGORY OF "SMALL FINANCIAL COUNTERPARTY" Currently, an NFC which exceeds one of the clearing thresholds (summarised in our July 2017 Note) will cease being an NFC below the clearing thresholds (an NFC-) and become an NFC+. NFCs are permitted to exclude risk-reducing OTC derivatives transactions when calculating the thresholds. An NFC+ is subject to the clearing and margining requirements under EMIR. There is no equivalent threshold requirement made in the categorisation of FCs. A new category of "small financial counterparty" (SFC) will be introduced. This will be calculated by reference to the existing clearing thresholds applicable to NFCs (see below for further detail on how this will be calculated). SFCs will be exempt from the clearing requirements for future OTC derivatives transactions, provided that they can demonstrate to the relevant competent authority that they fall below the threshold. The effect of this proposal will be to exempt those FCs that enter into a limited volume of OTC derivatives transactions from having to comply with the clearing requirements under EMIR. We expect this will be welcomed as a significant reduction in bureaucracy and costs for entities that qualify as SFCs. Although an interim draft of EMIR 2.1, published in January of this year, purported also to exempt SFCs from the requirement to exchange collateral as margin, ultimately this amendment was not adopted. CALCULATION OF CLEARING THRESHOLDS Currently, an NFC will become subject to the clearing and margining requirements under EMIR if the aggregate gross notional value of its outstanding, non risk-reducing OTC derivatives transactions entered into by that NFC and all other NFCs within its group, calculated on a rolling basis over a period of 30 working days, exceeds one of the clearing thresholds summarised in our July 2017 Note. The clearing thresholds currently in place for NFCs will also apply to FCs. However, The European Securities and Markets Authority (ESMA) has been given a mandate to develop two distinct sets of clearing thresholds (one for FCs and another for NFCs) taking into account the interconnectedness of FCs and their perceived greater systemic risk. 3

4 NFCs and FCs will have the option of whether or not to calculate their position on an annual basis. An NFC that elects to perform the annual calculation will only become subject to the clearing and margining requirements if the aggregate gross notional value of all outstanding, non risk-reducing OTC derivatives transactions entered into by that NFC (and all other NFCs within its group) over the previous 12 months exceeds one of the clearing thresholds. An FC that elects to perform the annual calculation will become exempt from the clearing requirement under EMIR if the aggregate gross notional value of all outstanding OTC derivatives transactions (regardless of whether they are risk-reducing transactions) entered into by that FC and all other entities within its group over the previous 12 months falls below one of the clearing thresholds. NFCs and FCs that elect not to perform the annual calculation will be deemed to have exceeded the clearing threshold (see below for details on the impact of exceeding the clearing threshold). The discretionary nature of the calculation is likely to be welcomed by large FCs and NFC+s that are already subject to the obligation to clear OTC derivatives transactions to which a mandatory clearing obligation applies. These entities will be relieved of the burden of having to perform this unnecessary calculation when they know that they will be above the threshold. Under EMIR 2.1, FCs and NFCs that elect to perform the calculation will be required to aggregate, and then take an average of, their month-end figures for each month in the year immediately preceding the calculation rather than focussing on the months of March, April and May. This will have the effect of reducing the monitoring burden for NFCs that are close to the clearing threshold, as the calculation will only need to be performed once a year. Both FCs and NFCs should be prepared for there to be further changes as ESMA seeks to put in place distinct clearing thresholds. This could see the clearing thresholds for FCs revised downwards, meaning that certain FCs that would otherwise be re-categorised as SFCs may not fall below a revised threshold in future. IMPACT OF EXCEEDING CLEARING THRESHOLDS Currently, the effect of an NFC exceeding any one of the relevant clearing thresholds (which only apply to NFCs), is that it will become an NFC+ and therefore be subject to the clearing and margining requirements for future OTC derivatives transactions for all asset classes to which a mandatory clearing and margining obligation applies, even if no other threshold is exceeded. NFCs Where an NFC performs the calculation and is deemed to have exceeded one of the relevant thresholds, it will become subject to the clearing obligation, for future OTC derivative transactions to which a mandatory clearing obligation applies only in respect of the asset class for which the clearing threshold has been exceeded. Where an NFC elects not to perform the calculation, it will be deemed to have exceeded the clearing thresholds and will be subject to the clearing and obligation for future OTC derivatives transactions to which a mandatory clearing obligation applies for all asset classes. In each case, where an NFC exceeds a clearing threshold in respect of an asset class, it will also become subject to the requirement to exchange 4

5 NFCs FCs collateral as variation margin in respect of that particular asset class. Where an FC either elects not to perform the calculation or performs the calculation and is deemed to have exceeded any one of the thresholds, this will trigger the clearing obligation for future OTC derivatives transactions to which a mandatory clearing obligation applies for all asset classes. Where an FC that was previously exempt from the clearing obligation as an SFC performs the calculation and is deemed to have exceeded any one of the thresholds, it will be required to clear its OTC derivatives transactions to which a mandatory clearing obligation applies within four months of becoming subject to that clearing obligation. Under the current regime, an NFC- that is confident that it will not exceed any of the current clearing thresholds may be comfortable that it does not need to calculate or report its position on an annual basis. However, under EMIR 2.1, an NFC- that fails to calculate its position in relation to any clearing threshold will be deemed to have exceeded all of the clearing thresholds. There is, therefore, an increased administrative burden on NFCs generally to monitor their use of OTC derivatives transactions. Currently it is unclear whether, how and to whom NFCs that are below some or all of the clearing thresholds should report (to avoid being deemed not to have performed the calculation and therefore becoming an NFC+ in respect of all asset classes). FCs The proposal for FCs that were previously exempt from the clearing obligation to clear all OTC derivatives transactions to which a mandatory clearing obligation applies within four months of becoming subject to the clearing obligation may mean that SFCs whose use of OTC derivatives transactions is close to the clearing threshold will need to put in place and maintain procedures to ensure that they will be able to clear OTC derivatives transactions in short order, thus negating some of the benefits of the exemption. EXTENSION OF TEMPORARY CLEARING EXEMPTION FOR PENSION SCHEME ARRANGEMENTS Under Article 89 of EMIR, pension scheme arrangements (PSAs) benefit from a temporary exemption from the clearing requirements under EMIR. This exemption is due to expire on 16 August For PSAs deemed to be "Large PSAs", the temporary exemption from the clearing obligation will be extended for a further two years. For the remaining PSAs, termed "Small PSAs", who are perceived not to present the same systemic risks as larger PSAs, the temporary exemption from the clearing obligation will be extended for a further three years. With effect from when the relevant extension (two or three years, as applicable) expires, the European Commission will, either: (i) extend the exemption by one year (in the case of "Large PSAs") or two years (in the case of "Small PSAs") if it considers that a viable solution has been agreed on by industry stakeholders but that additional time is needed for the implementation of that solution; (ii) allow the exemption to lapse whilst encouraging industry stakeholders to implement a solution 5

6 beforehand, if it considers that a viable solution has been found; or (iii) submit its own proposal for a solution if it considers that no other solution has been found. The European Commission has been charged with adopting a delegated act setting out which PSAs can be considered "Small PSAs", taking into account that pension schemes falling within the category of "Small PSAs" should not represent more than 5% of the OTC derivative transactions entered into by all PSAs. It is expected that the volume of OTC derivatives transactions entered into by PSAs falling within the new category of "Small PSAs" will not exceed the clearing thresholds, as a result of which most "Small PSAs" will continue to be exempt from the clearing obligation even after the exemption lapses. Given that the precise scope of the new category of "Small PSAs" remains unclear, PSAs may choose to proceed on the basis that they will need to put in place procedures to facilitate clearing by the end of the two (or three) year extension. For the remaining PSAs, the effect of the revised proposal is to reduce the "3 + 2" year exemption (proposed in an interim draft of EMIR 2.1) to a "2 + 1" year exemption. Although the extension is likely to be welcomed by PSAs, the revised proposal makes clear that the extension will not be permanent and places pressure on PSAs and other industry stakeholders to put in place the necessary arrangements to facilitate clearing. TEMPORARY/TECHNICAL BREAK IN THE EXEMPTION FOR PSAs EMIR 2.1 attempts to address the temporary/technical break in the exemption period identified in the July 2017 Note by stating that the exemption will apply retroactively from 16 August 2018, being the date of expiry of the current exemption. However, this would still leave a period of uncertainty between expiry of the current exemption and entry into force of the new retroactive exemption where PSAs are technically in scope for clearing. On 3 July 2018, ESMA released a statement acknowledging this issue and recommending a period of regulatory forbearance to bridge this gap. The Financial Conduct Authority (FCA) has endorsed ESMA's proposal and has issued a statement that it will not require PSAs to start preparing for clearing during the gap between expiry of the current exemption and the new exemption coming into effect. END TO THE FRONTLOADING REQUIREMENT FOR CLEARING Article 4(1)(b)(ii) of EMIR currently requires the largest FCs with the highest level of OTC derivatives trading activity to clear certain OTC derivatives transactions entered into before the clearing obligation under EMIR comes into effect (where the relevant OTC derivatives transaction has a prescribed minimum remaining maturity). No changes since our July 2017 Note namely it is proposed that this requirement be removed from EMIR. Please refer to the comments in our July 2017 Note. On the whole we expect this development to be welcomed, not least for the potential cost savings and reduced administrative burden. UPDATE TO REPORTING REQUIREMENTS EMIR requires all parties and central counterparties (CCPs) to report details of concluded, modified or terminated OTC derivatives transactions to a trade repository (TR). The obligation applies to both counterparties (i.e. two-sided reporting, rather than the single-sided reporting found under other regimes, such as Dodd-Frank in the US). Many small (principally buy-side) counterparties delegate reporting of their OTC derivatives transactions to their larger (principally sell-side) In general, the proposals to amend reporting obligations under EMIR have not changed substantially from those described in our July 2017 Note. One significant change is that an NFC- transacting with a TCE that would be an FC if it was established in the EEA will no longer be legally liable for reporting where: (i) the TCE is in a jurisdiction with a legal regime that would require equivalent reporting; or (ii) the TCE chooses to be subject to the EMIR 6

7 counterparty. However, it is not possible for a smaller counterparty to absolve itself of the legal liability to report (or for the content of any report submitted on its behalf). The alternative is to establish direct membership of a TR, with the associated costs and administrative burdens. reporting requirements as if it was an FC. In the latter case, the TCE must register with ESMA. There has also been clarificatory language inserted on the following points: 1. In respect of transactions between FCs and NFC-s, the new language clarifies that the FC will be solely liable for reporting, and must report a single data set. However, NFC-s will be obliged to provide to the FC, and be legally liable for, any details that the FC cannot reasonably be expected to possess. NFC-s may choose to take on the reporting obligations themselves, in which case they should inform the FC and will remain liable. 2. For exchange traded derivative (ETD) transactions, the CCP should report to the TR specified by their counterparty, and clearing members and their clients should be able to choose where to report their ETD transactions. 3. All intragroup transactions involving an NFC will be exempt, regardless of the NFC's place of establishment. In addition to the implications described in our July 2017 Note, the new provision shifting responsibility for reporting to TCEs in the circumstances set out above should reduce the burden on NFC-s when facing such entities. Separately, the European Commission has been charged with proposing future changes to the reporting requirements for ETD transactions in response to industry concerns that the requirement to report these transactions imposes a significant burden on counterparties. We expect that these changes will be welcomed by entities as effectively reducing the cost and administrative burden associated with reporting the high volume of ETD transactions conducted on a daily basis. END TO THE BACKLOADING REQUIREMENT FOR REPORTING EMIR requires 'backloading' the reporting of details of historic derivatives transactions. No changes since our July 2017 Note namely it is proposed that this requirement be removed from EMIR. Please refer to the comments in our July 2017 Note. On the whole we expect this development to be welcomed, not least for the potential cost savings and reduced administrative burden. 7

8 HOW WE CAN HELP If your business is likely to be affected by EMIR 2.1, or you wish to discuss any of the issues raised in this note, please contact one of the Derivatives and Structured Products team, or your usual Travers Smith contact. 10 Snow Hill, London EC1A 2AL T: +44 (0) F: +44 (0) Peter Hughes Partner E: T: +44 (0) Jonathan Gilmour Partner E: T: +44 (0) Vanessa Kalijnikoff Battaglia Senior Associate E: T: +44 (0) Joseph Wren Senior Associate Cindy Smith Senior Associate E: T: +44 (0) E: T: +44 (0) The information in this document is intended to be of a general nature and is not a substitute for detailed legal advice. Travers Smith LLP is a limited liability partnership registered in England and Wales under number OC and is authorised and regulated by the Solicitors Regulation Authority. The word "partner" is used to refer to a member of Travers Smith LLP. A list of the members of Travers Smith LLP is open to inspection at our registered office and principal place of business: 10 Snow Hill London EC1A 2AL. Travers Smith LLP also operates a branch in Paris.