Derivatives London Client Alert EMIR Clearing Obligation - Pension Exemption The European Commission signals its acceptance of an extension to August 2017 February 2015 For More Information please contact Vincent Keaveny Partner Structured Finance/Derivatives +44-(0)20-7919- 1818 Vincent.Keaveny@bakermckenzie.com Under EMIR, OTC derivatives that are standardised will be subject to a mandatory central clearing obligation and must be cleared through central counterparties ("CCPs") (the "Clearing Obligation"). Certain highly liquid interest rate swaps will be the first OTC derivatives to become subject to the Clearing Obligation. The final requirements of the interest rate swap Clearing Obligation will be known by the start of August 2015. There will then be a phase-in period varying from 6 months to 3 years depending upon the categories of the counterparties to the transaction. Under EMIR "pension schemes arrangements" ("PSAs" see Glossary below) were granted transitional relief from the clearing obligation for three years with the possibility of being extended for a further year for trades that are objectively measurable as reducing investment risks directly relating to the financial solvency of the scheme. Such transitional relief is due to expire on 16th August 2015. In a draft report 1 published on 2nd February the European Commission recommended the extension of this transitional exemption for a further two years, until August 2017, as well as signaling its intention to continue to monitor the situation to assess whether such period should be extended by a further one year, to the final deadline of August 2018. At this stage the report is only in draft form however it is likely that the recommendation will be adopted by ESMA. Background Farid Anvari Of Counsel Structured Finance/Derivatives +44 207 919 1564 Farid.anvari@bakermckenzie.com EMIR came into force on 16th August 2012 however many of the key obligations require further detailed requirements, so-called Level 2 rules, to be implemented to flesh out the obligations themselves. As mentioned, certain highly liquid interest rate swaps will be the first OTC derivatives to become subject to the Clearing Obligation. A clearing obligation for certain highly liquid 1 Available at http://ec.europa.eu/finance/financial-markets/derivatives/index_en.htm#150203 1
credit default swaps will follow shortly thereafter. The Clearing Obligation, imposes an obligation on counterparties within scope of EMIR to clear certain OTC derivative contracts through a CCP. One of the key ways in which CCPs are designed to withstand the default of a clearing member or client is the exchange of collateral or "margin". Accordingly any transaction subject to the Clearing Obligation will be subject to such collateralisation requirements. CCPs only accept highly liquid assets as margin, generally this is cash. This is in contrast to the position in a bilateral relationships where pension schemes are able to post non-cash assets to their derivative counterparties. Pension scheme arrangements generally minimise their cash position in favour of higher yielding assets. Mindful of the negative impact on pensioners of imposing this additional cost of clearing on pension funds EMIR provided the transitional exemption from the clearing obligation until 12th August 2015. This period was to enable CCPs to develop alternative technical solutions for the transfer by PSAs of non-cash collateral as margin. Whilst work has been undertaken at a number of CCPs as yet no technical solution has yet been finalised. This is the reason given in the report for its recommendation that the transitional exemption be extended a further two years to August 2017. The technical solution that is mentioned in the report as being the furthest progressed is a potential PSA repo service being developed by one CCP. The cleared repo service would enable the PSA to transform existing non-cash assets into cash to meet CCP margin requirement whilst retaining investment returns of the assets long term. The repo would be cleared through the CCP moving the PSA's credit risk to the CCP. Other technical solutions being considered by CCPs include: collateral transformation by CCPs, direct acceptance by CCPs of non-cash assets with pass through to receivers of variation margin ("VM"); acceptance of non-cash assets with a security interest passed through to the receivers of VM; quad-party collateral for VM security interest; collateral transformation by the clearing members; agency stock lending and secured lending by no-financial entities. Each of these other alternatives has drawbacks flagged in the report. In addition the report questions whether the repo market can ever be sufficiently liquid to withstand the needs of the EU PSAs in stressed scenarios given the result of its study showing that the aggregate VM call for a 100 basis point move would be 204-255 billion euros for EU PSAs alone. The report concludes that, with the exception of the PSA repo service, no sufficient progress has been made by CCPs in developing technical solutions for the transfer of non-cash collateral as VM. Accordingly it goes on to recommend the extension. Conclusion The extension to the pension fund exemption to the Clearing 2
Obligation is welcome news to all PSAs however it does not mean that PSAs can afford to delay consideration of the impact of collateralisation of their derivatives contracts. However, there is some concern from banks which provide clearing services that they will not be required to provide clearing services for PSAs for an extended period despite having incurred the cost of building EMIR-compliant clearing platforms. PSAs are still required to comply with the other aspects of EMIR in particular the risk mitigation and reporting obligations. The risk mitigation obligations include a requirement on financial counterparties 2, and non-financial counterparties 3 belonging to a group with significant OTC derivatives trading, to have risk management procedures that require the exchange of collateral. The Level 2 rules on margining of non-cleared derivatives transaction are in the process of being finalised 4. At present the implementation date for such rules is December 2015 although this implementation timetable is being hotly contested by market participants. PSAs will need to wait for the final rules on margin for noncleared derivatives, expected shortly, to be able to make a final assessment of the cost differential between trading derivatives on a cleared versus non-cleared basis. Glossary Definition of "pension scheme arrangement" under EMIR a) institutions for occupational retirement provision within the meaning of Article 6(a) of Directive 2003/41/EC, including any authorised entity responsible for managing such an institution and acting on its behalf as referred to in Article 2(1) of that Directive as well as any legal entity set up for the purpose of investment of such institutions, acting solely and exclusively in their interest; b) occupational retirement provision businesses of institutions referred to in Article 3 of Directive 2003/41/EC; c) occupational retirement provision businesses of life insurance undertakings covered by Directive 2002/83/EC, provided that all assets and liabilities corresponding to the business are ring-fenced, managed and organised separately from the other activities of the insurance undertaking, without any possibility of transfer; d) any other authorised and supervised entities, or arrangements, 2 A financial counterparty means an investment firm authorised in accordance with Directive 2004/39/EC (MiFID); a credit institution authorised in accordance with Directive 2006/48/EC (CRD); an insurance undertaking authorised in accordance with Directive 73/239/EEC (First Non-Life Insurance Directive); an assurance undertaking authorised in accordance with Directive 2002/83/EC (Recast Life Assurance Directive); a reinsurance undertaking authorised in accordance with Directive 2005/68/EC (Reinsurance Directive); a UCITS and, where relevant, its management company, authorised in accordance with Directive 2009/65/EC (UCITS Directive); an institution for occupational retirement provision within the meaning of Article 6(a) of Directive 2003/41/EC (IORP Directive) and an alternative investment fund managed by alternative investment fund managers authorized or registered in accordance with Directive 2011/61/EU (AIFMD). 3 An NFC is an undertaking established in the European Union other than a financial counterparty or a CCP (a legal person that interposes itself between the counterparties to the contracts traded on one or more financial markets, becoming the buyer to every seller and the seller to every buyer). 4 Consultation Paper Draft regulatory technical standards on risk-mitigation techniques for OTC-derivative contracts not cleared by a CCP under Article 11(15) of Regulation (EU) No 648/2012 Available at: https://www.eba.europa.eu/documents/10180/655149/jc+cp+2014+03+%28cp+on+risk+mitigation+for+otc+derivati ves%29.pdf 3
operating on a national basis, provided that: (i) (ii) they are recognised under national law; and their primary purpose is to provide retirement benefits; Definition of "occupational retirement provision" or "institution" in Article 6(a) of Directive 2003/41/EC Means an institution, irrespective of its legal form, operating on a funded basis, established separately from any sponsoring undertaking or trade for the purpose of providing retirement benefits in the context of an occupational activity on the basis of an agreement or a contract agreed: individually or collectively between the employer(s) and the employee(s) or their respective representatives, or with self-employed persons, in compliance with the legislation of the home and host Member States, and which carries out activities directly arising therefrom; Institutions referred to in Article 3 of Directive 2003/41/EC Institutions for occupational retirement provision which also operate compulsory employment-related pension schemes which are considered to be social-security schemes covered by Regulations (EEC) No 1408/71 and (EEC) No 574/72 shall be covered by this Directive in respect of their non-compulsory occupational retirement provision business. In that case, the liabilities and the corresponding assets shall be ring-fenced and it shall not be possible to transfer them to the compulsory pension schemes which are considered as social-security schemes or vice versa. Life insurance undertakings covered by Directive 2002/83/EC "assurance undertaking" shall mean an undertaking which has received official authorisation in accordance with Article 4 Baker & McKenzie Derivatives Practice - London Baker & McKenzie is one of the world's leading international derivatives practices and we have developed a vast wealth of experience and talent around the world which we harness to provide an unparalleled global service to our clients. Our approach is to provide practical, professional and cost-effective advice. We act for a diverse client base including corporate endusers both multinational and domestic, investment and commercial banks, governmental and supranational entities, insurance companies, financial market intermediaries, funds and investors. Our wide client base gives us a unique view of all aspects of the global derivatives market. We advise on derivatives regulation, clearing and the full range of derivative products from OTC derivatives and exchange traded products to debt capital markets instruments and securitisation structures. Baker & McKenzie International is a Swiss Verein with member law firms around the world. In accordance with the common terminology used in professional service organizations, reference to a "partner" means a person who is a partner, or equivalent, in such a law firm. Similarly, reference to an "office" means an office of any such law firm. This may qualify as "Attorney Advertising" requiring notice in some jurisdictions. Prior results do not guarantee a similar outcome. Before you send e-mail to Baker & McKenzie, please be aware that your communications with us through this message will not 4
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