Page 1 Regulatory Briefing EMIR a refresher for investment managers: are you ready for 12 February 2014? February 2014 With effect from 12 February 2014, the trade reporting obligations in the European Market Infrastructure Regulation (EMIR) go live. 1 From that date, all counterparties need to report details of any derivative contract (OTC or exchangetraded) they have concluded (modified or terminated) to a recognised trade repository under the EMIR reporting requirements. This Briefing revisits the impact of EMIR on the asset management industry and considers what investment management agreements should look like to adequately address the reporting obligations that the legislation brings. A. An overview of EMIR a refresher EMIR was designed as a response to the risks arising from opacity in the trading of derivatives that was exposed by the 2008/2009 financial crisis. Similar legislation has been passed across the world. In the US for example, Title VII of the Dodd-Frank Act includes comparable requirements. EMIR introduced a mandatory clearing obligation in respect of certain OTC derivative contracts, reporting and risk management requirements for derivative contracts and uniform requirements for the performance of activities of central counterparties (CCPs) and trade repositories. 2 EMIR aims to ensure that information on all European derivative transactions will be reported to trade repositories and be accessible to supervisory authorities, including the European Securities and Markets Authority (ESMA). The European Commissioner for Internal Markets and Services, Michel Barnier, heralded EMIR as ensuring that the 'era of opacity and shady deals is over'. 3 EMIR aims to secure an efficient and safe derivatives market by reducing counterparty and operational risk through increasing transparency. EMIR applies (see Article 2(5)) to all derivative contracts identified in Annex 1 Section C (4) to (10) of MiFID. The list includes most options, futures and swaps on interest rates, securities and commodity derivatives if cash settled or traded on a regulated market or multilateral trading facility (MTF). EMIR entered into force on 16 August 2012 but since technical standards needed to be drafted by ESMA following that date, many of the provisions only become law in 2014. 4 EMIR applies to counterparties to derivative trades, CCPs and trade repositories. B. The substance of EMIR The obligations imposed by EMIR are tailored by reference to whether a counterparty is a financial counterparty or a non-financial counterparty (an NFC). In the case of an NFC the amount of derivative trading it carries out is key. 1 See the EU regulation 6 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories at: http://eur-lex.europa.eu/lexuriserv/lexuriserv.do?uri=celex:32012r0648:en:not 2 Article 9. 3 http://europa.eu/rapid/press-release_memo-12-90_en.htm?locale=en. 4 See the FCA timetable at http://www.fca.org.uk/firms/markets/international-markets/emir.
Page 2 (1) Financial Counterparty A financial counterparty is broadly defined in Article 2(8) of EMIR and includes: (1) credit institutions; (2) insurance, assurance and reinsurance undertakings; (3) occupational pension funds; (4) alternative investment funds managed by an AIFM authorised or registered in accordance with AIFMD (Directive 2011/61/EU); (5) investment firms, as defined in the Markets in Financial Instruments Directive (MiFID); and (6) UCITS funds. The central clearing obligation, the risk mitigation techniques for uncleared trades and the reporting requirements apply to financial counterparties. (2) Non-financial counterparties (NFCs) An NFC is defined in Article 2(9) of EMIR as an undertaking established in the EEA, other than a CCP or a financial counterparty. NFCs are divided into two groups: (1) counterparties whose trading exceeds the EMIR clearing threshold (often referred to as NFC+s); and (2) counterparties whose trading falls below the clearing threshold. This distinction is used to determine whether the clearing obligation will apply to the counterparty and also to what extent the risk mitigation techniques will apply. The reporting requirement (see below) applies to contracts entered into by all NFCs irrespective of the level of derivative trading they carry out. (3) The central clearing obligation EMIR imposes a mandatory central clearing obligation on certain classes of standardised OTC derivative trades (at Article 4). 5 OTC derivative contracts falling within the scope of the clearing obligation must be cleared through an authorised EEA CCP or in a third-country CCP recognised as 'equivalent'. Since CCPs have strict prudential and risk management requirements under EMIR (including capital requirements, margin requirements, liquidity risk controls and default fund requirements), the hope is that swapping an original counterparty with a CCP will result in a lower counterparty risk and consequently present less risk to the stability of the financial system. The clearing obligation only applies to NFCs if their derivative trading exceeds a clearing threshold (in effect a material volume of trades). Once the threshold is exceeded the EMIR requirements will apply to these NFC+s in the same way as they apply to financial counterparties under EMIR. The following clearing thresholds apply (as per the ESMA Guidelines 6 ) to a party s rolling average position over 30 working days (excluding hedging transactions): 1 billion in gross notional value for OTC credit derivatives; 1 billion in gross notional value for OTC equity derivatives; 3 billion in gross notional value for OTC interest rate derivatives; 3 billion in gross notional value for OTC foreign exchange derivatives; and 3 billion in gross notional value for commodity derivatives and other OTC derivatives not listed above. Not all OTC contracts count towards the clearing threshold so it is important to refer to the ESMA technical standards. Significantly, subject to limited exemptions, once the threshold is passed by a group all companies in the group become subject to the clearing requirement. 7 EMIR applies to OTC derivative transactions carried on outside the EU between third-country counterparties in two situations: (1) where a non-eu transaction has a 'direct, substantial and foreseeable effect' in the EU; and (2) where it 5 An OTC derivative is defined in Article 2(7) of EMIR as a derivative contract, the execution of which does not take place on a regulated market within the meaning of Article 4 (1) (14) of MiFID or on a third country market considered as equivalent to a regulated market in accordance with Article 19(6) of MiFID. OTC derivative contracts are eligible for clearing where they meet pre-defined eligibility criteria set by ESMA by reference to their standardisation and liquidity. 6 http://www.esma.europa.eu/system/files/emir_for_non-financials.pdf. 7 The significant implications for groups and the relevant exemptions (see Articles 4(2) and Articles 11(5) to (11)) are not considered here.
Page 3 is necessary or appropriate to prevent the evasion of EMIR. ESMA has published 'Final Guidance' as to how it considers that this will work in practice. An important element of the extra-territorial application of EMIR relates to the EU's assessment (through ESMA) as to 'equivalent' third countries. ESMA will deem a third-country regime 'equivalent' where the legal provisions and the level of supervision and enforcement applied to derivative contracts is similar to that in the EU. 8 (4) Risk mitigation techniques A key part of EMIR is the risk mitigation requirements that apply to all counterparties to some degree. 9 To mitigate the risks inherent in uncleared trades, financial and NFCs entering into OTC derivative contracts must ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational and counterparty credit risk including at least: (a) the timely confirmation (where available by electronic means) of the terms of the relevant OTC derivative contract; and (b) formalised processes which are 'robust, resilient and auditable' in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them and to monitor the value of outstanding contracts. 10 (5) The Reporting Obligation Significantly for the asset management industry, with effect from 12 February 2014 EMIR provides that all counterparties established in the EU must report to a recognised trade repository details of any derivative contract that they have concluded, modified or terminated. The obligation to report applies to all derivative contracts of all asset classes which are or were outstanding on or after 16 August 2012 (the date that EMIR came in to force). The reporting obligation applies to CCPs as well as counterparties, irrespective of whether the contracts are traded on or off-exchange. The reporting obligation extends to intra-group derivatives including those between an EEA company and a group company outside the EEA. 11 While counterparties and CCPs are permitted to delegate the reporting obligation, they nevertheless retain primary legal responsibility for compliance with EMIR. They will as a result remain liable for any failure to report or misreporting. 12 February 2014 is the key date when the reporting obligations commence. The table below illustrates when the other trade reporting requirements bite. Derivative contract Entered into on or after 12 February 2014 (the reporting start date) Contracts that were outstanding on 16 August 2012 and are still outstanding on 12 February 2014. Contracts entered into (a) before 16 August 2012 and which were still outstanding on 16 August 2012 and (a) on or after 16 August 2012, which are not outstanding on 12 February 2014 Contracts that were entered into before 16 August 2012, but were no longer outstanding on or before that date. Reporting deadline Within one business day of the date that they are executed (Article 9 of EMIR and Articles 2 and 5(1) and (2) of the implementing regulation) On or before 13 May 2014. On or before 12 February 2017. Not subject to the reporting requirement. 8 See the relevant ESMA Guidance at http://www.esma.europa.eu/news/esma-delivers-second-set-advice-emir-equivalence. 9 The more significant requirements apply to financial counterparties and NFC+s under Article 10 of EMIR. 10 See Articles 10 and 11 of EMIR. Additional requirements are imposed on financial counterparties and NFC+s. 11 The rules relating to intragroup clearing and the clearing threshold are significant but not considered here in detail.
Page 4 C. EMIR for asset managers The obligations in EMIR bite regardless of whether a fund is party to a derivative contract directly or through an investment manager. The definition of financial counterparties captures EU-authorised entities including UCITS and AIFs. Those that fall outside these categories will still be caught where they engage in material volumes of OTC trading and cannot take the benefit of any exemptions (available in the case of hedging contracts 12, pension scheme arrangements until 15 August 2015 and intra-group transactions). Asset managers should carefully monitor the volume of their trades with the more onerous EMIR requirements in mind. Asset managers that are subject to mandatory clearing will be obliged (by Article 4 (3)) to either: (1) become a clearing member of a CCP (Article 2 (14); (2) become a client of an entity which is a clearing member (Article 2 (15)); or (3) become an indirect client (Article 4(3)). Cleared business gives rise to different documentation, risk management, reporting and cost considerations than OTC transactions. In a Q&A released in August 2013, ESMA provided some clarification for investment funds. 13 The Guidance explains that the party to the derivative transaction is generally the fund. When a fund manager executes a transaction for different funds at the same time (e.g. a block trade), it should immediately allocate the relevant part of that transaction to the relevant funds and report accordingly. In rare circumstances where the fund manager executes trades on its own account and not on behalf of the funds it manages, the counterparty would be the fund manager. Where the counterparty to a derivatives transaction is a fund (i) when the regulation refers to a number of trades or to a threshold, this should be assessed at the level of the fund (or in the case of an umbrella fund at the level of the subfund) and not at the level of the fund manager; and (ii) when a management company provides the service of portfolio management (as defined in Article 4 (9) of MiFID), and in doing so enters into a derivative contract, the client should be considered the counterparty to the derivative contract. D. ISDA The International Swaps and Derivatives Association Inc (ISDA) has prepared a set of protocols/documentation that aim to enable market participants to identify what they need to do to meet the requirements of EMIR. In particular to agree procedures to cover portfolio reconciliation and to meet the EMIR reporting requirements without breaching any pre-existing confidentiality obligations. These include: (i) the EMIR Counterparty Classification Tool offered by ISDA which is free to buy side firms and provides an online system enabling businesses to classify themselves according to the EMIR taxonomy by answering a series of questions; 14 (ii) the EMIR NFC Representation Protocol which aims to assist market participants identify the increased 'know your customer' requirements and meet them; (iii) the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol which sets out a procedure for portfolio reconciliation and for resolving differences/disputes; and (iv) the ISDA 2013 Reporting Protocol. 15 ISDA has also published a 'Reporting Guidance Note' (on 19 July 2013) provides guidance for asset managers. 16 E. How to fulfil the reporting obligation The obligation under EMIR is for both counterparties to a derivative contract to report each trade unless by prior arrangement one party can report on behalf of both counterparties. Where one report is made on behalf of both counterparties, the report should indicate this fact. The EMIR technical standards set out what information shall be submitted in relation to each of the counterparties and what information shall be submitted only once. As we mentioned previously, either counterparty to the trade may delegate reporting to a third-party (such as a central counterparty or trading platform) but legal responsibility for compliance with EMIR remains with the principal. 12 Hedging contracts are not specifically referred to in EMIR. The Regulation refers instead to contracts which are objectively measurable as reducing risks related to commercial activity or the treasury financing activity of the NFC or of that group (EMIR Article 10.3). Criteria to determine those contracts are specified in Technical Standards drafted by ESMA available at http://www.esma.europa.eu/system/files/2012-600_0.pdf 13 See http://www.esma.europa.eu/system/files/2013-1633_qa_iv_on_emir_implementation_0.pdf. 14 http://www2.isda.org/emir/; 15 At http://assets.isda.org/media/a07640b6-7/d77cbab1.pdf. 16 See http://www2.isda.org/functional-areas/protocol-management/faq/14 and http://www2.isda.org/functional-areas/protocol-management/faq/14.
Page 5 The FCA's website provides information on aspects of EMIR. The website includes access to a web portal through which counterparties can make a number of notifications required under EMIR. F. Concluding remarks To recap, the main obligations under EMIR are: central clearing for certain classes of OTC derivatives; the application of risk mitigation techniques for non-centrally cleared OTC derivatives; reporting to trade repositories; organisational, conduct of business and prudential requirements for CCPs; requirements for trade repositories, including the duty to make certain data available to the public and relevant authorities. The need for the timely confirmation of non-cleared derivative transactions came into effect on 15 March 2013. 17 Those relating to portfolio compression, portfolio reconciliation and dispute resolution were effective from 15 September 2013. As Martin Wheatley reminded the asset management industry in his recent speech, the provisions relating to trade repository reporting start on 12 February 2014. 18 Funds and their investment managers must agree between themselves who will in practice be responsible for meeting the obligations under EMIR and they must amend their investment management agreements accordingly. Given that investment managers will be entering into the OTC contracts on behalf of their clients, they are most likely to assume responsibility for confirming the terms of trade with the counterparties. Immediate practical steps to ensure that parties to derivative contracts comply with the reporting obligations under EMIR include: (1) obtaining an LEI code as soon as possible (the global reference number that uniquely identifies every legal entity or structure that is party to a financial transaction, in any jurisdiction). 19 Counterparties should use an interim entity identifier known as a pre-lei until LEIs are available; 20 (2) ensuring that sufficient data regarding derivative contracts is captured in order to meet the reporting obligations; (3) reviewing any delegated reporting arrangements in place and securing reporting agreements/permissions where they are needed; (4) identifying gaps in any agreement that is in place or that you are offered. For example, some banks (we understand in the region of 30-40% of them) have adopted a standard form reporting delegation agreement which accepts responsibility for common data reporting but leaves counterparty reporting to the fund. Only a careful review of the documents will enable fund managers/funds to ensure that they are clear what obligations they are left with in terms of legacy reporting and reporting on-going trades; (5) counterparties who do not intend to delegate the reporting of derivatives need to enter into an agreement with a trade repository (currently six have been approved by ESMA); (6) ISDA Master Agreements should have already been updated to meet the risk mitigation obligations in EMIR. Either through an ISDA Protocol or through bilateral agreements with counterparties; and (7) administrative processes must be in place to ensure that for at least five years after a contract has been concluded or modified a record of that derivative contract is maintained (Article 9(2) EMIR). 17 The Reporting standards and timings are available on the ESMA website at http://www.esma.europa.eu/system/files/emir_for_non-financials.pdf. 18 http://www.fca.org.uk/news/looking-ahead-to-2014. 19 The London Stock Exchange is one provider of LEI codes. See http://www2.londonstockexchangegroup.com/ppc-lei?pi_ad_id=35827005417&gclid=ckgi9ydgtlwcfqghwwodqvoarg. There is, by way of example costs, an initial allocation cost of 100+vat and annual maintenance cost of 55+vat per LEI. For firms who require a bulk allocation of 10 or more Pre-LEIs there is pricing based on economies of scale. The LEI code is a unique 20-character alphanumeric code. 20 http://www.leiroc.org/publications/gls/lou_20131003_2.pdf.
Page 6 For a fund (board) risks remain. While the reporting obligations can be delegated, if it goes wrong they remain responsible. With this in mind they must be sure that any agreement by which responsibilities under EMIR are delegated comprehensively captures all of the relevant reporting dates/trades. So that they are well placed to monitor compliance with reporting obligations, in so far as possible, boards should seek a contractual commitment from their investment manager to provide copies of the relevant reports submitted in compliance with EMIR. Investment managers too need to take care that they know precisely what compliance obligations they have assumed. If you require further information on anything covered in this briefing please contact grania.baird@farrer.co.uk, louise.steinberg@farrer.co.uk or your usual contact at the firm on 020 3375 7000. This publication is a general summary of the law. circumstances. Farrer & Co LLP, February 2014 It should not replace legal advice tailored to your specific