European Market Infrastructure Regulation

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European Markets Infrastructure Regulation (EU Regulation 648/2012 (EUR Lex)), better known as “EMIR” is the result of a final proposal published by the European Commission on 15 September 2010, to increase stability within OTC derivative markets.

What EMIR does

The Regulation introduces:

• Reporting: a reporting obligation for OTC derivatives;
• Mandatory Clearing: a clearing obligation for eligible OTC derivatives;
• Uncleared derivatives margin: measures to reduce counterparty credit risk and operational risk for bilaterally cleared OTC derivatives;
• CCP rules: common rules for central counterparties (CCPs) and for trade repositories; and
• Interoperability rules: rules on the establishment of interoperability between CCPs.

Mandatory clearing

The EU Regulation follows, and facilitates within the EU, the commitment made by G20 leaders in Pittsburgh, September 2009, that:

“All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by the end 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements. We ask the FSB and its relevant members to assess regularly implementation and whether it is sufficient to improve transparency in the derivatives markets, mitigate systemic risk, and protect against market abuse.”

On a global level, work is being undertaken by CPSS and IOSCO (the Committee on Payment and Settlement Systems and International Organisation for Securities Commissions) to update and strengthen the existing standards for CCPs, CSDs, payments systems, collectively referred to as Financial Market Infrastructures (“FMI’s”) together with the treatment of trade repositories. To date the work of the group has been progressing well, where the revised Principles were published last year for public consultation and it is anticipated that they will be finalized later this year.

Trade reporting

There is trade reporting and transaction reporting and we won’t think any less of you if you get these confused — as long as you don’t of us — and both of them are mandated by MiFID. Article 9(1) of EMIR also requires all counterparties and CCPs to report the details of derivative contracts they conclude (and modifications and terminations of those contracts) to trade repositories.

EMIR refit

At some stage the European Commission was persuaded it might have over-reached on certain aspects, and accordingly rowed back in the so-called EMIR refit. This created yet more work for the contractor-minions of old London town.

Hedging Exemption3.  In calculating the positions referred to in paragraph 1, the non-financial counterparty shall include all the OTC derivative contracts entered into by the non-financial counterparty or by other non-financial entities within the group to which the non-financial counterparty belongs, which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or of that group.

EMIR “Hedging exemption”

The question may arise as to whether an SPV is a non-financial counterparty and, if it is, whether article 10.3 of EMIR means you don’t have to engage in all that tedious measuring of notionals to ensure you stay small enough to count as an NFC-. Here’s what the hedging exemption says:

3. In calculating the positions referred to in paragraph 1, the non-financial counterparty shall include all the OTC derivative contracts entered into by the non-financial counterparty or by other non-financial entities within the group to which the non-financial counterparty belongs, which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or of that group.

Repackaging SPVs

Now this seems squarely to capture the derivative activity of a limited recourse repackaging SPV, which is entering derivatives to pass the cashflow of an asset, and receiving a cashflow to pay down a note. Even if you muff up the structuring, the “limited recourse” nature of an SPV forces a careful observer to the conclusion that an SPV who transacts derivatives in this way is “objectively measurably reducing risks directly relating it its commercial activity” — it is eliminating them in point of fact — and given the underlying security structure of such a deal (where the SPV secures its rights to the asset whose cashflow it is manufacturing in favour of the dealer to whom it is manufacturing that income stream) requiring the SPV to also post collateral as a credit mitigant makes no sense at all. There is no credit risk. The asset is the perfect delta-one hedge.

Nevertheless, this must have seemed too easy for some of the more curmudgeonly compliance professionals on the continent, and at the time of the EMIR refit the question arose as to whether this would cover SPVs (such as repackaging vehicles whose principal activity is to deal in financial instruments). The ESMA Q&A posed, on page 28, this question:

Can non-financial counterparties (NFCs) whose core activity is to buy, sell or own financial instruments, benefit from the hedging exemption when using OTC derivative contracts to hedge certain risks, for example risks arising from the potential indirect impact on the value of assets the NFC buys, sells or owns resulting from the fluctuations of interest rates, inflation rates, foreign exchange rates or credit risk?

And came forth the answer, on page 30:

Yes. The hedging exemption set out in Article 10(3) EMIR applies to all non-financial counterparties, irrespective of what their core activity is. The list of financial counterparties in Article 2(8) EMIR is a closed list. It does not allow for the treatment of non-financial counterparties as financial counterparties for certain EMIR provisions, such as Article 10(3). That provision itself does not distinguish which non-financial counterparty is allowed to use the hedging exemption depending on that counterparty’s specific activity.

AIFs

Though, trick for the young players — an AIF is a form of financial counterparty, so does not qualify for the hedging exemption.

See also

• EMIR refit
• Clearing thresholds - EMIR
• Portfolio reconciliation and dispute resolution - EMIR
• Financial counterparty
• Non-financial counterparty