The European Market Infrastructure Regulation (EMIR) entered into force on 16 August 2012 and, amongst other things, introduces (subject to the publication of regulatory technical standards (RTS) which set out the detail in respect of such requirements) the following obligations:
A Clearing Obligation: Certain OTC derivative contracts entered into between financial counterparties (FCs) and non-financial counterparties (NFCs) above the “clearing threshold” (NFC+s) will be required to be cleared via a central counterparty (CCP).
Risk mitigation techniques for uncleared transactions: OTC derivative contracts entered into between FCs and NFCs (including those below the “clearing threshold” (NFC-s)) that are not required to be cleared will be subject to various risk mitigation requirements (including, in the case of FCs and NFC+s, collateral and capital requirements). The applicability and the extent of the risk mitigation requirements will depend upon the EMIR status of the entity in question.
The clearing and risk mitigation requirements also apply to contracts entered into between two entities established in one or more third countries (TCEs) that would be subject to the clearing obligation if they were established in the EU, provided that the contract has a direct, substantial and foreseeable effect within the EU or where such an obligation is necessary or appropriate to prevent the evasion of any provisions of EMIR. EMIR mandates that ESMA shall produce RTS setting out further detail on the type of contracts covered.
Following a consultation process, the Final Report and the Extra-territoriality RTS were published by ESMA on 18 November 2013 (although they were dated 15 November 2013). The Extra-territoriality RTS relate to contracts entered into between two TCEs only and are not relevant in respect of contracts entered into between (i) a TCE and an EU entity, or (ii) two EU entities, in which case the clearing obligation or risk mitigation requirements would apply subject to, in the former case, the rules on “equivalence” – see further below.
Additionally, if the European Commission declares the legal, supervisory and enforcement arrangements of a third country “equivalent” to those in EMIR, counterparties shall be deemed to have satisfied their EMIR obligations where at least one counterparty is established in such third country. It may, therefore, be the case that TCEs (that would otherwise be within scope by virtue of the Extra-territoriality RTS) are not required to comply with EMIR by virtue of complying with an “equivalent” regime (whether for the purposes of that specific transaction or more generally depending on whether the TCE is established in an equivalent jurisdiction or simply contracting with a TCE established in an equivalent jurisdiction). The starting point is, therefore, that the Extra-territoriality RTS will apply to OTC derivative contracts between two TCEs unless “equivalent” rules apply. However, a discussion of “equivalence” is outside the scope of this briefing paper.
The practical application of EMIR in respect of OTC derivatives contracts entered into with or between TCEs will consequently vary depending upon
the EMIR status of the entity (i.e. whether it is equivalent to a FC, NFC+ or NFC-);
whether the transaction has a "direct, substantial and foreseeable effect" in the EU or whether the transaction should be brought within EMIR to prevent the evasion of EMIR; and
whether a third country regime is deemed “equivalent” resulting in deemed compliance with EMIR.
This briefing paper will focus on the application of EMIR to transactions between two TCEs (i.e. non-EU entities) where at least one of those entities is not established in a jurisdiction where the regime is deemed “equivalent” for EMIR purposes and, in particular, the position following the publication of the Extra-territoriality RTS.
STATUS AND TIMING
The Extra-territoriality RTS now need to be approved by the European Commission (which has three months to endorse them) before they are submitted to the European Parliament and the Council for approval and the final version can be published in the Official Journal of the European Union. The RTS will then enter into force on the twentieth day following such publication.
Article 3 (relating to prevention of the evasion of EMIR) will apply immediately upon entry into force of the RTS. However, the application of Article 2 (relating to contracts with a direct, substantial and foreseeable effect within the EU) will be delayed for six months following the entry into force of the RTS to allow TCEs additional time to prepare for compliance.
Only OTC derivative contracts entered into after the date of entry into force of the Extra-territoriality RTS will be considered as having a direct, substantial and foreseeable effect within the EU.
WHICH CONTRACTS WILL HAVE A DIRECT, SUBSTANTIAL AND FORESEEABLE EFFECT?
As discussed above, the Extra-territoriality RTS deal with transactions between two parties, both of which are TCEs, and define the circumstances in which such transactions will have a "direct, substantial and foreseeable effect" in the EU. The Extra-territoriality RTS do not address equivalence; this is left to Article 13 of EMIR and subsequent equivalence determinations. Therefore, even though a transaction between two TCEs may have a "direct, substantial and foreseeable effect" in the EU and, as a result, the parties may be subject to EMIR obligations, those obligations may be deemed fulfilled if one of the parties is established in a jurisdiction which is found to be equivalent.
According to the Extra-territoriality RTS, there are two types of OTC derivatives contract which will have a "direct, substantial and foreseeable effect" in the EU:
EU guarantor: Contracts between TCEs where at least one TCE benefits from a guarantee of an EU entity, provided such EU entity is a FC; and
EU branches: Contracts between EU branches of TCEs where the TCEs would qualify as FCs if they were established in the EU.
OTC derivatives contracts which will not, by reason only of the characteristics specified below, have a “direct, substantial and foreseeable effect” in the EU include:
EU currency and underlying: Contracts denominated in Euro or another Eurozone currency or with payments or underlying assets denominated or paid in such currencies – currency and underlying are not relevant.
TCE subsidiary of EU entity: OTC derivative contracts entered into by the third country subsidiary of an entity established in the EU (unless expressly guaranteed by the EU parent).
EU specified entities: Contracts where the acceleration of the obligation of any EU established entities listed in an OTC derivatives contract result from the default of the TCE counterparty to such contract (for example, the acceleration of the obligations of any Specified Entity established in the EU listed in the relevant ISDA Master Agreement).
Contracts between TCEs where at least one TCE benefits from a guarantee of an EU FC
The rationale for including such contracts is that the default of the guaranteed TCE counterparty could have a “direct” effect in the EU by virtue of the potential exposure of the EU guarantor (regardless of whether all or part of the liability under the relevant OTC derivatives contract is guaranteed). Therefore, only one of the TCE counterparties need benefit from a guarantee and the guarantee can cover all or part of the liability under the relevant OTC derivatives contract. However, in order to fall within scope the following criteria must be met:
There must be a “guarantee” as defined in the Extra-territoriality RTS : A definition of “guarantee” was included to provide legal certainty in response to concerns raised by market participants in respect of the earlier draft RTS which did not include an explicit definition (on the basis that the substance of the guarantee should be more important than the form). The Final Report helpfully confirms that other arrangements such as credit default swaps, insurance contracts, implicit guarantees and general letters of comfort are out of scope (unless, in the case of the latter two arrangements, they are drafted as a legal obligation of the issuer) , but these specific exclusions are not carried through into the Extra-territoriality RTS themselves; instead, the Extra-territoriality RTS and introduce a definition of “guarantee” as set out below:
“an explicitly documented legal obligation by a guarantor to cover payments of the amounts due or that may become due pursuant to the OTC derivative contracts covered by that guarantee and entered into by the guaranteed entity to the beneficiary where there is a default as defined in the guarantee or where no payment has been effected by the guaranteed entity.”
The definition will undoubtedly encourage further discussion and comment.
The EU guarantor must be a FC established in the EU: The scope is limited to EU FC guarantors as these entities are more likely to have greater exposure to TCEs, competent authorities have greater visibility of guarantees issued by FCs and should, according to ESMA, have the ability to enforce compliance with the Extra-territoriality RTS. There has been no clarification, however, in respect of the meaning of “established in the Union” and so there remains some uncertainty as to exactly which FC guarantor entities are within scope. Additionally, questions remain in respect of how the regulatory authorities will be able to monitor compliance when the EU guarantor is not affiliated to the relevant TCE.
The aggregate notional amount of the liability of the guaranteed TCE must be at least EUR 8 billion or equivalent (the EUR 8 Billion Threshold): If the guarantee covers all the liability under one or more OTC derivatives contracts of a guaranteed TCE, the aggregate notional amount must be at least EUR 8 billion or equivalent. If the guarantee covers part of the liability under one or more OTC derivatives contracts of a guaranteed TCE, the aggregate notional amount must be at least EUR 8 billion or equivalent divided by the percentage of the liability covered. This requirement is included to ensure that the effect is “substantial” and generates a significant risk of default for the EU guarantor. The figure of EUR 8 billion is intended to provide consistency with the minimum threshold for initial margin requirements for non-centrally cleared derivatives (see the BCBS and IOSCO final framework on margin requirements for non-centrally cleared derivatives at Requirement 2.5). If the amount of the guarantee is increased, this threshold must be reassessed to ensure that the relevant contracts would not, as a result of the increase, now have a direct, substantial and foreseeable effect within the EU. All OTC derivative contracts should be taken into account for the calculation of the EUR 8 Billion Threshold even if entered into before the date of entry into force of the Extra-territoriality RTS.
The guarantee is at least equal to 5 per cent. of the sum of current exposures in OTC derivative contracts of the guarantor (the 5 Per Cent Threshold): This requirement works together with the EUR 8 Billion Threshold criterion to ensure that the effect is “substantial” and generates a significant risk of default for the EU guarantor. The Extra-territoriality RTS do not clarify whether “the guarantee” in this context refers to the aggregate notional amount of the guarantee. All OTC derivative contracts should be taken into account for the calculation of the 5 Per Cent Threshold even if entered into before the date of entry into force of the Extra-territoriality RTS. “Current exposures” is defined in Article 272 (17) of Regulation (EU) No 575/2013, the Capital Requirements Directive (CRD).
The Extra-territoriality RTS clarify, in response to feedback from market participants, that the benchmarking of the cumulative thresholds should be carried out at the point of entry into the relevant OTC derivative contract and then upon any “increase in the liability resulting from the OTC derivative contracts or of a decrease of the current exposure” . The benchmarking should be carried out on the day of the increase of the liability in respect of the EUR 8 Billion Threshold and on a monthly basis for the 5 Per Cent Threshold. Clarity on the frequency of calculation is welcome, as a requirement for a more frequent ongoing calculation would have been potentially very onerous for market participants.
There is also clarification that the thresholds apply on a counterparty (as opposed to a group) basis and that a proportional value of the threshold would apply where a guarantee covers only a proportion of the liability under an OTC derivatives contract).
OTC derivative contracts entered into following the entry into force of the Extra-territoriality RTS but before such contracts benefit from a guarantee meeting the above requirements (i.e. a guarantee is issued after the contracts are entered into) or before the amount of an existing guarantee is increased, will be considered as having a direct, substantial and foreseeable effect within the EU and will, consequently, be required to comply with the relevant EMIR requirements. This may pose difficulties to the extent that EMIR compliance has not been considered when entering into a specific transaction due to the fact that EMIR compliance at that stage was not required.
In addition to the points raised above, there is still a lack of clarity on the application of this test in a number of respects including whether counterparties can accept and rely on representations from TCEs that the relevant thresholds have not been breached, how regulators will ensure and monitor compliance with these requirements from a practical perspective, how a chain of guarantor counterparties should be considered and how the exchange rate for calculating any equivalent amount should be determined.
Contracts between EU branches of TCEs where the TCEs would qualify as FCs if established in the EU
OTC derivatives contracts entered into between two EU branches of TCEs could have a “direct” effect in the EU as such branches are likely to be actively participating in the EU derivatives market but may not be regulated by a third country regime (given the EU presence) or by a regime recognised as “equivalent”. This could have a direct, substantial and foreseeable effect in the EU to the extent that such branches play a key role in the EU market but were not appropriately regulated. ESMA believes that quantitative thresholds should not apply do to the potential systemic risk posed.
OTC derivative contracts between an EU branch of a TCE and another TCE (not acting through an EU branch) are not within scope and would be subject to the relevant third country regime.
It remains to be seen whether ESMA’s approach in respect of two TCE branches will be consistent with the approach taken in other jurisdictions.
WHICH CONTRACTS WILL BE DEEMED TO BE ENTERED INTO FOR THE PURPOSES OF EVASION OF EMIR?
Transactions which have been structured in a way to avoid EMIR clearing and risk mitigation obligations will be considered to have been entered into for the purposes of evading EMIR. Consistent with an approach often taken in tax legislation, ESMA intends to take a substance over form approach to this requirement to ensure enough flexibility is included in the legislation with the aim of avoiding legal loopholes by which parties can evade compliance with EMIR by structuring transactions in a specific way. Form is, therefore, not important and all steps or parts of an arrangement will be considered in their entirety, together with the purpose of structuring the arrangement in such a way, on a case-by-case basis. In deciding whether an arrangement is captured, the following (as set out in Article 3 of the Extra-territoriality RTS) will be considered:
Does the way in which the OTC derivatives contract is concluded, viewed as a whole and having regard to all the circumstances, have as its primary purpose the avoidance of the application of any provision of EMIR?
Does the arrangement defeat the object, spirit and purpose of the EMIR provisions that would otherwise apply including when it is part of an artificial arrangement or artificial series of arrangements?
The Extra-territoriality RTS consider that an artificial arrangement includes “an arrangement that intrinsically lacks business rationale, commercial substance or relevant economic justification and consists of any contract, transaction, scheme, action, operation, agreement, grant, understanding, promise, undertaking or event”.
Originally, ESMA proposed to provide a non-exhaustive list of situations that could be particularly relevant when determining whether a contract is designed to evade EMIR. However, in response to concerns raised by market participants in respect of potential legal uncertainty, this has now been removed from the Extra-territoriality RTS. Whilst this is a welcome development, the language is still broad and may raise concerns that genuine economic activity could potentially be captured due to the wide range of arrangements that can be covered. It is a potential source of concern that it is the “primary purpose” of the arrangement that should be considered rather than the “sole purpose”.
It is also still unclear which regulatory body will decide whether a contract is entered into for purposes of evasion of EMIR.
WHERE ARE WE NOW?
As compared to the previous draft RTS, the Extra-territoriality RTS provide increased certainty in respect of the types of OTC derivative contracts that may be considered to have a direct, substantial and foreseeable effect in the EU and may be deemed to be entered into for the purposes of the evasion of EMIR.
However, a number of concerns remain outstanding, notably: How will the definition of “guarantee” be interpreted in practice? What is the precise scope of the requirements in respect of guarantors and FCs given the uncertainty of certain terms (such as “established in the Union”)? How will compliance be monitored by regulators on a cross-border basis? What are the circumstances in which an OTC derivatives contract will be considered to have been entered into for the purposes of evading EMIR, particularly given that arrangements should be considered on a case-by-case basis?
Additionally, and as recognised by ESMA , cross-border co-operation remains imperative in order for the extra-territoriality provisions to be effective in practice, opportunities for regulatory arbitrage to be minimised and a non-duplicative and consistent application of requirements across jurisdictions to be secured. It is, therefore, important that regulators continue to work towards ensuring that the “equivalence” provisions in each jurisdiction are clear in order to ensure that market participants have the requisite level of certainty in respect of which requirements apply to them in the context of a cross-border transaction.
In the interim, market participants should be actively considering whether OTC derivatives contracts that benefit from an EU FC guarantee or that are entered into by their EU branches need to comply with the EMIR clearing and risk mitigation requirements and how this will affect practice.