The European Markets Infrastructure Regulation (EMIR) implements, within Europe, the mandatory clearing of certain OTC derivative contracts through a framework of central counterparties (CCPs), and establishes a requirement for all non-cleared OTC derivative contracts to be subject to more stringent risk mitigation requirements, including the requirement to transaction report all OTC derivative contracts to a trade repository and the authorisation and regulation of the CCPs themselves. The requirements are imposed on all entities that enter into any form of derivative contract within the EU. However, it also applies indirectly to non-EU firms trading with EU firms.
Although EMIR came into force on 16 August 2012, its provisions have been taking effect throughout 2013 and 2014 and are ongoing. This article will focus on the requirements that affect hedge funds. In summary, the three main areas are as follows:
Much has been written about the risk mitigation requirements and transaction reporting so we are not going to focus very much on these areas, but will consider the mandatory clearing rules that are currently being implemented in Europe, some months behind the US.
EMIR applies to all standardised eligible OTC derivatives, including interest rate, credit, equity, foreign exchange derivatives and commodity OTC derivatives contracts that have been declared by ESMA to be subject to the clearing obligation. Currently there is uncertainty regarding which FX transactions will be captured because EMIR relies on the MiFID definition for financial instruments. The problem with this is that Member States have transposed MiFID differently, so there is not a single, commonly adopted definition of FX derivative contracts in the European Union.However, the European Commission’s consultation on this matter closed on 9 May, so there should be a formal commission proposal clarifying the position imminently.
The application of certain parts of EMIR is dependent on the classification of an entity as set out below. The risk mitigation and transaction reporting requirements are applicable to everyone trading OTC derivatives within the EU. But the clearing obligation is dependent on the type of entity, as some exemptions apply if the entity does not exceed the clearing thresholds. The entity classifications are as follows:
Prima facie non-EU funds are outside the application of EMIR. However, if the investment manager of a non-EU fund is or becomes an AIFM then the non-EU fund falls within the definition of an FC. Consequently, if an investment manager is already an AIFM, has applied to be an AIFM but delayed the approval until the 22 July, or intends to submit theapplication by the 22 July, not only will AIFMD be applicable when the approval is granted, but so will EMIR.
There is another rule that could capture a non-EU entity within the scope of EMIR, even if it does not have a AIFM, and that is if the non-EU entity’s activities are considered to have a direct, substantial and foreseeable effect within the Union. But this is a very subjective test and should only ever be applicable to very large hedge funds.
All FCs, as well as NFCs exceeding the clearing threshold, will have to clear OTC derivatives transactions that are within a class of OTC derivatives which ESMA has declared to be subject to mandatory clearing.
The approval of the first central counterparty (CCP) under the European Market Infrastructure Regulation (EMIR) was Sweden’s Nasdaq OMX on 18 March 2014, which kick-started a six-month process by the European Securities and Markets Authority (ESMA) to determine whether the clearing obligation should apply to particular classes of OTC derivatives. As there are now six CCPs authorised within the EU, ESMA will have to determine whether a clearing obligation should apply for all or any of the classes of derivatives that the CCPs are able to clear. Draft Regulatory Technical Standards (RTS) are now due by 18 September.
It should be remembered that entities can choose to clear before the regulations are in force, and can also choose to clear asset classes that EMSA does not include within its RTS. Some investment managers have a preference for doing so. In the RTS ESMA has to specify:
ESMA has stated that it will consider a variety of factors when determining whether to apply a clearing obligation for any particular class of derivatives product, including the degree of standardisation of contract terms, the volume and liquidity of the relevant class of OTC derivatives, and the availability of fair, reliable and generally accepted pricing information. Hopefully the determinations will be sensible. One issue that could be interesting is if ESMA makes different determinations of which classes to include versus the US, because then whether a clearing obligation applies will depend on where the entity is located or domiciled.
How a CCP works and other documentation
The new centrally cleared model closely mirrors how clearing houses operate for exchange-traded derivatives. Most hedge funds will not have direct access to the CCP, as this is not commercially viable, so they will have to gain access indirectly via a clearing member. So, in effect, they will still face their clearing member and have counterparty risk exposure to the clearing member, but the collateral, or some of it, will be held at a CCP.
This is the main benefit of the CCP model whereby the collateral is held in either a fully segregated account in the client’s name or a client omnibus account. However, it should be noted that the excess margin taken by the clearing member is not automatically held at the CCP. Consequently, one has to consider the agreements very carefully, and assess the counterparty risk exposure accordingly. We think it is sensible to amend the contract to provide for this. Otherwise, in the event of clearing member bankruptcy the amount of the excess collateral is unsecured and the fund would have to make a claim in the bankruptcy for this sum. The CCP would look to port the transactions and corresponding collateral it held to a new clearing member but cannot transfer collateral that it does not hold. Therefore, if the excess is lost in the bankruptcy, a fund would have to post more collateral to the new clearing member. So the benefit of this model would be lost to some degree.
The standard documentation developed by the ISDA/FOA can be used under either the ISDA Master Agreement or a Futures and Options agreement. Most clearing members have established it under the latter. The main exception to this is the LCH documentation. The addendum to my mind is not very user-friendly by design. If the industry was going to deviate from the ISDA for OTC derivatives, cleared products having one totally new document covering these products would have been more efficient than an addendum that varies another agreement that is not even a market standard. To add to the problem, some clearing members have also varied the addendum. So there is not really a standard market agreement; it is just based on the same starting document.
It should also be noted that these agreements are taking time to negotiate due to the fact this is all new ground for everyone. But if ESMA actually makes its determination by 18 September 2014, then the clearing of certain classes of assets could be mandatory very soon thereafter. Time is starting to run out if hedge funds do not focus on this matter soon.