The determination of the circumstances in which OTC derivative contracts are ‘objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity’ represents the key EMIR qualification, since when the criteria are met, the OTC derivative contract is excluded from the computation of the clearing threshold.
Pursuant to Article 10 of the draft EMIR where a non-financial counterparty takes positions in OTC derivative contracts and these positions exceed the clearing threshold as specified in EMIR (for clearing thresholds see ‘Calculating clearing thresholds under EMIR draft Regulation and ESMA Draft Technical Standards’), that non-financial counterparty shall:
(a) immediately notify ESMA and the competent authority thereof; and
(b) become subject to the clearing obligation for future contracts if the rolling average position over 30 working days exceeds the threshold;
(c) clear all relevant future contracts within four months of becoming subject to the clearing obligation.
A non-financial counterparty that has become subject to the clearing obligation in accordance with requirement indicated under letter (b) above and that subsequently demonstrates to the competent authority that its rolling average position over 30 working days does not exceed the clearing threshold, shall no longer be subject to the clearing obligation.
EMIR also states that in calculating the positions referred to above, the non-financial counterparty should 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’.
It is thus important to establish the criteria governing the above qualification.
ESMA RTS on OTC Derivatives
The ESMA’s draft for the Commission Delegated Regulation supplementing EMIR with regard to regulatory technical standards on OTC derivatives (Draft Regulatory Technical Standards on OTC Derivatives) in Article 1 provides that an OTC derivative contract is objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or of that group, when, whether by itself or in combination with other derivative contracts, and whether directly or through closely correlated instruments, it meets one of the following conditions:
a. it covers the risks arising from the potential change in the value of assets, services, inputs, products, commodities or liabilities that the non-financial counterparty or its group owns, produces, manufactures, processes, provides, purchases, merchandises, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the ordinary course of its business;
b. it covers the risks arising from the potential indirect impact on the value of assets, services, inputs, products, commodities or liabilities referred to in letter a, resulting from fluctuation of interest rates, inflation rates or foreign exchange rates.
c. it qualifies as a hedging contract pursuant to International Financial Reporting Standards (IFRS) adopted in accordance with Article 3 of Regulation (EC) No 1606/2002.
When it comes to the latter point Consultation Paper of 25 June 2012 (ESMA/2012/379) accompanying Draft Regulatory Technical Standards on OTC Derivatives (Consultation Paper) specifies that the relevant provisions in that regard are paragraphs 71-102 of International Accounting Standards (IAS) 39 on hedge accounting (see some of the most important requirements of the Standard in that regard here).
With respect to qualification as a hedging contract pursuant to International Financial Reporting Standards (IFRS) recital 14 in the preamble to the Draft Regulatory Technical Standards on OTC Derivatives explains moreover that in order to establish which OTC derivative contracts objectively reduce risks, the accounting definition may be used by counterparties even though they do not apply IFRS rules.
Some non-financial counterparties may use local Generally Accepted Accounting Principles (GAAP). Pursuant to the recital 14 in the preamble to the Draft Regulatory Technical Standards on OTC Derivatives it is expected that most of the contracts classified as hedging under local GAAP would fall within the general definition of contracts reducing risks directly related to commercial activity or treasury financing activity.