Clearing thresholds under EMIR Regulation and Regulatory Technical Standards on OTC derivatives
- Category: EMIR
22 November 2021
19 November 2021
When a financial counterparty calculates its positions for the purpose of the clearing threshold determination in accordance with Article 4a(3) of EMIR, should it include in the calculation the OTC derivative contracts that are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity entered into by the non-financial counterparties that are part of the same group?
Answer provided by the European Commission in accordance with article 16b(5) of the ESMA Regulation:
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?
Answer provided by the European Commission in accordance with article 16b(5) of the ESMA Regulation
Although the lion's stare of this market as measured by notional amounts outstanding is taken by the interest rate segment (which accounts for more than 80% of the total) and the entire Commodity part (Emissions being within) 0,4% (notional amounts outstanding below $3 trillion) only, the latter remains the significant part of financial market and it will likely still grow in importance.
When it comes to the clearing obligation, OTC derivatives regarding emission rights are classified by the European Securities and Markets Authority (ESMA) for EMIR purposes as a subtype "Emissions", type (or "Base product" as defined by ISDA) "Environmental" covered by asset class "Commodity derivatives" (see ESMA "Discussion Paper The Clearing Obligation under EMIR of 12 July 2013, ESMA/2013/925").
Pursuant to notifications received by ESMA, clearing solution for the above class is currently provided for instance by the Nasdaq OMX (the complete ESMA's list of the CCPs providing clearing with asset classes' breakdown can be accessed here).
It follows, OTC derivatives regarding emission rights may become subject to the clearing obligation if they fulfill the criteria to be assessed by ESMA for this purpose (further information on the state of the clearing obligation process see here).
Besides, the interesting EMIR regime characteristics is that central clearing may be mandatory for eligible contracts, even if only one CCP is clearing a specific eligible contract.
Clearing thresholds' significance
Non-financial counterparties are not subject to the requirements of EMIR:
- to centrally clear or
- to exchange collateral on non-centrally cleared transactions;
provided that they are not in breach of predefined thresholds.
Consequently, market participants – including systemically important ones – could not be able to exercise any discretion as to where/whether they clear, although they may have major reservations as to the viability of a CCP's risk management systems (partly a function of their policies on acceptable collateral) but will have no choice but to clear contracts in that CCP (ISDA Comment Paper: A Prudent Approach to Collateral Requirements at CCPs (EMIR Article 43)).
Considering, in turn, the personal scope of clearing obligation, and financial counterparties notwithstanding, clearing thresholds in the EMIR architecture represent the border delineating systemically-important non-financial entities, which have been subjected to more demanding rules on the derivatives market.
The personal scope thus targeted may, however, change in the course of financial market developments.
Clearing obligation with respect to non-financial counterparties and the values for clearing thresholds by class of the OTC derivative contract
In Article 10 (relating to non-financial counterparties) EMIR provides that where a non-financial counterparty takes positions in OTC derivative contracts and these positions exceed the clearing threshold, that non-financial counterparty should:
(a) immediately notify ESMA and the competent authority;
(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.
It is noteworthy, Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 published by the European Commission in May 2017 proposed to substitute the above rule with the requirement on the non-financial counterparties to assess their situation vis-à-vis the clearing obligation only once a year, based on the average activity over the months of March, April and May.
Pursuant to Commission Delegated Regulation on Clearing Thresholds the relevant values are determined by class of OTC derivative contracts:
(a) EUR 1 billion in gross notional value for OTC credit derivative contracts;
(b) EUR 1 billion in gross notional value for OTC equity derivative contracts;
(c) EUR 3 billion in gross notional value for OTC interest rate derivative contracts;
(d) EUR 3 billion in gross notional value for OTC foreign exchange derivative contracts;
(e) EUR 3 billion in gross notional value for OTC commodity derivative contracts and other OTC derivative contracts not defined under points (a) to (d).
Draft Report of 26 January 2018 of the European Parliament (Committee on Economic and Monetary Affairs) suggested, moreover, to simplify the new rules for small financial counterparties and to reduce bureaucracy and cost, the mandatory check by all financial counterparties of their position (above or below the threshold) to be replaced by a voluntary check by those financial counterparties that would reasonably expect to fall below the threshold.
The quantitative values and specific rules for calculation of the clearing thresholds can be found in the Commission Delegated Regulation (EU) No 149/2013 of 19 December 2012 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP (Commission Delegated Regulation on Clearing Thresholds or RTS) - see box.
The value of the clearing thresholds will be reviewed periodically.
Companies are required to indicate in their EMIR transaction reports whether the reporting counterparty is above a clearing threshold - Field 16 of the Table 1 of the Annex to the Commission Implementing Regulation (EU) 2017/105 of 19 October 2016 amending Implementing Regulation (EU) No 1247/2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories (format: Y = Above the threshold and N = Below the threshold).
The said Field 16 should be left blank in the case where the reporting counterparty is a financial counterparty in the meaning of Article 2(8) of EMIR.
RTS underline that the classes of OTC derivatives determined for the purpose of the clearing thresholds may be different from the classes of OTC derivatives for the purpose of the clearing obligation.
The two elements are worth of a specific considerations:
- one - that for the purpose of setting the clearing thresholds, the notional value of OTC derivative contracts subject to the clearing obligation is taken into account,
- and the second – setting the clearing thresholds per asset class.
Business context of EMIR clearing thresholds concentrates on the following crucial considerations:
1. Hedging transactions do not count for calculations (defined as “objectively measurable as reducing risks related to commercial activity or treasury financing activity of the non-financial counterparty or of that group”);
2. Calculation must cover entire worldwide group (in calculating the positions at issue, the non-financial counterparty must 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);
3. Includes intra-group (exemption available upon the competent authority notification);
4. Notional value is relevant;
5. Effects of the threshold breach:
- in one asset class brings all classes into clearing (this rule as from 17 June 2019 applies to financial counterparties only),
- “immediate” notification to ESMA and to the national competent authority required,
- 30 day rolling average triggers clearing after 4 months.
Recitals to Commission Delegated Regulation on Clearing Thresholds observe that the structure of the OTC derivatives activity of non-financial counterparties usually leads to a low level of netting as OTC derivative contracts are concluded in the same direction.
As a result, the difference between the sum of the net positions and exposures per counterparty and per class of OTC derivatives would be very close to the gross value of contracts.
Therefore, and in order to reach the objective of simplicity, the gross value of OTC derivative contracts is required to be used in the determination of the clearing threshold.
It is also necessary to note that voluntarily cleared OTC derivative contracts are included in the calculation of the clearing threshold.
When it comes to the requirement to notify immediately ESMA and the competent authority about the threshold exceedance, ESMA has prepared for the market participant's use:
Important practical question with respect to implementation of the notification requirement by corporate groups is whether all entities of the group must notify the relevant national competent authority and ESMA, or there should be a single notification per entire group.
The ESMA's stance on the issue is that for each Member State in which the group has legal entities, which trade OTC derivatives, a notification should be submitted to the national competent authority once the group has exceeded the threshold.
This notification must include, among other things, the names of all NFC group legal entities within that Member State which trade OTC derivatives.
The group should also submit a single notification to ESMA, listing all of the NFC group legal entities within the EU which trade OTC derivatives.
ESMA's reports acknowledge, it is the existing practice that counterparties notify ESMA with a single notification listing all the EU entities of the group.
ESMA in its clarifications also reflected points arising from market participants' potential mistakes when calculating the entity position versus clearing threshold, and, consequent mistaken notifications.
Responding to the question:
"What should be the procedure for NFC that had notified the relevant competent authority and ESMA that they were above the clearing threshold on the basis of certain assumptions, but are in fact below the clearing threshold on the basis of amended and correct assumptions?"
ESMA adopted the following stance:
"When the clearing threshold is not (and would not have been) exceeded if the NFC had applied from the beginning the correct assumptions for the calculation of the clearing threshold, the NFC should inform the competent authority and ESMA of this fact. The NFC will be regarded as a NFC- for past and future obligations."
Nevertheless, it seems the said requirements are sometimes omitted by the entities covered, as the ESMA's Report on non-financial counterparties of 13 August 2015 mentions (p. 31) that within the 29 groups that were found to exceed at least one threshold, only 5 have provided a notification under Article 10.
The adopted approach based on the notional amount adds up the nominal value of all outstanding OTC derivative contracts, irrespective of whether they are in or out of the money.
Pursuant to recitals to Commission Delegated Regulation on Clearing Thresholds, given that non-financials that do not exceed the clearing threshold are not required to mark-to-market their OTC derivative contracts, it would not be reasonable to use this measure to determine the clearing thresholds as it would impose a heavy burden on non-financials which would not be proportionate to the risk it would address.
It is important to note that using the notional value of OTC derivative contracts allows for a simple approach when making calculations of the clearing thresholds.
The straightforward consequence of this regulatory decision is that non-financials in application of the clearing thresholds are not exposed to external events, they otherwise would be if the marking-to-market method was used.
In effect, an increase in market price of the emissions derivative contract does not lead in itself a company to exceed the clearing threshold.
In fact, the inadvertent crossing of the clearing threshold would be possible even though the company would not have concluded any additional contracts, if - instead of the notional-value approach - the marking-to-market conception was adopted.
The use of the notional amount as a reference is also the reason for setting relatively “high” value of the clearing thresholds.
When the notional amount of a derivative contract is subject to modifications which were already foreseen in the original contract specifications (e.g. a reduction/increase of the notional at fixed dates), the updated notional amount should be taken into account for the purpose of calculating the clearing threshold (ESMA's clarification of 11 November 2013).
ESMA has also made specific comments on how the notional value should be calculated in respect of instruments like options, contracts for difference (CFD) and commodity derivatives which are designated in units such as barrels or tons.
In that respect it was clarified that nominal or notional amounts are the reference amount from which contractual payments are determined in derivatives markets.
It can also be defined as the value of a derivative's underlying assets at the applicable price at the transaction's start (in the case of options, this is not the premium).
This definition, however, seems not to be entirely adequate from the risk management perspective in the case of options that fall deeply out of the money, as the counterparty risk tends to be, in such a situation, negligible.
Another ambiguity may arise when determining a notional amount with respect to contracts where prices will only be available by the time of settlement.
In such a case the notional amount should be evaluated using the price of the underlying asset at the time the calculation of the positions in OTC derivatives to be compared to the clearing thresholds is made.
With respect to contracts with a notional amount that varies in time, the notional amount to be considered is the one valid at the time the calculation of the positions in OTC derivatives to be compared to the clearing thresholds is made.
Calculation per asset classes
Untill 17 June 2019 the clearing obligation applied to all OTC derivatives contracts concluded after the clearing threshold was exceeded, irrespective of the asset class, which these OTC derivative contracts were ascribed to.
For the purpose of the clearing thresholds, 5 asset classes are relevant i.e. credit derivatives, equity derivatives, interest rate, foreign exchange and, finally, commodity and other.
The rule that the excess of one of the values set for a class of OTC derivatives triggers the excess of the clearing threshold for all classes was reasoned in the recitals to Commission Delegated Regulation on Clearing Thresholds by the following circumstances:
(1) OTC derivative contracts reducing risks are excluded from the calculation of the clearing threshold;
(2) the consequences of exceeding the clearing threshold are not only related to the clearing obligation but extend to risk mitigation techniques;
(3) the approach for the relevant obligations under EMIR applicable to non-financials should be simple in view of the non-sophisticated nature of most of them.
Nevertheless, the calculation of clearing thresholds per asset classes remained a controversial issue. It was argued, for example, clearing represents a cost for firms trading gas and electricity across the EU, and, therefore, gas and power should be combined as a single commodity class or the so-called 'breach one, breach all' principle should be revised (CEER Response to European Commission Consultation on EMIR, Ref: C15-MIT-63-03, 13 August 2015).
Market data evidencing the thresholds' exceedance by non-financial counterparties (NFCs) in divergent asset classes show that close to zero non-financial counterparties were found to exceed, for example, the equity and credit threshold, but it was interpreted as a mere consequence of the very low activity of non-financial counterparties in those two asset classes (see the aforementioned ESMA's Report on non-financial counterparties of 13 August 2015, p. 31).
Other interesting breakdowns in terms of non-financial counterparties' activity in specific asset classes are:
- A very large majority of NFCs are active in only one asset class of OTC derivatives (in most cases interest rates and, to a lesser extent, FX);
- In terms of volumes, NFCs appear to be active in only three asset classes: Interest rates, FX and Commodities. Based on trade repositories' data, their reported activity in Equity and Credit OTC derivatives is almost inexistent;
- The Commodity and the FX OTC derivatives markets are the only two asset classes in which a relatively important number of NFCs bear some systemic relevance as compared to financial counterparties (FCs). This is demonstrated by numbers related to size and, in the case of the Commodity market, also by numbers related to interconnectedness;
- In particular in the Commodity asset class, there are many groups of large non-financial counterparties below a clearing threshold (Large NFC-) among the biggest market participants. As an illustration, the second biggest market participant in the OTC commodity market as measured by outstanding notional amount was found to be a group of NFC-;
- The current Commodity, FX and Interest rate thresholds are exceeded by a small and consistent number of NFC groups (around 10 groups per asset class representing a few hundreds of counterparties). In addition, non-financial counterparties exceeding the clearing threshold (NFC+) represent only a small portion of the total NFC volumes (between 2% and 10% depending on the asset class).
Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 published by the European Commission in May 2017 envisioned the rule that the non-financial counterparties would be required to clear only the asset classes for which they have breached the clearing threshold.
Hence, the principle that the clearing obligation applies to all OTC derivatives contracts concluded after the clearing threshold was exceeded, irrespective of the asset class to which these OTC derivative contracts belong to, is nullified as from 17 June 2019 as to non-financial counterparties (for small FCs it remains in force).
This modification of the rules is explained by high level of interconnectedness of financial counterparties (see recital 8 of the Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories (EMIR REFIT)).
As regards the calculating of the non-hedging positions in OTC derivatives to be compared to the clearing threshold an ambiguity appeared whether the non-financial counterparties are able to benefit from any netting effect.
Finally, non-financial counterparties were allowed to net their OTC trades when computing the clearing thresholds, however, under very strict conditions described in OTC Question 3(e) of the ESMA Q&A on the implementation of EMIR.
Regulatory clarification in that regard is that in order to determine whether the NFC is above or below the clearing threshold, the NFC should first net their positions per counterparty and contracts and then add up the absolute notional value of all these net positions (calculated based on the notional amounts of the contracts).
Netting per contracts and counterparty, according to ESMA, should be understood as fully or partially offsetting contracts having exactly the same characteristics (type, underlying, maturity, etc.) with the only exception of the direction of the trade and notional amount (in case of partial offset) concluded with the same counterparty.
This interpretation, however, appears to excessively limit existing market practices, where under bilateral master agreements, netting of contracts with different maturities (but with the adjusted composition within the basket) may be useful from the risk management perspective as well. Such offsetting configurations were not taken into account by ESMA when prescribing the allowable netting formula.
Which contracts "are objectively measurable as reducing risks directly relating to the commercial or treasury financing activity" i.e. qualify as hedging in the EMIR sense
EMIR requires that in calculating the clearing thresholds, the non-financial counterparty must 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.
Simply put, at present hedging is excluded from clearing thresholds' calculations, however, it is noteworthy, in the aforementioned ESMA's Report on non-financial counterparties of 13 August 2015 (p. 12)ESMA had considered the move from the current two-step process (hedging/non hedging and clearing threshold) to a one-step process, where counterparties would qualify as a non-financial counterparty above a clearing threshold (NFC+) when their outstanding positions exceeded certain thresholds per asset class, irrespective of the qualification of the trades as hedging or non-hedging (which conception was subject to heavy criticism from some industries, see EFET Press Release 97/15 of 31 August 2015 EFET response to the European Commission consultation on a review of EMIR).
It is useful to add, current framework for NFC+ captures a very limited fraction of the total NFC volumes (as measured by outstanding notional amounts): 10% for Commodities, 5% for FX and 2% for Interest rate. Those numbers would grow to 91%, 42% and 44% under the hypothetical one-step framework.
Companies are required to identify in their EMIR transaction reports which transactions are directly linked to commercial activity or treasury financing - Field 15 of the Table 1 of the Annex to the Commission Implementing Regulation (EU) of 19.10.2016 amending Implementing Regulation (EU) No 1247/2012 laying down implementing technical standards with regard to the format and frequency of trade reports to trade repositories according to Regulation (EU) No 648/2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories.
The said Field 15 should be left blank in the case where the reporting counterparty is a financial counterparty in the meaning of Article 2(8) of EMIR.
Commission Delegated Regulation on Clearing Thresholds stipulates 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, leases, sells or incurs or reasonably anticipates owning, producing, manufacturing, processing, providing, purchasing, merchandising, leasing, selling or incurring in the normal 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 point (a) above, resulting from fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk;
(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.
It is noteworthy that the above criteria have the alternative and not the cumulative character.
Role of the IFRS definition of hedging
Recitals to the Commission Delegated Regulation on Clearing Thresholds clarify that the accounting definition based on International Financial Reporting Standards (IFRS) rules may be used by counterparties even though they do not apply IFRS rules.
For those non-financial counterparties that may use local accounting rules, it is, however, expected that most of the contracts classified as hedging under such local accounting rules would fall within the general definition of contracts reducing risks directly related to commercial or treasury financing activity.
The IFRS definition of hedging instruments and hedged items can be found in paragraphs 6.1.1 to 6.3.7 of the IFRS 9 Financial Instruments published in July 2014).
ESMA clarifications also underline the definition of hedging for EMIR purposes includes and is broader that the definition used in the IFRS accounting rules.
Therefore OTC derivative contracts that qualify as hedging under the definition of the IFRS rules also qualify as hedging for EMIR purposes.
Moreover, some OTC derivative contracts may qualify as hedging for EMIR purposes (which includes also proxy hedging and macro or portfolio hedging - see below) although they do not qualify as hedging under the definition of the IFRS rules.
Macro and portfolio hedging compliance
Recitals to the Commission Delegated Regulation on Clearing Thresholds acknowledge the existence of the activities like proxy hedging and macro or portfolio hedging. The recitals clarify that in some circumstances, it may not be possible to hedge a risk by using a directly related derivative contract i.e. a contract with exactly the same underlying and settlement date as the risk being covered. In such case, the non-financial counterparty may use proxy hedging and utilize a closely correlated instrument to cover its exposure such as an instrument with a different but very close underlying in terms of economic behaviour. Those OTC derivative contracts as well as the OTC derivative contracts that certain groups of non-financial counterparties enter into, via a single entity, to hedge their risk in relation to the overall risks of the group, referred to as macro or portfolio hedging, may constitute hedging for the purpose of RTS and should be considered against the criteria for establishing which OTC derivative contracts are objectively reducing risks.
In its Questions and Answers on EMIR ESMA made the general observation that some OTC derivative contracts like proxy hedging and macro or portfolio hedging may qualify as hedging for EMIR purposes although they do not qualify as hedging under the definition of the IFRS rules.
ESMA also formulated the following criteria for the implementation of risk management systems:
i. The risk management systems should prevent non-hedging transactions to be qualified as hedging solely on the grounds that they form part of a risk-reducing portfolio on an overall basis.
ii. Quantitative risk management systems should be complemented by qualitative statements as part of internal policies, defining a priori the types of OTC derivative contracts included in the hedging portfolios and the eligibility criteria, and stating that the transactions in contracts included in the hedging portfolios are limited to covering risks directly related to commercial or treasury financing activities.
iii. The risk management systems should provide for a sufficiently disaggregate view of the hedging portfolios in terms of e.g. asset class, product, time horizon, in order to establish the direct link between the portfolio of hedging transactions and the risks that this portfolio is hedging. NFCs should establish a sufficiently clear link between the type of contracts entered into and the commercial or treasury financing activity of the group. Where some components of a derivatives portfolio can be shown to be hedging but others are speculative, the speculative components must be counted towards the clearing threshold. In such a case, it is not acceptable to class the whole portfolio, including the speculative components, as hedging even if it can be shown that the aggregate effect of the whole portfolio is risk reducing.
iv. When a group has NFCs established in different countries of the Union, and that group has a central unit responsible for the risk management systems of several entities of the group, the systems should be used consistently in all the entities of the group.
v. The risk management system should not be limited to a binary mechanism whereby, up to a certain limit (e.g. a predefined risk metric reaches a predefined value in absolute or relative terms), all OTC derivative transactions are classified as hedging, and once this limit is exceeded, all OTC derivative transactions are classified as non-hedging.
The above criteria notwithstanding, ESMA, however, underlined that the implementation of risk management systems should be assessed by the relevant national competent authorities on a case by case basis.
The role of internal policies of non-financial counterparties
In the above Q&A document ESMA also shed some light on the issue whether policies adopted by non-financial counterparties or audited accounts are sufficient to demonstrate compliance with hedging definition.
The policies adopted by a counterparty, in particular when they are audited, provide an indication of the nature of the OTC derivative contracts this counterparty can conclude. This indication should be comforted by the analysis of the OTC derivative contracts actually concluded and the effective hedging that need to take place when the contract is concluded and during the life time of the contract.
Therefore, except where the OTC derivative contracts concluded by a counterparty qualify as hedging contracts under the IFRS rules, neither audited accounts nor internal policies per se are sufficient to demonstrate that the relevant contracts are for hedging purposes, but need to be supplemented by evidences of the actual risk directly related to the commercial or treasury financing activity that the contract is covering.
Other potential areas of concern
Considering the potential occurence of less frequent operations and the ambiguity whether they should be captured in the scope of the definition of the "normal course of business" as well as whether OTC derivative contracts concluded rarely qualify for hedging ESMA explained that the frequency of the OTC derivative contract is not a criterion to determine whether it is considered in the scope of the commercial activity or treasury financing activity of non-financial counterparties.
The final observation which should not be neglected when identifying hedging contracts excluded from computation of the clearing thresholds within the group of companies, is that the non-financial counterparties must consider for this purpose not only its own exposition, but also those of other non-financial counterparties within the group.
ESMA in its analyses highlighted the fact non-financial counterparties are required to develop more sophisticated solutions for monitoring purposes.
UK Financial Conduct Authority Factseet on Non-Financial Counterparties (NFCs) subject to EU Regulation on derivatives, central counterparties and trade repositories refers to the review conducted between June and September 2013.
As followed from the review, NFCs had established a clear trading strategy statement identifying the NFC's hedging needs, with trading activity monitored against the strategy and any trades not directly related to the hedging part of the strategy clearly identified.
Where NFCs have some trading which is hedging and some which is designed to be profitable for the firm without a link back to commercial or treasury risk, NFCs are clearly flagging the non-hedging trades in internal systems and counting them towards the clearing threshold.
NFCs are operating an asset-backed trading strategy to hedge future revenue, with the aim of demonstrating that trading activity is objectively necessary for 'hedging purposes' and does not amount to speculative activity. This was achieved by ensuring the derivative contract does not exceed the hedging need as this would otherwise be classified as a speculative trade.
However, it appears, the differentiation criteria for hedging and trading portfolios are not always sufficiently clear. FCA gives for instance the following remark:
"Some NFCs used a combination of fixed-to-floating and floating-to-fixed interest swaps to achieve a desired balance of exposure to market interest rate movements. Those NFCs had not always considered adequately whether the fixed-to-floating component of such a strategy could legitimately be considered hedging, given that it appears to increase the NFC's exposure to market movements."
So, definitely, are, in principle, fixed-to-floating interest rate swaps eligible to be counted as hedging derivatives for EMIR clearing threshold calculation? As it occurs, it can be questionable.
Market statistics as regards the hedging exemption
When it comes to the industry data, the aforementioned ESMA Report of 13 August 2015 refers to some interesting facts:
- Across asset classes, the proportion of the volumes concluded for hedging purposes is around 67%-73% for NFC+, as measured by trade count and notional amounts respectively;
- For NFC-, in turn, the proportion of the volumes concluded for hedging purposes is higher than for NFC+, with 88% as measured by trade count, and a higher percentage as measured by notional amounts;
- In addition, more than 80% of the NFC- qualify all their transactions as hedging (besides, it is useful to note, counterparty may qualify as NFC+ even if it qualifies all its trades as hedging because of the aggregation of the positions at group level);
- A very large majority of Small NFC- (94%) systematically qualify all their trades under the same banner, either 100% hedging, or, in fewer cases, 100% non-hedging;
- A majority of Large NFC- (85%) qualify 100% of their trades as hedging;
- As a result, those counterparties do not exceed any of the clearing threshold even when their portfolios of OTC derivatives are substantial and higher than the portfolios of NFC+.
A summation of this thread was made by ESMA in the Report of 13 August 2015. The EU financial market watchdog acknowledges the fact, the hedging definition in the EMIR meaning provides for certain margin of discretion and interpretation, thus leading to an inconsistent application.
Considering, moreover, calculations are made at group level, compliance with the hedging definition is a "very complex matter".
Derivative contracts executed on non-EU exchanges
Analysing the issue whether derivative contracts executed on non-EU exchanges should be counted for the purpose of the determination of the clearing threshold, ESMA has made the following clarification:
Derivative contracts executed on a third-country market which has been considered to be equivalent to an EU regulated market by the European Commission in accordance with Article 2a of EMIR, are not OTC derivatives under EMIR and do not count for the purpose of the determination of the clearing threshold under Article 10 of EMIR.
However, derivative contracts executed on third-country markets which have not been considered to be equivalent to an EU regulated market, will count for the determination of the clearing threshold.
Article 2a states that the European Commission shall publish a list of those markets that are to be considered to be equivalent.
ESMA maintains on its website a consolidated list of third-country markets that have been considered to be equivalent to an EU regulated market for the purpose of the OTC derivative definition under EMIR (see here the list of non-EU exchanges equivalent to a regulated market).
Intragroup transactions when calculating clearing thresholds
The approach to intragroup transactions as regards calculating clearing thresholds was a controversial issue among market participants during the process of drafting EMIR regulatory standards.
Relation between intragroup and the corresponding external transactions pursuant to ESMA regulatory guidance of 5 August 2013
In a group typically there is one, or more, company that is specialised in dealing in derivatives with entities outside the group. This trading company enters into external derivative contracts which, to the maximum possible extent, mirror one or more derivative contracts with entities within the group.
For the purpose of calculating positions to be compared to the clearing threshold, where the derivative contracts concluded by the group non-trading NFC qualify as hedging contracts, then the correspondent external contracts should also be considered as hedging contracts. On the contrary, where the derivative contracts concluded by the group non-trading NFC do not qualify as hedging contracts, then the correspondent external contracts should not be considered as hedging contracts either.
In the simplest scenario, whereby an external transaction perfectly mirrors a derivative contract concluded by a group non-trading NFC, which does not qualify as hedging contract, the counter value to be considered for the sake of calculating the clearing threshold amounts to three times the notional value of the intragroup or external transaction.
For illustration purpose, let us suppose that:
- A is a NFC
- B is a NFC in the same group as A, and B is the entity specialised in dealing derivatives with entities outside the group
- A and B enter into an OTC derivative transaction, with a notional value of 100, e.g. A buys 100 and B sells 100
- B enters into an opposite transaction with an entity outside the group (C), i.e. B buys 100 from C.
Then the total notional amount to be counted towards the clearing threshold is:
- Zero, if the transaction between A and B satisfies the hedging conditions with respect to A;
- 300, if the transaction between A and B does not satisfy the hedging conditions with respect to A, i.e. 100 for the buy transaction between A and B, 100 for the sell transaction between B and A, and 100 for the buy transaction between B and C.
Some responses during consultation processes argued that the calculation of the clearing threshold should not consider OTC derivative contracts entered into at the group level but only at the level of the legal entity. In this respect, ESMA however has taken the view that these issues are related to provisions in the Level 1 text and the mandate granted by EMIR to develop Level 2 provisions does not extend to these aspects (see Final Report of 27 September 2012, ESMA/2012/600 on Draft technical standards under the Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC Derivatives, CCPs and Trade Repositories).
Consequently, the European financial regulator adopted the stance that intra-group transactions must be counted against clearing thresholds.
Intragroup transactions are placed by EMIR in one important aspect at an disadvantage in comparison with analogous trades with entities from outside the group.
The said "discrimination" is reflected in the fact that if two group entities having the character od non-financial counterparties enter into an intragroup transaction with each other, which does not fall within the hedging definition, both sides of the transaction should be counted towards the threshold. The total contribution to the group-level threshold calculation would therefore be twice the notional of the contract.
The correctness of this approach has been confirmed by ESMA in Q&A on EMIR.
The said handicap does not appear for non-hedging intragroup transactions between one non-financial counterparty and one financial counterparty, only the non-financial counterparty side of the transaction needs to be counted.
Another issue is that answering to the question whether OTC derivative positions taken by jointly controlled entities or entities accounted for under the equity method should be counted against the clearing thresholds ESMA made clear that only the positions of fully consolidated subsidiaries should be taken into account for these purposes.
The potential intragroup exemptions are elaborated on in greater detail under the following link.
Practical intra-group compliance issues regarding group position versus clearing threshold
The NFCs within a group with financial counterparties (FCs) are commonly represented by a central team within the group which is responsible for identifying NFCs within the group, and ensuring those NFCs meet the requirements as stated by EMIR.
The activities of NFCs within the group for EMIR compliance purposes need to be adequately identified and monitored to be included in the global group clearing threshold calculation.
It is advisable to create a single centre of competence and point of contact within a group (usually the group treasury) responsible for reporting against the clearing threshold which takes the global group position into account (however, possible conflicts of interest between the group participants should be properly managed).
For EMIR compliance purposes, a uniform, group-wide policy is also necessary for defining hedging trades, with a process in place to monitor the level of non-hedging activity if trading is outside of this scope (the back-to-back contracts within the group need also to be reported).
Inevitably, such a monitoring whether trades are concluded for hedging or non-hedging comes with costs, in the impact assessment accompanying the draft regulatory technical standards on EMIR submitted by ESMA to the European Commission on 27 September 2012 (ESMA/2012/600 Annex VIII) those costs were estimated at EUR 50,000 one-off plus EUR 40,000 on-going per year and per counterparty.
It is noteworthy, even the smallest entities are currently required to classify all their transactions as hedging or non-hedging.
"OTC derivative" terminology complexities
ESMA's Q&As on EMIR Implementation OTC Q.1 (d) clarified the following:
"Derivatives transactions, such as block trades, which are executed outside the trading platform of the regulated market, but are subject to the rules of the regulated market and are executed in compliance with those rules, including the immediate processing by the regulated market after execution and the clearing by a CCP, should not be regarded as OTC derivatives transactions. Therefore, these transactions should not be considered for the purpose of the clearing obligation and the calculation of the clearing threshold by NFC that only relates to OTC derivatives.
Derivatives transactions that do not meet the conditions listed in the first paragraph of this sub-answer (d) should be considered OTC. For example, derivatives contracts that are not executed on a regulated market and are not governed by the rules of an exchange at the point of execution should be considered OTC even if after execution they are exchanged for contracts traded in a regulated market. However, the replacement contract itself may be considered exchange traded if it meets the relevant conditions."
MiFID II interconnections
Pursuant to MiFID II Directive EMIR clearing obligation will not apply during the 42-month transitional period (counted from the entry into application of the said Directive) to C6 energy derivatives (i.e. physically settled coal and oil traded on an OTF) entered into:
- by non-financial counterparties below clearing threshold, or
- by non-financial counterparties that will be authorised for the first time as investment firms as from the date of entry into application of the MiFID II.
Moreover, during the above-mentioned 42-month transitional period C6 energy derivatives contracts will also not count towards the clearing threshold under EMIR
When it comes to MiFID II another point shouldn't be neglected - namely the impact of trading on the newly-created OTF markets.
OTF trading in the EMIR nomenclature is understood as OTC, hence these volumes will count towards the clearing thresholds.
It is important to remember, under EMIR only regulated markets (or third-country equivalent) are not OTC, in consequence, besides OTF, all MTFs trading (like, for instance, GFI) increase clearing thresholds calculations.
Whether such particular treatment of regulated markets is fully reasonable in this context, it can potentially be disputed, but the wording of the law is sufficiently clear in that regard.
General observation is that new rules for the MiFID II ancillary activity exemption will lead the largest non-financial counterparties to being subject to the clearing obligation under EMIR, limiting EMIR clearing thresholds to a residual tool for picking up 'systemic' NFCs.
However, it should be noted that the MiFID thresholds operate differently from the EMIR ones in two important aspects:
- both thresholds used by the MiFID II ancillary activity exemption are percentage-based, and not absolute numerical values as in the case of EMIR.
- they only apply to commodity derivatives and emission allowances derivatives (for which the EMIR threshold is EUR 3 billion).
Concerns regarding allocation of responsibility when calculating clearing thresholds
Among potential compliance concerns regarding EMIR and particularly the issue of clearing thresholds is the question how the counterparty trading with the non-financial counterparty (NFC) is going to be made aware that the NFC has or has not yet exceeded the clearing threshold and how the responsibility for breaching the respective restrictions is shared.
The relevant questions, amongst others, are:
1) Under what conditions the counterparty of the NFC may be held liable for the effects of NFC’s breaching clearing threshold and what extent of the diligence is required of the said counterparty by law?
2) Is the representation made by the NFC in the signed-off agreement about the absence of legal impediments for the valid conclusion of the agreement sufficient for effective exculpation?
3) Is the “common sense” pattern the only standard in that regard or there are other that should be complied with by market parties?
The closely interlinked issue is the potential public disclosure of the information on the clearing threshold status. That aspect was strongly underlined by the industry when stating (mentioning explicitly the portfolio reconciliation as the EMIR risk mitigation technique, but applying at least by analogy to effects of the counterparty being below or above the clearing threshold):
“The uniform identification of counterparties as FCs, NFC+ or NFCs is central to the consistent cross-market implementation of individual firms’ policies and procedures designed to meet the reconciliation requirements established under EMIR. In the absence of industry sources or a requirement to make counterparty representation mandatorily available, firms will need to rely on counterparty representation and internal reference data which could lead to inconsistent treatment of firms, particularly as it relates to the distinction between NFC and NFC+ where the reconciliation threshold and frequency are quite different, depending upon counterparty categorization. It would be extremely beneficial if ESMA (to whom the relevant report by an NFC breaching the clearing threshold is made, in the first instance) could make this information centrally available to the industry in a way that the information can be relied upon and give certainty to those dealing with firms as to how they should be categorised. It should also be noted that the CFTC makes registered firm classifications available to the public via the National Futures Association (NFA) website” (ISDA Commentary on EMIR RTS on Portfolio Reconciliation, Dispute Resolution and Compressions (in European Commission Delegated Regulation C92012) 9593 final (19 December 2012)) of 14 February 2013).
The clarification has been made available by ESMA on 20 March 2013 on the issue whether the financial counterparty is responsible for the proper qualification of its counterparty as being above or below the clearing threshold.
The ESMA's answer was as follows:
"NFCs which trade OTC derivatives are obliged to determine their own status against the clearing threshold. FCs should obtain representations from their NFC counterparties detailing the NFC’s status. FCs are not expected to conduct verifications of the representations received from NFCs detailing their status and may rely on such representations unless they are in possession of information which clearly demonstrates that those representations are incorrect."
The above language indicates the obligation to verify the counterparty position versus clearing threshold has been imposed on market participants to a certain extent only, and the relevant check need not to be thorough.
At a minimum the necessary audit should cover two points:
1) whether the relevant representation was made, and
2) whether the entity is in possession of information which "clearly demonstrates that those representations are incorrect."
However, as always, every clarification rises further ambiguities. In this case the said further doubt may be for instance, whether the assessment referred to above in point 2 should be made on the entire group level or from the perspective of the subsidiary company only.
In other words, will the subsidiary company be lawfully discharged from liability for the incorrect assessment of its counterparty clearing-threshold status if the meaningful documents are cognizant of by its head office only? The said ambiguity is emphasised by the overall EMIR's approach with respect to groups of associated companies, sometimes treated as a single entity (in particular when it comes to evaluation whether the clearing threshold has been crossed).
Clearing obligation as a result of portfolio compression
Another ambiguous case is the situation where as a result of the portfolio compression a non-financial counterparty crosses a clearing threshold and becomes subject to the clearing obligation.
There is no formally inscripted exemption from the clearing obligation for such an occurrence, however, taking into account issues of practicality and analogies from other significant jurisdictions, it seems that such cases shouldn't be covered by the clearing requirement. This legislative shortcoming can't, however, be decisively resolved without regulatory guidance.
FX movements' impact on clearing thresholds
The effects of NFC’s inadvertent crossing the threshold as a result of non-EUR denominated contracts moving in or out of EUR value threshold due to FX movements had been ambiguous from the regulatory point of view, until ESMA in Q&A document has explained that counterparties "are expected to use updated exchange rates every time they calculate the total position to be compared to the clearing threshold" (the respective question had the wording: "When counting a contract denominated in a currency other than Euro, does the conversion to euro have to be done every day to reflect exchange rate fluctuation?").
Market participants should be also mindful of the fact that all OTC derivative transactions entered into by non-financial entities within the group, whether or not those entities are established within the EU, must be included in the clearing threshold calculation.
It may be particularly challenging to perform a group-wide threshold calculation when the EU-located non-financial counterparty (NFC) had relatively small trading activities, but needed to include the derivatives activity of other larger entities outside the EU in their calculation. EU-based NFCs need to have accurate information on the global group's derivative position since they are responsible for the requirements under EMIR.
So, it needs to be stressed that positions taken by third-country non-financial entities in the same group as the non-financial counterparty, which would be non-financial counterparties if they were in the EU, count for the calculation of the clearing threshold.
ESMA in its EMIR Q&As has underlined in this context that the group to which the non-financial counterparty belongs includes subsidiaries, sisters and parent companies of the non-financial counterparty wherever the ultimate parent company is established.
EMIR reform propositions on clearing thresholds - May 2017
Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, COM(2017)208 published by the European Commission in May 2017 put forward some important modifications with respect to clearing thresholds legal regime, in particular, a new Article 4a is inserted and in Article 10, paragraphs 1 and 2 are significantly modified - see boxes.
Non-financial counterparties required to clear only the asset classes for which they have breached the clearing threshold
Non-financial counterparties required to assess their situation vis-à-vis the clearing obligation only once a year, based on the average activity over the months of March, April and May
Contracts by NFCs above a clearing threshold will continue to have to be cleared through a CCP
OTC derivatives used to hedge risks related to their activities continue to be subtracted from the firm's overall position and do not count towards the threshold set for the clearing obligation
Small financial counterparties, such as small banks or funds, below the clearing threshold free from the requirement to clear centrally
Proposal for a Regulation of the European Parliament and of the Council amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories (COM(2017)208) of May 2017
New Article 4a of EMIR:
Financial counterparties subject to a clearing obligation
1. A financial counterparty taking positions in OTC derivative contracts shall calculate, annually, its aggregate month-end average position for the months March, April and May in accordance with paragraph 3.
Where the result of that calculation exceeds the clearing thresholds specified pursuant to Article 10(4)(b), the financial counterparty shall:
(a) immediately notify ESMA and the relevant competent authority thereof;
(b) be subject to the clearing obligation referred to in Article 4 for future OTC derivative contracts, irrespective of the asset class or asset classes for which the clearing threshold has been exceeded;
(c) clear the contracts referred to in point (b) within four months of becoming subject to the clearing obligation.
2. A financial counterparty that has become subject to the clearing obligation in accordance with paragraph 1 and subsequently demonstrates to the relevant competent authority that its aggregate month-end average position for the months March, April and May of a given year no longer exceeds the clearing threshold referred to in paragraph 1, shall no longer be subject to the clearing obligation set out in Article 4.
3. In calculating the positions referred to in paragraph 1, the financial counterparty shall include all OTC derivative contracts entered into by that financial counterparty or entered into by other entities within the group to which that financial counterparty belongs."
In Article 10, paragraphs 1 and 2 are replaced by the following:
“1. A non-financial counterparty taking positions in OTC derivative contracts shall calculate, annually, its aggregate month-end average position for the months March, April and May in accordance with paragraph 3.
1. Where the result of that calculation exceeds the clearing thresholds specified pursuant to paragraph 4(b), that non-financial counterparty shall:
(a) immediately notify ESMA and the authority designated in accordance with paragraph 5 thereof;
(b) be subject to the clearing obligation referred to in Article 4 for future OTC derivative contracts in the asset class or asset classes for which the clearing threshold has been exceeded;
(c) clear the contracts referred to in point (b) within four months of becoming subject to the clearing obligation.
2. A non-financial counterparty that has become subject to the clearing obligation in accordance with the second subparagraph of paragraph 1 and subsequently demonstrates to the authority designated in accordance with paragraph 5 that its aggregate month-end average position for the months March, April and May of a given year no longer exceeds the clearing threshold referred to in paragraph 1 shall no longer be subject to the clearing obligation set out in Article 4.”
FIA Response of 18 July 2017 to the European Commission EMIR Review Proposal – Part 1 (REFIT Proposals) supports the change proposed in Article 10(1)(b) of the European Commission's proposal to restrict the clearing obligation to the specific classes of OTC derivatives for which the clearing threshold has been exceeded.
However, according to the FIA the European Commission’s proposal has omitted to introduce a complementary amendment to Article 11(3) of EMIR as regards to margin requirements for uncleared transactions.
This means that an NFC that exceeds the clearing threshold in only one asset class will continue to be treated as an NFC+ for the purposes of the uncleared margin rules and be required to exchange collateral in relation to all OTC derivatives, irrespective of the asset class to which they belong and whether they exceed the clearing threshold for each such asset class.
By only making amendments to Article 10(1)(b) and not Article 11(3), in the FIA opinion the proposal does not provide any practical relief to NFCs as clearing relief without corresponding margin relief still puts a substantial burden on NFCs.
Such a result seems to FIA incongruous with the proposed relief from an all-encompassing clearing obligation introduced in Article 10(1)(b) and does not alleviate the negative impact the margin rules have on corporate treasury derivative use (e.g. in FX and interest rate derivatives).
Also ISDA observes (International Swaps and Derivatives Association (ISDA) comments on the ‘EMIR Refit’ proposal, 18 July 2017, p. 18) that this imposes a substantial burden on the central treasury functions of corporate groups, which would – in case one of their affiliates breach the clearing threshold in one asset class, e.g. commodities – be forced to adhere to the non-cleared margin RTS, thereby being forced to collateralize transactions in another asset class (e.g., interest rate and FX instruments).
Consequently, ISDA believes there is an argument supporting amendments to provide that the relief from the clearing obligation for asset classes for which no clearing threshold is breached be accompanied by relief from bilateral margin exchange.
Interestingly, the Report of 23 May 2018 of the European Parliament’s Committee on Economic and Monetary Affairs (Rapporteur Werner Langen, (COM(2017)0208 – C8-0147/2017 – 2017/0090(COD)), PE 616.810v02-00) proposed to develop two distinct clearing thresholds, one for financial counterparties and another for the non-financial counterparties. The reason for this, in the said Committee’s opinion, is that the above categories of counterparties present different risks’ profiles.
The said Committee also proposed that thresholds should be updated regularly, in order to take into account any development of financial markets.
The EMIR REFIT amendments have been finally adopted in the Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 2019 amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivative contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories, which on 28 May 2019 has been published in the Official Journal of the EU (the date of entry into force on 17 June 2019).