Given the additional operational burden EMIR imposes on counterparties trading OTC in emission derivatives (obligation to centrally clear OTC derivative contracts or to apply risk mitigation techniques), and the global nature of emissions derivatives market, the key aspect is to establish the territorial scope of EMIR requirements.
What are the circumstances in which the EMIR clearing obligation, risk mitigation techniques and margin requirements will apply to emissions' contracts between two non-EU entities?
The main points are as follows:
EMIR stipulates that two entities established in one or more third countries that would be subject to the clearing obligation if they were established in the Union must clear their OTC derivative contracts provided they have a direct, substantial and foreseeable effect within the Union.
Similarly, Article 11(12) of EMIR stipulates that risk mitigation techniques laid down in paragraphs 1 to 11 of Article 11 of EMIR apply to OTC derivatives between third country entities that would be subject to those obligations if they were established in the Union provided those contracts have a direct, substantial and foreseeable effect within the Union.
The OTC derivative contracts meet the said criteria of having a direct, substantial and foreseeable effect within the Union when:
1. they are covered by a guarantee issued by a financial counterparty established in the Union subject to some quantitative thresholds, or
2. they are concluded between Union branches of third countries entities.
OTC Question 23 [last update 31 March 2015]
Article 2 RTS on Third Country contracts - Effect on existing trades
(a) Does the RTS on Third Country contracts apply to OTC derivative contracts concluded before the date of entry into force of the RTS?
(b) Does the RTS on Third Country contracts apply to OTC derivative contracts made after the entry into force of the RTS, but covered by a guarantee which meets the conditions set out in the RTS which was provided before the entry into force of the RTS
Answer 23
(a) No and this answer is also set out in paragraphs 44 and 45 of ESMA's Final Report dated 15 November 2013 on the RTS.
(b) Yes and the last paragraph of Article 2(1) expressly contemplates that application. If there is a change in some of the inputs to the calculation against the threshold, i.e. the inclusion in a guarantee of an addi-tional existing trade or an increase in the amount of the guarantee, then relevant contracts entered into after the effective date of the RTS would be brought within scope of Article 2. The parties to the relevant arrangements for the OTC derivatives then falling within the scope of the RTS would be required promptly to meet the relevant requirements.
Hence, the broader context of the regulation at issue can be summarised as follows:
1. EMIR obligations apply to OTC derivative contracts when counterparties are established in the Union.
2. When one counterparty is established in the Union and the other counterparty is established in a third country (cross-border transaction), the clearing obligation or risk mitigation requirements would apply subject to the mechanisms to avoid duplicative or conflicting rules.
3. When the two counterparties are established in third countries, EMIR only applies under certain conditions specified in the Commission Delegated Regulation (EU) No 285/2014 of 13 February 2014 supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on direct, substantial and foreseeable effect of contracts within the Union and to prevent the evasion of rules and obligations (hereinafter referred to as "EMIR cross-border RTS" or "RTS on Third Country contracts" or "RTS").
These conditions relate to transactions having a "direct, substantial and foreseeable effect in the Union" or conducted under arrangements designed to evade EMIR rules.
Transactions caught by the "direct, substantial and foreseeable" condition are only those conducted by non-EU derivatives counterparties, which are guaranteed by an EU regulated financial firm (over certain cumulative thresholds - see box) or transactions conducted between EU branch offices of non-EU entities - point 4 below.
The mechanisms to avoid duplicative or conflicting rules would also apply in such case.
4. Transactions concluded between EU branches of non-equivalent third country entities are captured by EMIR.
Operations involving indirectly third-country firms considered to have a direct, substantial and foreseeable effect within the Union and consequently subjected to EMIR
1) OTC derivative contracts between EU branches of non-equivalent third countries,
2) guarantees provided by EU financial counterparties (determined by specific quantitative threshold - at least 8 billion euro equivalent for an aggregated notional amount and 5 percent of the sum of the current exposures (as defined in Regulation No 575/2013)) to cover OTC derivative contracts concluded by counterparties established in third countries.
The entities subject to the above rules would, however, be able to disapply the provisions of EMIR and apply the equivalent provisions in a third country, if at least one of the two counterparty is established in a jurisdiction for which the Commission adopted an implementing act on equivalence.
5. Differently, OTC derivative contracts between the EU branch of a non-EU entity and another non-EU entity, are left to the regimes of the third countries involved, as these transactions are cross-border transactions between two non-EU entities, whereas in case indicated under point 4 above the transaction would be solely executed within the Union by two non-EU entities.
To conclude, in the scenario of OTC derivative contracts between the EU branch of a non-EU entity and another non-EU entity the transaction is not subject to EMIR.
Cross-border guarantees covered by EMIR
As was said above when the two counterparties are established in third countries, EMIR (clearing obligation and the risk mitigation techniques including) applies where transactions have a "direct, substantial and foreseeable effect in the Union".
Among such transactions are those conducted by non-EU derivatives counterparties which are guaranteed by an EU regulated financial firm over cumulative thresholds:
- at least 8 billion euro equivalent for an aggregated notional amount and
- 5 percent of the sum of the current exposures (as defined in Regulation No 575/2013).
Below you can find specific comments on detailed arrangements of this conception.
Definition of the term: "guarantee"
In the draft RTS the term "guarantee" raised ambiguities what would constitute a guarantee, and whether implicit guarantee, letters of comfort, insurance contracts and CDS would constitute a guarantee for the purpose of analysing EMIR cross-border issues.
Doubts were based on the fact that earlier versions of the RTS did not contain of the definition of the term guarantee, and might encompass different types of contract.
'Guarantee' means 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.
In the final RTS the relevant definition was therefore introduced with the aim for providing legal certainty.
In effect, the definition refers to explicitly documented legal obligations, thereby excluding implicit guarantees and in general letters of comfort, unless they are drafted as a legal obligation of the issuer.
Credit derivatives, i.e. credit protection sold in the form of an OTC derivative, and contracts of insurance are also out of the scope of the definition of guarantee as resulting risks are addressed through different instruments.
OTC Question 22 [last update 31 March 2015]
Article 2.1 of RTS on Third Country contracts - Conditions – cumulatively or singly?
In the following three cases in which a single guarantor gives several guarantees, should these guarantees be considered cumulatively or singly for the purpose of assessing whether the conditions in Article 2(1) of the RTS on Third Country contracts are met?
(case a) Guarantee A over Guaranteed Entity A's liabilities to Beneficiary A and Guarantee B over Guaranteed Entity B's liabilities to Beneficiary B, where the two guarantees are unrelated, except that they have the same guarantor.
(case b) Guarantee A over Guaranteed Entity A's liabilities to Beneficiary A and Guarantee B over Guaranteed Entity A's liabilities to Beneficiary B.
(case c) Guarantee A over Guaranteed Entity A's liabilities to Beneficiary A and Guarantee B over Guaranteed Entity A's liabilities to Beneficiary A.
OTC Answer 22
(case a) Without prejudice to Article 3 of the RTS on Third Country contracts, the conditions should be read separately for each guarantee.
The two third country entities are different for each of the guarantees described.
(case b) Both guarantees should be looked at in conjunction because they both could involve exposure on the EU guarantor in relation to a single guaranteed entity as otherwise the multiplication of guarantees could allow circumvention of the provision.
(case c) The conditions should be read by taking the two guarantees together.
Legal enforceability of the guarantee
Somebody may ask whether questions as to the legal enforceability of the guarantee may influence on the EMIR applicability to the third-country cross-border derivative transactions.
Interestingly, the criterion "legally enforceable" was present in the early drafts of the EMIR cross-border RTS but was removed from the characteristics of the guarantee in the final text, since, as was argued, this reference would force counterparties to conduct due diligence on contracts and would create operational difficulties. It was also recalled that, ultimately, only courts could determine legal enforceability.
Finally, to be mindful of the fact that it is in the interest of the parties to ensure that their contracts are legally enforceable, due diligence to this effect is not be required for the sole purpose of EMIR cross-border RTS.
Affiliation relationship between the guarantor and the guaranteed entity
In order to be considered within the scope of the RTS, the guarantee must be issued by a financial counterparty.
ESMA has underlined that the key criterion does not lie with the affiliation of the guaranteed counterparty and the issuing party, but the risk to be addressed results from the guarantee irrespective of the affiliation relationship that may exist between the both.
In this respect, a few respondents suggested during the draft RTS consultation process limiting the guarantees to the ones issued by a financial counterparty which is also the parent company of the guaranteed entity (arguing that counterparties to the OTC derivative would otherwise have no link of affiliation in the Union) but this suggestion was not considered legitimate and was not included in the final legislative text.
On the contrary, guarantees issued by non-financial counterparties based in the EU have not been assigned the same weight as the financial ones when it comes to risk in the derivatives' world and are not covered by the EMIR cross-border RTS.
8 billion euro threshold
When it comes to the reference to the 8 billion euro equivalent threshold, it is consistent with the thresholds for exemption for initial margin requirements set out in the final report on margin requirements for non-centrally cleared derivatives issued by BCBS IOSCO (the minimum level below which non-centrally cleared OTC derivatives would not be subject to initial margin requirements is set to 8 bn of gross notional outstanding).
It needs to be underlined that this threshold is to be calculated on a gross basis.
The arguments supporting this choice is that the threshold set for margin requirement also refers to a gross value and it was considered, it would be preferable to maintain the consistency between the two approaches.
Furthermore, allowing netting would introduce uncertainty about precisely which contracts would be deemed offsetting.
OTC Question 21 [last update 31 March 2015]
Art 2.1 of RTS on Third Country contracts – Responsibility
Which entity is responsible for assessing whether an OTC derivative contract would be covered by the "guarantee limb" of the RTS on Third Country contracts (i.e. Article 2(1) of Commission Delegated Regulation (EU) No 285/2014 of 13 February 2014) and for compliance with any obligations under EMIR arising as a result of the application of the RTS on Third Country contracts – the guarantor, the third country entity whose liabilities are covered (the "guaranteed entity") or the third country beneficiary of the guarantee?
OTC Answer 21
The regulation applies within the Union and the EU financial entity granting the guarantee is responsible for assessing whether the conditions are met for the regulation to apply and for ensuring that the relevant EMIR requirements are met.
For this purpose, it can arrange the relevant procedure (e.g. a notification) with the guaranteed third country entity in order to get the information and data it needs to perform the assessment and ensure compliance.
Hence, the RTS provides that the guarantee shall be issued by a financial counterparty but does not require any affiliation between the guarantor and the guaranteed entity.
Thresholds measurement timing
When it comes to the moment when the monitoring should be performed against the thresholds, for guarantees below 8 billion, the monitoring should occur on the day the amount of the guarantee is increased.
When the amount of the guarantee is above 8 billion, but the liabilities resulting from the OTC derivatives contracts covered by the guarantee are below 8 billion or 5%, the conditions should be monitored on the day of the increase of the liability for the 8 billion threshold and on the month of the decrease of the sum of current exposures for the 5% threshold.
Calculation at the entity level
The notional amount and current exposure set for the thresholds should be calculated of the legal entity and not at the level of the group.
Given the possibility to split the amount of a guarantee among several guarantors, a proportional value of the threshold will be applied when the guaranty covers only a part of the liability resulting from the OTC derivative contracts.
Inter-temporal issues
OTC derivative contracts concluded after the date of application of the RTS but before a guarantee that meets the cumulative quantitative thresholds covers them, are considered to have a direct, substantial and foreseeable effect within the Union.
Contracts concluded before the date of application of the technical standards will not be subject to the application of the relevant provisions of EMIR.
However, for the calculation of the 8 bn and 5% thresholds all the relevant outstanding contracts should be considered, even if concluded before the date of application of the RTS.
EMIR treatment of derivatives contracts between EU branch offices of non-EU entities
Among the transactions having a "direct, substantial and foreseeable effect in the Union" and, consequently being subject to EMIR requirements (clearing obligation and the risk mitigation techniques including) are transactions conducted between EU branch offices of non-EU entities.
The reasoning underlying the above propositions is that branches of third country entities established within the Union may be significant players in the European market as well as liquidity providers.
It is to be noted that OTC derivative contracts between the EU branch of a non-EU entity and another non-EU entity are not captured by EMIR.
Another characteristic of the EMIR regime for transactions between EU branches of third-country entities in OTC derivatives is the absence of any de minimis thresholds, which means that even small derivative contracts are entirely covered.
It is also noteworthy, the said arrangements are designed as mandatory and not as any opt-in framework, whereby EU branches could deem their transactions to have a direct, substantial and foreseeable effect within the Union in order to allow them to demonstrate that they are subject to EMIR and therefore benefit from substituted compliance in other jurisdictions.
Any discretion on the side of the EU branches of non-EU entities with respect to EMIR requirements is thus disapplied. Underlying intention was to ensure a level playing field.
Contracts entered into by subsidiaries established in third countries of EU parent
Contracts entered into by subsidiaries established in third countries of EU parent are not considered to have a direct, substantial and foreseeable effect within the Union and, consequently, subjected to EMIR.
Subsidiaries are different legal entities and, unless explicitly guaranteed, the parent generally is not legally responsible for its subsidiaries.
Acceleration of the obligation between Specified Entities under ISDA Master Agreement
The events like the acceleration of the obligation between Specified Entities under ISDA Master Agreement as a consequence of default on the part of only one Specified Entity were also considered for EMIR cross-border purposes but finally found not relevant.
In spite of the fact that in the situation when counterparties established in a third country have listed for the purpose of acceleration or cross default in their master agreement a financial counterparty or a non-financial counterparty established in the Union, their derivative contracts may have an effect within the Union, the European financial regulators consider that it would be disproportionate to include such transactions in the scope of EMIR.
It was argued that the effect of the acceleration did not impact the parties to the obligation or the obligation itself but only the timing of the obligation and the transaction and resulting liabilities remained between the counterparties. The only change relate to the moment when the obligations become due.
Grounds for determination whether an entity established in a third country is an NFC+ or NFC-
Another potentially contentious issue ESMA shed some light on in its regulatory clarifications (Q&A document as updated on 5 August 2013) is the specific manner in which a counterparty should determine whether an entity established in a third country which they believe would be an NFC is an NFC+ or NFC-.
If the third country entity is part of a group which also includes NFCs established in the Union, its NFC+ or NFC- status should be assumed to be the same as that of the EU NFCs and this information should be requested from the counterparty.
If the third country entity is not part of such a group, but benefits from a similar, limited exemption in its own jurisdiction, it may be assumed that the entity would be NFC- were it established in the Union.
If neither of the above holds, the only way to determine the status of such a third country entity would be for it to calculate its group-level position against the EMIR clearing threshold.
Counterparties might obtain representations from their third country counterparties detailing the NFC's status.
The EU counterparty is not expected to conduct verifications of the representations received from the third country entity detailing their status and may rely on such representations unless they are in possession of information which clearly demonstrates that those representations are incorrect.
If it is not possible to assess what would be counterparty's status under EMIR, firms should assume that their counterparty status is NFC+ and apply EMIR requirement accordingly.
Anti-evasion
As was said above when the two counterparties are established in third countries, EMIR would apply where transactions are conducted under arrangements designed to evade EMIR rules.
Regarding anti-evasion, ESMA proposed an approach which looks to the primary purpose of the transaction, not just its form, and provides a list of factors which may indicate evasion.
Decisions on equivalence
The mechanism of equivalence will allow counterparties to be deemed to have fulfilled EMIR obligations, including those related to the clearing obligation and the risk mitigation techniques.
When one of the third country counterparties to an OTC derivative contracts is established in an equivalent country, both counterparties will be deemed to have fulfilled obligations under EMIR, including those related to the clearing obligation and the risk mitigation techniques as the case may be, by applying the equivalent rules of the third country.
The above rules have been expressed by the recital to the EMIR cross-border RTS in the following words:
"Given that pursuant to Article 13(3) of Regulation (EU) No 648/2012, the provisions of that Regulation would be deemed fulfilled when at least one of the counterparties is established in a country for which the Commission has adopted an implementing act declaring equivalence in accordance with Article 13(2) of Regulation (EU) No 648/2012, these regulatory technical standards should apply to contracts where both counterparties are established in a third country whose legal, supervisory and enforcement arrangements have not yet been declared equivalent to the requirements laid down in that Regulation."
ESMA has, among others, assessed the equivalence of the regulatory regimes of Australia (Ref. 2013/1159), Hong Kong (Ref. 2013/1160), Japan (Ref. 2013/1158), Singapore (Ref. 2013/1161), Switzerland (Ref. 2013/1162) and the US (Ref. 2013/1157).
The third-country rules were compared with EMIR requirements for central clearing, reporting, CCPs, TRs and non-financial counterparties as well as risk mitigation techniques for uncleared trades.
ESMA considers third-country regimes equivalent where the legal provisions and the level of supervision and enforcement is similar to that of EMIR.
The European Commission is expected to use ESMA's technical advice to prepare possible equivalence decisions.
Where it adopts such a decision, certain provisions of EMIR may be disapplied in favour of equivalent third-country rules and, depending on the specific area determined to be equivalent, ESMA may:
- recognise within the EU a a central counterparty (CCP), which is authorised outside the EU; or
- recognise within the EU a TR which is authorised outside the EU;
ESMA's advice is based on a factual assessment of the rules of each jurisdiction but has also taken into account possible consequences for the stability and protection of EU entities and investors that an equivalence decision would have.
ESMA's advice has also considered upcoming regulations in several jurisdictions that may impact the equivalence assessment.
The first 'equivalence' decisions have been adopted by the European Commission for the regulatory regimes of central counterparties (CCPs) in Australia, Hong Kong, Japan and Singapore (see more on the European equivalence regime for CCPs and the effects of the CCPs' equivalence decisions).
The equivalence status to the US legal framework governing risk mitigation techniques (margin requirements including) has been granted by the Commission Implementing Decision (EU) 2017/1857 of 13 October 2017 on the recognition of the legal, supervisory and enforcement arrangements of the United States of America for derivatives transactions supervised by the Commodity Futures Trading Commission as equivalent to certain requirements of Article 11 of Regulation (EU) No 648/2012 of the European Parliament and Council on OTC derivatives, central counterparties and trade repositories.
The US counterpart CFTC issued the parallel media report: CFTC Comparability Determination on EU Margin Requirements and a Common Approach on Trading Venues, Release: pr7629-17, October 13, 2017).
Segregation and portability
The requirements on clearing members that are established in EMIR (e.g. those in Articles 38 and 39 of EMIR) apply to clearing members of all CCPs established in the European Union.
ESMA's Q&A of 11 November 2013 clarified that the non-EU clearing members of EU CCPs providing services to EU clients are also subject to the segregation requirements in Article 39.
The references to clearing members in Article 39 are not limited to EU clearing members, so all clearing members of EU CCPs are required to comply. CCPs are expected to require all clearing members to comply with the relevant EMIR provisions through their rules.
On the other hand, EU clearing members of non-EU CCPs are not required to comply with Article 39 when offering client clearing on non-EU CCPs.
However, EU clearing members will only be allowed to be a clearing members of a non-EU CCP which has been recognised as meeting equivalent requirements to EMIR under the process set out in Article 25 of EMIR.
This will include an assessment of the CCP's segregation arrangements.
Other key issues
Market participants should be also mindful of the clarification in the ESMA EMIR Q&As that derivatives traded on non-EU exchanges would be included in the EMIR definition of OTC derivatives unless and until such time as the European Commission declares such non-EU exchanges as being equivalent to a regulated market in a published list.
Equally important is 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 of 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.
Dates od applicability
The EMIR cross-border RTS enterd into force on 10 April 2014 (twentieth day following their publication in the Official Journal, which was 21 March) but Article 2 (which sets out which contracts have a direct, substantial and foreseeable effect within the EU) applies from 10 October 2014.
The OTC derivative contracts concluded before the date of application of the relevant part of the RTS will not be considered as having a direct, substantial and foreseeable effect within the Union.
This approach is justified by the fact that time is needed to ensure compliance and that, for some contracts, at the time when they were concluded, the application of some provisions of EMIR could not have been anticipated and were therefore not considered when setting the terms of the transactions.
Furthermore, this approach is in line with that adopted in EMIR for the application of the clearing obligation (article 4(1) (b) of EMIR).
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Documentation |
ESMA Consultation Paper Draft Regulatory Technical Standards on contracts having a direct, substantial and foreseeable effect within the Union and non-evasion of provisions of EMIR of 17 July 2013, ESMA/2013/892
Final Report Draft technical standards under EMIR on contracts with a direct, substantial and foreseeable effect within the Union and non-evasion of 15 November 2013, ESMA/2013/1657)
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Links |
ESMA's EMIR third country equivalence website