Regulation of the European Parliament and Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR)
- Category: Financial
Regulation No 648/2012 of the European Parliament and Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR - European Market Infrastructures Regulation) represents the European Union implementation of the Group of Twenty (G20) Pittsburgh summit declaration aiming at reducing the systemic risk from the over-the-counter ('OTC') derivative contracts.
As initially agreed in 2009, the G20 reform program included four elements:
- all standardised OTC derivatives should be traded on exchanges or electronic platforms, where appropriate,
- all standardised OTC derivatives should be cleared through central counterparties (CCPs),
- OTC derivative contracts should be reported to trade repositories,
- non-centrally cleared derivative contracts should be subject to higher capital requirements.
EMIR was adopted by the European Parliament on 29 March 2012 and entered into force on 16 August 2012, however a number of provisions in EMIR required ESMA to develop draft regulatory (RTS) and implementing (ITS) technical standards. Therefore certain provisions of EMIR fully apply following the entry into force of the Commission Regulations endorsing the draft RTS and ITS developed by ESMA.
The bulk of RTS on EMIR have been endorsed by the European Commission on 19 December 2012, however, some of the core requirements of EMIR became applicable in 2017 only (like collateral requirements) or have even more extended timelines (mandatory clearing).
EMIR is relevant to anyone who trades in derivatives, irrespective of whether on an exchange or otherwise, and whether within the EU or outside, however, the personal scope of its specific requirements differs significantly. EMIR as a regulation is binding in its entirety and directly applicable in all European Union Member States.
EMIR lays down:
- clearing and bilateral risk-management requirements for OTC derivative contracts,
EMIR drives derivatives market participants to clear some of their trades with the central counterparties (CCPs), provided the relevant deadlines stipulated by the Regulatory Technical Standards are met. The key parameter in EMIR with respect to so-called non-financial counterparties (NFCs) is clearing threshold, which also plays a role of a significance criterion. The former observation does not alter the fact that all transactions regarding derivatives will be reported to the trade repository, irrespective of whether they are cleared by the CCP or not.
For financial institutions covered by EMIR the new regulation means the need for making choice as regards the settlement model (i.e. in the role of the clearing member, client or through indirect clearing arrangements - in such a case a strategic choice for clients between omnibus and individual client segregation account is to be made), the necessary changes in client agreements regarding, among others, collateral, as well as modifications to internal procedures and IT infrastructure. Among the costs of implementation, apart from internal compliance expenses, also the burden of CCP fees should be envisioned.
Regulatory position on the scope of the notion 'OTC derivatives' under EMIR
EMIR lays down clearing and bilateral risk-management requirements for over-the-counter ('OTC') derivative contracts, while the reporting requirements are for derivative contracts (EMIR Article 1(1)). Therefore, the key importance is attached to the clear and precise definitions for the 'derivative contract' as well as 'over-the-counter derivative'.
These are set out in Article 2 point 5 and 7 of EMIR, which reads:
- 'derivative contract' or 'derivative' means a financial instrument as set out in points (4) to (10) of Section C of Annex I to Directive 2004/39/EC as implemented in Article 38 and 39 of Regulation (EC) No 1287/2006, and
- 'over-the-counter derivative' means a derivative contract the execution of which does not take place on a regulated market as within the meaning of Article 4(1)(14) of Directive 2004/39/EC or on a third-country market considered as equivalent to a regulated market in accordance with Article 2a of EMIR.
Hence, the definition of 'derivative contract' includes options, futures, swaps, forward rate agreements and other derivative contracts in relation to a extensive range of underlyings, but excludes spot transactions (physically settled transactions which settle by T+2 or within the period generally accepted in the market as the standard delivery period for the relevant underlying).
Emission allowances traded spot are not covered by EMIR since the term 'derivative contract' defined in EMIR does not include such a product. This qualification is not changed by MiFID II amendments, even though emission allowances in themselves are classified by MiFID II as financial instruments.
Considering Article 2 point 5 and 7 of EMIR in its definition of the 'derivative contract' or 'derivative' is referring only to financial instruments enumerated in points (4) to (10) of Section C of Annex I of MiFID and MiFID II has added emission allowances in the entirely new point 11 of the said Section C of this Annex, consequently emission allowances traded spot, while being MiFID II financial instruments, still are beyond the scope of instruments covered by EMIR.
Under MiFID II derivatives on emission allowances are financial instruments (Section C4) and, consequently, EMIR instruments.
European financial regulator ESMA has acknowledged in its Questions and Answers on EMIR that:
(b) 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.
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).
Another problem relates to the question whether the definition of OTC derivatives under EMIR should cover derivative contracts which are not executed on a regulated market, but which share the same characteristics as exchange traded derivatives, so that once cleared they become fungible with them. Answering this question ESMA reminded that the definition laid down in Article 2(7) of EMIR of the ‘OTC derivative’ or ‘OTC derivative contract’ explicitly refers to the place of execution ("a derivative contract the execution of which does not take place on a regulated market"). The characteristics that the above-mentioned contracts have in common with exchange traded derivatives are therefore not relevant for the purpose of the definition of OTC derivatives.
Also divergent implementations of the derivatives' definition under MiFID I Directive by the EU Member States' national laws lead to discrepancies in EMIR application across the EU. This was the subject of the correspondence between ESMA and the European Commission, but it appears, the problem will be definitively solved with the MiFID II entry into force only (see the derivatives' definition in Article 2(1)(29) MiFIR).
Another reflection is EMIR provisions refer in general to MiFID I Directive, hence require a major revamp.
Another key preliminary issue is the territorial scope for relevant EMIR requirements. The following operations involving indirectly third-country firms have been 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 (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.
EMIR’s implementation is a phased process. Although the EMIR’s general entry into force was in 2012, different start dates have applied to a range of requirements, often depending on category of counterparties, per individual obligations or per specific OTC derivative.
The risk mitigation techniques (bilateral margining excluding), have started to apply first, then reporting and the clearing obligation and then in 2017 bilateral margining for non-centrally cleared trades.
The clearing obligation started applying as of 21 June 2019 (category 3) and 9 of May 2019 (category 4).
See below more detailed comments on EMIR’s implementation timelines.
Risk mitigation techniques
As of 15 March 2013:
- some risk mitigation techniques have started applying (daily valuations: mark-to-market/mark-to-model, timely confirmation);
- non-financial counterparties have started counting their positions against the clearing thresholds and have started notifying the National Competent Authorities (NCAs) and ESMA if they are above the clearing threshold; and
- trade repositories have started applying to ESMA for registration (the database for ESMA registered trade repositories see here) and CCPs can start applying to NCAs for authorisation under EMIR.
The date on which the relevant requirements for risk mitigation techniques: portfolio reconciliation, portfolio compression and dispute resolution came into force was 15 September 2013.
The reporting obligation applies to all derivative transactions as from 12 February 2014 with the reservation that the start date for reporting collateral and valuations (applying to financial counterparties and non-financial counterparties above the clearing threshold (NFCs+) is 11 August 2014.
Non-financial counterparties below the clearing threshold are not required to report collateral, mark to market, or mark to model valuations (RTS Article 3(4)).
Six months after the authorisation of CCPs, and following the notification to ESMA by national competent authority of that authorization, ESMA needs to issue technical standards identifying the classes of derivatives subject to the clearing obligation. For each of these procedures, ESMA has up to six months from the time of the notifications to draft the respective RTS, consult and submit them for endorsement to the European Commission. After the Commission's endorsement, the RTS are subject to a non-objection period by both the European Council and Parliament, after which the clearing obligation will be phased-in per type of counterparties. The first procedure of this kind have started on 18 March 2014 following the authorisation of Nasdaq OMX Clearing AB as the first EU-based CCP on 18 March 2014. In accordance with the procedure laid out under Article 5(1) of EMIR, ESMA was notified of the fact including the classes of OTC derivatives cleared by Nasdaq OMX Clearing AB - being intrest rates, debt instrument and equity (emission allowances as included in the commodity asset class are subject to this notification).
Among the first three European CCPs authorized by ESMA were also:
- European Central Counterparty N.V. (EuroCCP - NL), Netherlands
- KDPW_CCP, Poland.
The above public register contains two types of information:
1. The list of the classes of OTC derivatives notified to ESMA - this section of the register was published for the first time on 18 March 2014 after a notification was received by ESMA under the procedure described in Article 5(1) of EMIR, i.e. following the authorisation of the first CCP to clear certain classes of OTC derivatives. This part of the Public Register is updated after each CCP authorisation.
The European financial regulator's task will be in each case to assess whether the classes of OTC derivatives notified meet the criteria defined in EMIR, and, if the conditions prove fulfilled, to propose draft regulatory technical standards (RTS) on the clearing obligation with respect to those classes of assets.
The clearing obligation procedure defined in Article 5(2) of EMIR is triggered every time a new CCP clearing OTC derivatives is authorised.
For the clearing obligation, ESMA will only assess the suitability of those classes notified to ESMA.
This means that if CCPs are authorised on different dates, several clearing obligation procedures may run in parallel.
2. As of January 2017 central clearing of standardised OTC derivative contracts was mandated as regards the interest rate swaps and CDS classes, which account for the vast majority of the activity in OTC derivatives to be cleared.
Margin requirements for OTC derivative contracts that are not centrally cleared entered into force in January 2017 and follow a gradual phase-in based on the internationally agreed implementation calendar (see here more details on collateral requirements under EMIR).
Article 2 of 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 (stipulating rules with respect to guarantees issued by financial counterparties established in the European Union as well as the EU branches of the third-country entities) applies from 10 October 2014.
Read more on EMIR cross-border issues.
Evolution of the EMIR legal framework
On 13 August 2015 ESMA proposed some modifications to the EMIR regulatory framework (see ESMA Press release (ESMA/2015/1260) ESMA recommends changes to EMIR framework), which were outlined in four reports:
ESMA Annual Report 2015, 15 June 2016, ESMA/2016/960 (p. 46) described the content of these four documents as follows:
"ESMA drafted four other reports on EMIR that were submitted to the Commission on 13 August. Three reports were in response to a request from the Commission, and the corresponding mandate included in the review clause of EMIR, on three specific topics. The fourth report was on additional issues and was a response to the public consultation the Commission ran from May to August 2015. First of all, in the first EMIR Review Report on the systemic importance of non-financial counterparties (NFC), the main findings are around the definition of NFC and on the application of the hedging criteria in the calculation of the thresholds, which is prone to differences of interpretation. The report proposed some changes to ensure a level-playing-field and the proper measure of the systemic relevance of NFCs. In relation to the second EMIR Review Report on procyclicality, the report analyses the different options adopted by CCPs to cope with procyclicality and recommends further specifying the rules for implementing the counter-cyclical tools for margins and collateral, including regular testing and transparency on the results. The third EMIR Review Report covered collateral margining and securing arrangements but primarily the arrangements related to segregation and portability. In particular, the report elaborated on the issue of conflict of laws with regard to insolvency, in relation to which it suggests to clearly indicate the rights attached to each account structure and to use different margin periods of risk to incentivise more secure account structures. ESMA also drafted a fourth EMIR Review Report that elaborated on many different matters ESMA has faced during the implementation of EMIR. In particular, it highlighted particular concerns and possible improvements related to the clearing obligation, the process of recognition of third-country CCPs as well as the necessary changes to ensure a more effective supervision and enforcement for trade repositories."
The above reports were the basis for the European Commission’s Proposal of May 2017 for the EMIR Refit (COM(2017)208) - see box below).
Derivative transactions concluded on exchanges reported only by the CCP on behalf of both counterparties
Intragroup transactions excluded from reporting, if one of the counterparties is a non-financial counterparty
Transactions between a financial counterparty and a small non-financial counterparty reported by the financial counterparty on behalf of both counterparties
Reporting on historic transactions no longer required
Non-financial counterparties required to clear only the asset classes for which they have breached the clearing threshold
Small financial counterparties, such as small banks or funds, below the clearing threshold free from the requirement to clear centrally
a new three–year temporary exemption for pension funds from central clearing
The legislative procedure for the EMIR Refit has been completed on 28 May 2019 when 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) was published in the Official Journal of the EU (with the date of entry into force 20 days following its publication, i.e. on 17 June 2019).