As follows from Article 7(4) read in conjunction with Article 7(2) of the EMIR, for the qualification whether an OTC transaction regarding any derivative contract set out in Annex I Section C numbers (4) to (10) of the MiFID (including, consequently, also derivatives for which the underlying asset are emission allowances) entered into by the commodity firm, is subject to the clearing obligation, the decisive significance have two premises:
1) the positive: the breach of the clearing threshold value (to be specified by the European Commission through a delegated act),
2) the negative: the ability of the OTC derivative contracts entered into by a commodity firm to be objectively measured as directly linked to the commercial activity of that counterparty.
So, as we have established that the mere commodity trading firms as a separate from the regulated investment firms category of market actors (see: Emissions market and EMIR – non-financial counterparties also covered) may, as a principle, have something in common with the European Market Infrastructure Regulation (EMIR) and consequently become subject to the mandatory clearing obligations with the participation of central-counterparties (CCP – meaning an entity that legally interposes itself between the counterparties to the contracts traded within one or more financial markets, becoming the buyer to every seller and the seller to every buyer and which is responsible for the operation of a clearing system) in the next step let’s take a closer look at the scope for potential transactions that may become an object of interest of the new regulation.
It is appropriate to explain at the beginning that by the colloquial phrase ‘mere commodity trading firms’ (in other words: non-financial counterparty) I mean undertakings established in the Union other than the 'financial counterparties' (meaning, in turn, investment firms as set out in Directive 2004/39/EC, credit institutions as defined in Directive 2006/48/EC, insurance undertakings as defined in Directive 73/239/EEC, assurance undertakings as defined in Directive 2002/83/EC, reinsurance undertakings as defined in Directive 2005/68/EC, undertakings for collective investments in transferable securities (UCITS) as defined in Directive 2009/65/EC, institutions for occupational retirement provision as defined in Directive 2003/41/EC).
As regards the subject-matter, the scope of the draft for a new legislative proposal being revealed by the Commission on 15 September 2010 (COM(2010) 484 final) covers all categories of OTC (traded over-the-counter) derivative contracts set out in Annex I Section C numbers (4) to (10) of the MiFID Directive (see: box).
(4) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash;
(5) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event);
(6) Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF;
(7) Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in C.6 and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls;
(8) Derivative instruments for the transfer of credit risk;
(9) Financial contracts for differences.
(10) Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market or an MTF, are cleared and settled through recognised clearing houses or are subject to regular margin calls.
Derivatives contracts relating to emission allowances are explicitly mentioned as financial instruments in point 10 of the Annex I Section C of the MiFID Directive.
Implications of the clearing obligation
As follows from Article 7(4) read in conjunction with Article 7(2) of the EMIR, for the qualification whether an OTC transaction regarding any derivative contract set out in Annex I Section C numbers (4) to (10) of the MiFID (including, consequently, also derivatives for which the underlying asset are emission allowances) entered into by the commodity firm, is subject to the clearing obligation, the decisive significance have two premises:
1) the positive: the breach of the clearing threshold value (to be specified by the European Commission through a delegated act),
2) the negative: the ability of the OTC derivative contracts entered into by a commodity firm to be objectively measured as directly linked to the commercial activity of that counterparty.
If the positive condition is met and the negative one is not met, in such a case a commodity trading firm engaging in transactions in financial instruments set out in Annex I Section C numbers (4) to (10) of the MiFID (although not necessarily being covered by the MIFID as benefiting from an exemption) will be subject to the clearing obligation pursuant to the new EMIR Regulation.
It is important to note that pursuant to the Article 7(2) of the EMIR draft Regulation if the positions exceed the clearing threshold the party becomes liable to the clearing obligation for all its contracts. The said provisions arises some doubts and, as it seems, serious consequences.
Namely, assuming hypothetically:
1) certain commodity firm having contracts in derivatives relating to underlying asset being EUAs for instance, and
2) these contracts not being concluded for commercial purpose but in carrying-out a speculative part of a business, and
3) using for the above-mentioned contracts the form of a master framework agreements like for instance ISDA, EFET, or IETA standards, and
4) in certain point in time it occurs that the clearing threshold has been exceeded;
EMIR requires that the party becomes liable to the clearing obligation for all its contracts.
EMIR, however, does not explain how to apply the new mechanism for counterparty risk management in a situation where the contract concluded by the parties already provided for adequate collateral.
Assuming, it isn’t the purpose of EMIR provisions to duplicate, an alternative as a principle, ways of counterparty risk management, such as the clearing by the central counterparty and individually agreed collateral, there could be inferred that at the moment the clearing obligation becomes effective in relation to such historical contracts, the parties thereto would modify pre-existing collateral covenants. The sufficient reason to do such modifications to the contract will be the fact that maintaining the collateral costs money and such spending – when contract is cleared by the CCP – is no longer justified.
It seems, furthermore, that parties to the contract should in advance contain appropriate provision thereto, because in the absence of pre-existing mutually agreed contractual conditions situation where OTC contract suddenly becomes subject to the clearing obligation might lead to certain conflicts between the parties, especially as regards costs. It also seems reasonable that standard contract frameworks such as IETA, EFET, ISDA elaborate appropriate master contract clauses on such a occasion.
In the light of the above circumstances the answer to the question whether the above-mentioned master contract frameworks need to be complemented to reflect the new legal context arising for the entry into force of the EMIR Regulation seems to be positive.