The text of the legislative proposal for EMIR, originally proposed of the European Commission on 15 September 2010 (COM(2010) 484 final), being analysed in the post ‘The implications of the European Market Infrastructure Regulation (EMIR) for commodity firms trading on the emissions market’, has been substantially changed by the European Parliament on 5 July 2011 (ordinary legislative procedure: first reading).
The modifications made are far-reaching and in a particular way influence on the position of the commodity firms trading on the emissions market. Beneath a cursory review of the main amendments to the draft EMIR by the European Parliament on 5 July 2011 with focus on those particularly relevant for non-financial counterparties.
The following remarks should be read being mindful of the general fundamental assumption that not all CCP-cleared OTC derivatives can be considered suitable for mandatory CCP clearing and that the clearing obligation relates only to OTC derivative contracts which are considered eligible for clearing in the published ESMA decision. The Regulation establishes detailed procedure for taking decisions concerned, in particular provides that before taking a decision, ESMA shall conduct a public consultation and, where appropriate, consult with the competent authorities of third countries. Any decision of the ESMA on the subject will be published in a register accessible on the ESMA’s website. That register will contain the eligible classes of derivatives and the CCPs authorised to clear them.
The definition of the OTC derivatives was amended by the European Parliament in such a manner that currently mean derivative contracts whose execution does not take place on a regulated market or on a third-country market considered as equivalent to a regulated market or on any other organised trading venue established under Directive 2004/109/EC of the European Parliament and of the Council of 15 December 2004 on the harmonisation of transparency requirements in relation to information about issuers whose securities are admitted to trading in a regulated market that clears such contracts through a CCP.
One should also be mindful of the fact that the number of amendments made on the 5 July 2011 is considerable and those mentioned beneath are only part of them. The selection made is the result of the subjective views of the author as regards significance of amendments in the context of the regulatory position of non-financial counterparties.
1.1. The fundamental switch in approach to the obligations of non-financial counterparties - in comparison with the European Commission of 15 September 2010 - is that the information threshold in the European Parliament version of the EMIR is irrelevant. A non-financial counterparty are currently subject to the reporting obligation in full extent, the same as financial institutions. Consequently all derivative contracts entered into by the non-financial counterparties are to be reported to a trade repository registered by ESMA. According to the clear indication in recital 23 in the preamble to the Regulation, in order to allow for a comprehensive overview of the market and for assessing systemic risk to trade repositories should be reported both cleared and non-cleared contracts.
1.2. Counterparties should report the details of any derivative contract they have entered into and any material modification, novation or termination of the contract. The agreed termination of a contract or lapsing of a transaction – as opposed to its premature termination – shall not be considered as a modification.
1.3. The recordkeeping obligation for a period of five years of all the information needed to report was also introduced.
1.4. In the context of reporting it is appropriate to add that according to the explicit provision of the draft Regulation a counterparty that reports the full details of a contract to a trade repository on behalf of another counterparty shall not be considered in breach of any restriction on disclosure of information imposed by that contract or by any legislative, regulatory or administrative provision. No liability resulting from that disclosure shall fall on the reporting entity or its directors or employees or other persons acting on its behalf.
1.5. The deadline for the submission of the report is the working day following the conclusion, modification, novation or termination of the contract (small comment is appropriate in this place as regards imprecise terminology of the draft: this provision contains the term: ‘working day’ although farther in the same context uses and defines ‘business day’ and once more repeats the regulation concerned).
2. Clearing obligation
2.1. The premises for the clearing obligation as regards non-financial counterparties have been also restructured on 5 July 2011. The clearing threshold will still be established by the European Commission (on the advice of ESMA) but the additional condition has been added that the non-financial counterparty will be subject to the clearing obligation only where it takes positions in OTC derivative contracts such that the rolling average position over 50 business days exceeds the threshold. The clearing obligation shall subsist as long as the non-financial counterparty's net positions and exposures in OTC derivative contracts exceed the clearing threshold and shall end once these net positions and exposures are below the clearing threshold over a specified time period.
2.2. In calculating the positions referred to in point 2.1 above, OTC derivative contracts entered into by a non-financial counterparty that are objectively measurable as directly linked to the hedging of commercial or treasury financing activity of that counterparty shall not be taken into account. In comparison with the proposal of the European Commission of 15 September 2010 the criterion of ‘treasury financing activity’ and the explicit reference to the notion of ‘hedging’ have been added in the text of 5 July 2011. In the European Commission version exempted from the clearing obligation were only ‘OTC derivative contracts objectively measurable as directly linked to the commercial activity of the non-financial counterparty’. It is noteworthy to mention that the clearing threshold and criteria for establishing which OTC derivative contracts are objectively measurable as directly linked to the commercial or treasury financing activity will be specified in draft regulatory technical standards developed by ESMA (after consulting EBA, the ESRB and other relevant authorities and conducting public consultations). Standards on this important matter will be ultimately adopted by the European Commission.
2.3. European Parliament has introduced an important exception to the clearing obligation for controlling relationships between undertakings. There will be no clearing obligation in the case of derivative contracts between subsidiary undertakings of the same parent company or between a parent company and a subsidiary undertaking. There should be born in mind that this derogation will not affect the reporting obligation or the obligations in relation to risk mitigation techniques.
The exemptions in question only apply where the parent company concerned has first notified the competent authority of its home Member State in writing that they intend to make use thereof. The notification must be made not less than thirty calendar days before the use the exemption. The competent authority shall ensure that the exemption is only used for derivative contracts that fulfill all of the following conditions:
(a) derivative contracts between subsidiary undertakings of the same parent company or between a parent company and a subsidiary undertaking are justified for economic reasons;
(b) the use of the exemption does not increase systemic risk in the financial system;
(c) there are no legal restrictions to capital flows between the subsidiary undertakings of the same parent company or between the parent company and the subsidiary undertaking.
3. Risk mitigation techniques
3.1. As regards risk mitigation techniques the European Parliament corrected the wording of the provision requiring the obligated parties (also non financial counterparties covered by the clearing obligation) that enter into an OTC derivative contract not cleared by a CCP, to ensure that appropriate procedures and arrangements are in place to measure, monitor and mitigate operational and credit risk. To the existing so far catalogue of the operational and credit risk also market risk has been supplemented.
3.2. The European Commission proposal placed on financial and non-financial counterparties addressed in point 3.1. above the obligation to have in place standardised processes which are robust, resilient and auditable in order to reconcile portfolios, to manage the associated risk and to identify disputes between parties early and resolve them, and to monitor the value of outstanding contracts. The draft Regulation stipulated for this purpose that the value of outstanding contracts was marked-to-market on a daily basis and that risk management procedures required the timely, accurate and appropriately segregated exchange of collateral.
In this connection, apart from ‘exchange of collateral’, the alternative was proposed by the European Parliament in the form of the ‘capital-backing commensurate with the risk, in accordance with the applicable regulatory capital requirements for financial counterparties’.
3.3. As part of the provisions on risk mitigation techniques the draft EMIR Regulation now also require that financial and non-financial counterparties addressed in point 3.1. above offer counterparties the option of segregation of initial margin at the outset of the contract. The important issue of segregation of assets in particular in relation of clearing members vis-á-vis their clients is further elaborated in the current text of draft EMIR – it deserves more detailed and separate analysis and is not touched in this post.
4.1. The pivotal rule was added that OTC derivatives contracts entered into before the date from which the clearing obligation takes effect for that class of derivatives are exempted from the clearing obligation.
4.2. In that connection it is appropriate to mention that although the Regulation will enter into force on the twentieth day following that of its publication in the Official Journal of the European Union, the obligations of counterparties under Articles 3, 6 and 8 of the Regulation (regarding clearing and reporting obligations and risk mitigation techniques) become effective six months after publication of the regulatory technical standards, implementing technical standards and guidelines related thereto drafted by ESMA and adopted by the Commission.
4.3. Derivative contracts that have been concluded prior to the date of application of the Regulation's registration of a trade repository for that particular type of contract shall be reported to that trade repository within 120 days of the date of registration of that trade repository by ESMA.
4.4. ESMA shall be empowered to examine whether a retrospective reporting obligation in respect of OTC derivative contracts can be introduced if the information in question is essential to the supervisory authorities. ESMA shall take the following criteria into account in reaching its decision:
(a) the technical requirements for submission of a report (notably whether transactions have been recorded electronically);
(b) the remaining times to maturity of outstanding transactions.
Before taking a decision, ESMA shall conduct a public consultation with the market participants (for the respective time-schedules relating to the implementation of the new obligations see farther).
4.5. In the connection with the provisions on retrospective impact of the EMIR Regulation it is noteworthy to mention additional guidance in the preamble to the draft Regulation indicating that clearing and reporting obligations should be dealt with in different ways. Whilst a retrospective clearing obligation is hardly feasible on legal grounds, given the need for post-collateralisation, the same is not true of a retrospective reporting obligation. In this case, on the basis of the results of an impact study, and using rules tailored to classes of derivatives, technical requirements and remaining periods to maturity, a retrospective reporting obligation could be laid down.
4.6. The recitals further explain that the retrospective reporting obligation is needed, to the largest possible extent, for both financial counterparties and non-financial counterparties over the threshold, in order to provide ESMA with comparative data. If such retrospective reporting is not feasible for any classes of OTC derivatives, an appropriate justification should be provided to the respective trade repository.
5.1. From the point of view of legal certainty the fundamental rule was added to the draft EMIR Regulation that an infringement of the rules of the Title II (regarding clearing, reporting and risk mitigation of OTC Derivatives) not affect the validity of an OTC derivative contract or the possibility for the parties to enforce the provisions of an OTC derivative contract. There was introduced also clear statement that an infringement of the said rules shall not give rise to any right to compensation from a party to an OTC derivative contract. This addition was made to the Article on penalties applicable to infringements which should include at least administrative fines.
5.2. There should be noted important changes as regards collateral requirements. The catalogue of highly liquid collateral accepted by a CCP was specified, including cash, gold, government and highquality corporate bonds, with minimal credit and market risk to cover its initial and ongoing exposure to its clearing members. For non-financial counterparties, CCPs may accept bank guarantees taking into account such guarantees in exposure to a bank that is a clearing member.
5.3. It is unquestionable that the use of the OTC derivatives by the non-financial counterparties (among others firms trading in emissions market), so far mainly unregulated, as a result of the EMIR Regulation will become more complex and complicated. The difficulties may occur even as regards the definitions of financial instruments referred to in points (4) to (10) of Section C of Annex I to the MiFID Directive (is envisioned issuance by ESMA of draft regulatory technical standards for guidelines for the interpretation and application of the above-cited parts of MiFID for the purposes of the EMIR Regulation).
5.4. The weight of the risks involved in the use of non-financial counterparties of OTC derivatives is underlined in the preamble to the draft EMIR Regulation where the indication was added by the European Parliament in the first reading requiring the non-financial counterparties to explain the use of derivatives through their annual report or other appropriate means.
5.5. As regards some more far-reaching trends there could be inferred from certain provisions of the draft concerned that there could be expected issuance of further specific regulations addressing specific commodity markets. The bias towards such a attitude is visible for instance in provision requiring the European Commission to assess by 31 December 2013 the systemic importance of the transactions of non-financial firms in OTC derivatives in different sectors, including in the energy sector.
5.6. On the other hand also there could be perceived in the amendment made by the European Parliament the legislative trend supporting the use of OTC derivatives by non-financial counterparties, that is the provision was added that the Commission should ensure that the necessary and appropriate use of OTC derivatives by non-financial counterparties to hedge market risks arising from business operations is not undermined in terms of pricing or availability by future legislative proposals.