Clearing in the EU after EU EMIR 3 | Shearman & Sterling LLP
The European Commission published proposals to amend the EU’s European Market Infrastructure Regulation (EMIR) in December 2022 (EMIR 3). According to the Commission, some of these measures are aimed at improving the competitiveness of EU CCPs and of EU clearing activities, and to reduce existing reliance by EU counterparties on U.K. CCPs. Since the Brexit referendum, the EU has been grappling with the bloc’s continued reliance on U.K. CCPs. The most controversial aspect is a new mandate for EU counterparties to hold “active accounts” at EU CCPs for all products, and to use such accounts for some products.
EMIR 3 would also bring in several technical changes relating to the clearing thresholds and how these operate for non-EU exchange trade derivatives (ETDs) and the exemption for certain intragroup transactions. Other proposals seek to mitigate some of the issues arising from the strain on the energy market, in particular the difficulties in fulfilling margin obligations.
This client note describes the EMIR 3 proposals in more detail.
Clearing at EU CCPs
EMIR 3 proposes to mandate that counterparties subject to the clearing obligation must hold active accounts with EU CCPs and clear with an EU CCP a proportion of their trades in interest rate derivatives denominated in euro and Polish zloty; CDS denominated in euro; and Short-Term Interest Rate Derivatives (STIR) denominated in euro. These are the three clearing services provided by U.K. CCPs that the European Securities and Markets Authority (ESMA) declared in 2021 as being of substantial systemic importance to the EU or to one or more of its Member States. Many in the industry will be concerned about the potential costs and burdens of this new obligation, as well as the risks that could arise from transitioning between CCPs.
In the lead up to the EMIR 3 proposals, there was industry debate as to whether or not the EU would grant U.K. CCPs permanent equivalence. Currently, the equivalence of U.K. CCPs is set to expire on 25 June 2025. The EMIR 3 impact assessment states that permanent equivalence was one of the early discarded options since that would not mitigate against the EU’s substantially systemic exposures to U.K. CCPs. Many, including the Governor of the Bank of England, Andrew Bailey, have questioned why the U.K. CCP equivalence decisions are time-limited. Most equivalence decisions for CCPs in other jurisdictions are not time-limited, although the EU is able to revoke a decision if a jurisdiction is deemed not to maintain equivalence with the EU regime.
ESMA will be responsible for drafting regulatory technical standards (RTS) on the proportion of activity for each class of derivative for which an active account must be used. The specified proportion must be set at such a level to result in a reduction in clearing in those derivative contracts through non-EU CCPs, in particular U.K. CCPs, and ensure clearing in such derivative contracts is no longer of substantial systemic importance. The draft RTS must be submitted to the European Commission within one year of EMIR 3 entering into force. The Commission will be able with a delegated act to remove or add a class of derivatives included in the scope of this obligation, if ESMA assesses that they are no longer of substantial systemic importance or that a different class of derivatives poses a new threat to financial stability. There are no details in the EMIR 3 proposals on whether any transitional period would apply to allow industry time to adapt to these potential changes, especially since the process of onboarding to a CCP can take some months. Clarification would also be welcomed as to whether the obligation will apply to derivative trades concluded before the obligation takes effect.
The Commission is encouraging EU public entities that clear derivatives to use an EU CCP (if the product is available). EU public entities are not subject to the clearing obligation under EMIR.
The Commission is also proposing amendments to the EU Capital Requirements Directive (applicable to banks and large investment firms) such that those firms will need to implement processes for monitoring and managing their concentration risk arising from exposures towards CCPs, taking into account the active account requirement. In addition, these firms will need to prepare specific plans and quantifiable targets in accordance with the active account proportions to monitor and address their concentration risk arising from exposures towards CCPs offering services of substantial systemic importance.
Disclosures of Clearing Services
Under the EMIR 3 proposals, clearing members and clients providing clearing services will be required to inform their clients of the possibility of clearing through an EU CCP. In addition, EU clearing members and clients that clear through a non-EU CCP will need to report to their national regulator the scope of that clearing activity annually, including:
- Type of financial instruments or non-financial contracts that are cleared;
- Average values cleared over a year per Union currency and per asset class;
- Collected margin amounts; and
- Default fund contributions and the largest payment obligation.
ESMA will prepare draft technical standards further specifying the information required and the format of such reports. These draft standards need to be submitted to the Commission within one year of EMIR 3 entering into force.
Reducing Bureaucracy for EU CCPs
Amendments are also proposed to improve the attractiveness of EU CCPs. A proposed clarification would provide that EU CCPs may also be authorised to provide clearing services and carry on other activities in relation to non-financial instruments. Tweaks are proposed for the authorisation and approval of extension of CCP activities, including making the authorisation process clearer and shorter, and introducing a non-objection procedure for the authorisation of additional services or activities that a CCP intends to offer which do not increase the level of risk for the CCP. Some detail on what constitutes a non-material service or activity would be stipulated in EMIR. However, an EU CCP would be able to request application of the non-objection procedure in other circumstances. “Insignificant” changes to risk models would also be subject to this faster procedure—some detail as to what will be considered as “significant changes” is proposed in the level 1 text.
The existing clearing thresholds have created huge problems for industry with Brexit, because non-EU ETDs are, for purposes of calculation of clearing thresholds, deemed to be “over the counter” (OTC), and the EU refused equivalence for the U.K., which would have addressed the issue. It is now proposed that the clearing obligation threshold would be calculated differently. Instead of the calculation for the threshold looking at the trading venue, it would instead relate to derivatives not cleared with an EU-authorised CCP or non-EU recognised CCP (note that U.K. CCPs are so recognised). The calculation will therefore focus on cleared or uncleared instead of ETD or OTC derivatives.
EMIR currently defines OTC derivatives as derivatives that are not traded on an EU-regulated market or equivalent third-country trading venue. Currently, OTC derivatives include those traded on U.K. markets because there is no EU equivalence for any of the U.K. markets. The revised clearing threshold calculation would eliminate problems for industry resulting from many ETDs being currently deemed as OTC.
ESMA will be given a new power to review the clearing thresholds periodically. It may change the relevant classes of derivatives or the monetary threshold for any class of derivative. The Commission encourages ESMA to consider in particular the threshold for commodity derivatives, which was increased from EUR 3 billion to EUR 4 billion at the end of November 2022. The increase was prompted by concerns raised by energy firms’ associations about the clearing thresholds (and by Brexit). Respondents to ESMA’s discussion paper noted that the recent rise in energy prices and the impact of Russia’s invasion of Ukraine had constrained their ability to operate without breaching the pre-existing clearing thresholds.
CCP Governance and Operational Issues
EMIR requires CCPs to have admission criteria that are non-discriminatory, transparent and objective, so as to ensure fair and open access to the CCP. CCPs must also ensure that clearing members have the financial resources and operational capacity required for participating in the CCP. Access restrictions are permissible only to control the CCP’s risk.
EMIR makes a distinction between corporate (non-financial counterparties or NFCs) and financially regulated (financial counterparties or FCs) counterparties. It became evident from the energy market volatility during 2022 that NFCs do not have access to the same degree of liquidity as FCs. Therefore, under EMIR 3, a CCP would only be able to accept an NFC as a clearing member if the NFC shows that it can meet margin requirements and default fund contributions, including in stressed conditions. Clearing member NFCs would be prohibited from offering client clearing services. This means that a clearing member that is an NFC would only be allowed to keep accounts at the CCP for assets and positions held for its own account.
Clarification is also proposed such that CCPs may not themselves be clearing members of other CCPs nor have other CCPs or clearing houses as direct or indirect clearing members.
ESMA will become responsible for preparing new RTS setting out the elements a CCP should consider when setting its admission criteria.
It is proposed to introduce a new obligation for entities providing clearing services as an intermediary to provide information to their clients about how a CPP’s margin model works, including providing a simulation of the margin requirements the client could be exposed to in different scenarios. The obligation would apply to margin required by a CCP and any additional margin called for by the clearing member or client providing clearing services. It would apply to clearing members of CCPs and clients of clearing members which offer indirect clearing. This could be too burdensome for those providing clearing services and could ultimately result in less transparency, because clearing members would be providing information on a model which is not theirs, which could lead to conflicting information.
EMIR requires clearing members to notify their clients of the potential losses and costs that may arise due to the application of default management procedures and loss and position allocation arrangements. The information must include the worst-case losses. It is proposed to extend this requirement to clients providing clearing services via indirect clearing.
Another proposal made in response to the 2022 issues with margin calls is that CCPs would be required to continuously (instead of regularly), monitor and revise margin levels. CCPs would need to consider the potential impact of their intraday margin collections and payments on the liquidity position of their participants, including not retaining, unduly, intraday variation margin calls after all payments due had been received.
An NFC that becomes subject for the first time to the obligation to exchange collateral for OTC derivative contracts not cleared by a CCP would have an implementation period of four months to negotiate and test the arrangements to exchange collateral. The EBA will be able to issue guidelines or recommendations to ensure a uniform application of the risk-management procedures.
Letters of Credit as Collateral
EMIR essentially ended the past practice of CCPs taking letters of credit (LCs) as collateral, requiring these to be collateralised in full. Since LCs needed collateral, it was cheaper and easier just to remit collateral directly to the CCP. This has made it harder for NFCs to fund margin calls. It is now proposed to allow clearing members that are NFCs to post LCs (referred to as bank guarantees or public guarantees) to be used as collateral, provided that they are unconditionally available upon request within the liquidation period. CCPs would need to take LCs into account when calculating their overall exposure to the bank providing the guarantee.
In addition, as with their intraday margin calls, a CCP would need to consider any potential procyclical effects when revising the level of the haircuts it applies to the assets it accepts as collateral. In practice, there are few NFC clearing members, partly due to previous EMIR reforms, so it is unclear what impact this liberalisation will have, if any.
EMIR currently provides that the Commission may adopt equivalence decisions for non-EU countries for the clearing and reporting obligations, intragroup transactions and the risk mitigation requirements. No equivalence decisions have been made for the clearing and reporting obligations or for intragroup transactions; however, there are several equivalence decisions for the risk mitigation techniques, namely the U.S., Canada, Brazil, Hong Kong, Singapore, Australia and Japan.
EMIR 3 would delete all of these equivalence mechanisms, as well as the other provisions on avoiding duplicative or conflicting rules. There is no confirmation as to whether the existing equivalence decisions on risk mitigation will still stand.
Equivalence and the NFC Reporting Obligation
EMIR currently provides that an NFC that is not subject to the clearing obligation (known as an NFC-) and that trades with an FC third-country counterparty is exempt from the reporting obligation, provided that there is an equivalence decision for the relevant third country and the third-country FC has reported the trade under its national laws. The exemption would still be available; however, an equivalence decision is no longer a condition for the exemption to apply.
Equivalence and Intragroup Transactions
EMIR exempts NFC and FC intragroup transactions from the clearing obligation and the margin requirements. The exemption is based on an equivalence framework. The Commission is proposing to replace that framework with a list of jurisdictions for which the exemptions cannot be granted. These would be those jurisdictions that are on the EU lists as high risk for AML and tax purposes. This is intended to provide more legal certainty and predictability for intragroup transactions. However, the Commission proposes that it would have a wide power to be able to adopt delegated acts identifying third countries whose entities would not benefit from these exemptions despite not being identified on the EU lists. The Commission would use this mechanism for a third country where other risk factors apply, such as counterparty risk or legal risk.
The Commission is proposing to amend the Capital Requirements Regulation (applicable to banks and large investment firms), so that the exemption from the own funds requirements for credit valuation adjustment (CVA) risk for intragroup transactions no longer links to the EMIR equivalence provisions for intragroup transactions. Instead, the exemption for intragroup transactions with a non-EU firm will be conditional on an equivalence decision on the non-EU country’s prudential supervisory and regulatory requirements. In the absence of an equivalence decision, firms may, until 31 December 2027, continue to exclude such intragroup transactions from the own funds requirements for CVA risk, provided that the relevant competent authorities have approved the third country as eligible for that treatment before 31 December 2026.
In relation to the reporting obligation, the exemption, which has applied since June 2020, for transactions between counterparties within a group, where at least one of the counterparties is an NFC, would be removed. This aims to provide transparency on intra-group transactions, including NFCs’ potential interconnectedness with the financial system. This amendment is proposed in response to the recent volatility in the energy markets.
Exemption for Trades With Third-Country Pension Schemes
EMIR 3 would introduce an exemption from the clearing obligation for an FC or NFC for derivatives trades with a third-country pension scheme arrangement that meets certain conditions, including that the pension scheme arrangement:
- Operates on a national basis;
- Is authorised, supervised and recognised under national law;
- Has a primary purpose of providing retirement benefits; and
- Is exempt from the clearing obligation under its national law.