Mandatory Clearing Makes Its Way to Europe: European Commission Adopts New Rules Requiring Clearing for OTC Interest Rate Derivatives

August 19, 2015

​On August 6, 2015, the European Commission issued a Delegated Regulation (the "Delegated Regulation") that requires all financial counterparties ("FCs") and non-financial counterparties ("NFCs") that exceed specified thresholds to clear certain interest rate swaps denominated in euro ("EUR"), pounds sterling ("GBP"), Japanese yen ("JPY") or US dollars ("USD") through central clearing counterparties ("CCPs").[1]  Further, the Delegated Regulation addresses the so-called "frontloading" requirement that would require over-the-counter ("OTC") derivatives contracts subject to the mandatory clearing obligation and executed between the first authorization of a CCP under European rules (which was March 18, 2014) and the date on which the clearing obligation takes place, to be cleared, unless the contracts have a remaining maturity shorter than certain minimums.  These mandatory clearing obligations for certain interest rate derivatives contracts will become effective after review by the European Parliament and Council of the European Union ("EU") and publication in the Official Journal of the European Union and will then be phased in over a three-year period, as specified in the Delegated Regulation, to allow smaller market participants additional time to comply. 

All market participants that have entities located in Europe that use derivatives, including intragroup transactions, as well as all entities that trade with a European counterparty, should pay attention to these developments, as the clearing obligations under Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories ("EMIR")[2] are calculated based on a broad group of derivatives transactions and on a group-wide basis, without regard to jurisdiction.  This is significantly different from the entity-based determinations under Title VII of the Dodd-Frank Act and the regulations of the Commodity Futures Trading Commission ("CFTC"), which are based on whether or not an entity is a "financial entity," as defined in the Commodity Exchange Act, and qualifies for an exception.[3]

The issuance of the Delegated Regulation came just before the closing of the comment period for the European Commission’s public consultation on the review of EMIR.[4]  This is a noteworthy development, as the European Commission has asked for comment in their review of EMIR on matters relating to the clearing obligation, including on the calculation of the clearing thresholds, CCPs and other related issues.  Accordingly, given the timing, it seems a difficult scenario that changes to EMIR could be made prior to the initial compliance dates for the clearing obligation.

This client alert summarizes the Delegated Regulation and highlights areas that all market participants should evaluate to ensure compliance. 

Background

On August 16, 2012, EMIR came into force with immediate consequences for entities engaged in derivatives affecting the European Economic Area ("EEA").[5]  Among other things, EMIR requires the mandatory clearing of certain OTC derivatives transactions and requires that the European Securities Markets Authority ("ESMA") propose classes of OTC derivatives that should be subject to clearing, as well as the appropriate phase-in for compliance.  In this regard, on July 11, 2014, ESMA published a consultation paper that proposed mandatory clearing for certain interest rate swaps and draft regulatory technical standards ("RTS") specifying, among other things, which interest rate swaps would be subject to clearing, the phase-in period for compliance and minimum maturities for frontloading.[6]  Following the consultation, ESMA submitted a final report to the European Commission on October 1, 2014 on the clearing obligation for interest rate swaps, which included amendments to the draft RTS based on comments received.[7]

According to Article 5 of EMIR, the European Commission, on the basis of a proposal from ESMA, should determine the types of OTC derivatives contracts that should be made subject to mandatory clearing by a CCP.[8]  Accordingly, the European Commission informed ESMA in December 2014 of its intention to adopt the draft RTS with certain amendments, which were sent back to ESMA.[9]  ESMA adopted a formal opinion on these amendments on January 29, 2015, and made certain additional changes to its approach based on the amendments.[10]  ESMA then adopted a revised opinion on March 6, 2015.[11]

The European Commission has now issued the Delegated Regulation in line with the formal opinion adopted by ESMA, which will now need to be reviewed by the European Parliament and the Council of the EU.  

Which entities are subject to the clearing obligation?

EMIR identifies that a clearing obligation applies to FCs[12] and NFCs that exceed the clearing thresholds set forth in in Article 11 of the Commission Delegated Regulation (EU) No 149/2013 ("NFC+s").[13]  The mandatory clearing requirements do not apply to those non-financial counterparties that do not exceed the clearing threshold ("NFC-s").  The clearing thresholds are as follows (in gross notional value, by asset class):

• EUR 1 billion — Credit derivative contracts
• EUR 1 billion — Equity derivative contracts
• EUR 3 billion — Interest rate derivative contracts
• EUR 3 billion — Foreign exchange derivative contracts
• EUR 3 billion — Commodity derivative contracts and other derivatives

For an EU NFC entity to determine whether or not it exceeds the clearing threshold, it must calculate all of the non-hedging transactions, which are defined under Article 10 of EMIR to mean those transactions that are not "objectively measurable as reducing risks related to commercial activity or treasury financing activity of the non-financial counterparty or of that group [of NFC affiliates],"[14] across its entire worldwide corporate group.[15]  Such a corporate group calculation would include not only the non-hedging transactions of those NFC affiliates that are organized in the EU, but also those non-financial affiliates organized outside the EU, including those that do not have a direct, substantial and foreseeable effect within the EU.[16]  Additionally, exchange-traded derivatives contracts executed on non-EU exchanges that are not recognized as equivalent would be counted as OTC derivatives and, if not hedging, must nonetheless be counted towards the notional amount for determining the clearing thresholds.  Accordingly, non-hedging futures contracts that are executed on US futures exchanges would need to be included in the corporate group calculation.  Furthermore, non-hedging intragroup transactions must be included in the calculation, resulting in double-counting of such internal transactions, as the thresholds are based on gross notional amount.

If the aggregate notional value of this entire worldwide NFC group exceeds the relevant clearing threshold in one asset class, then every NFC within the entire corporate group that is subject to EMIR would become an NFC over the clearing threshold (i.e., an "NFC+") and therefore subject to the mandatory clearing requirements for all asset classes.  Accordingly, NFC- entities that are using derivatives in the EU solely to hedge or mitigate commercial risks could nonetheless become NFC+ entities subject to the mandatory clearing requirements based on the activities of one or more NFC affiliates.  For example, an NFC entity may have affiliates located in the EU that use swaps solely to hedge their commercial risks; however, the NFC corporate group may include one or more affiliates within the corporate group that are located outside the EU that enter into derivatives for purposes other than hedging (e.g., to make markets in certain commodities).  If the non-hedging activities of those non-EU affiliates exceed the clearing thresholds for any one asset class, all NFCs within the corporate group that are subject to EMIR become subject to the clearing mandate for all swaps that are required to be cleared, regardless of asset class and regardless of whether a particular NFC entity is itself engaging in non-hedging activities.

What contracts must be cleared?

The Delegated Regulation would require the clearing of the following interest rate swap categories, which are detailed in Annex 1 to the Delegated Regulation:

• Fixed-to-Float (i.e., plain vanilla) interest rate swaps that:
• Reference the Euro Interbank Offered Rate ("EURIBOR") or the London Interbank Offered Rate ("LIBOR")
• Have a maturity of 28 days to 50 years
• Settled in one of the following currencies: EUR, GPB, USD or JPY
• Basis (i.e., Float-to-Float) interest rate swaps that:
• Reference EURIBOR or LIBOR
• Have a maturity of 28 days to 50 years
• Settled in one of the following currencies: EUR, GPB, USD or JPY
• Forward Rate Agreements ("FRAs") that:
• Reference EURIBOR or LIBOR
• Have a maturity of three days to three years
• Settled in one of the following currencies: EUR, GPB or USD
• Overnight Index Swaps ("OIS") that:
• Reference Euro OverNight Index Average, FedFunds or the Sterling OverNight Index Average
• Have a maturity of seven days to three years
• Settled in one of the following currencies: EUR, GPB or USD

However, contracts with covered bond issuers or with cover pools for covered bonds would be exempt from the clearing obligation so long as certain criteria are met.[17]

When must entities comply with the mandatory clearing obligation?

Articles 2 and 3 of the Delegated Regulation set forth four categories of entities and phases in compliance with the clearing obligation based on these categories, with certain exceptions.  The categories are defined as follows:

For situations where a swap is concluded between counterparties in different categories, the compliance date would be the later date.  For example, if a clearing member enters into a transaction with an NFC that is not in Categories 1, 2 or 3, the compliance date would be three years after the regulation enters into force.

For swaps entered into between a counterparty established in the EU and another established in a third country[19] that are part of the same group (i.e., an intragroup transaction), the Delegated Regulation provides a longer compliance timeframe to allow for equivalence determinations with third countries.  Specifically, the Delegated Regulation explains that compliance will be required three years after the date the regulation enters into force if there has been no equivalence decision adopted pursuant to Article 4 of EMIR or, if an equivalence decision has been adopted, the later of the following dates:  60 days after the date of entry into force of the decision adopted pursuant to Article 13(2) of EMIR for the purposes of Article 4 of EMIR, or the date when clearing takes effect pursuant to the phase-in compliance timeframes specified above.  This alternative compliance timeline would apply so long as certain conditions are met with respect to the intragroup transaction.

How is frontloading addressed?

Article 4(1)(b) of EMIR requires that OTC derivatives contracts (that have become subject to the clearing obligation) that are entered into or novated either on or after the date from which the clearing obligation takes effect or during the frontloading period, under certain conditions, must be cleared.  Article 4(1)(b)(ii) of EMIR explains the frontloading period to include derivatives contracts concluded after the notification that the first CCP is authorized to clear a certain class of derivatives (which was March 18, 2014 for interest rate derivatives), but before the date that the clearing obligation becomes effective, provided that the remaining maturity on such derivatives contracts justifies frontloading.  Article 4 of the Delegated Regulation sets forth these minimum remaining maturities which can be used to determine whether or not frontloading is necessary for a given transaction.    

Specifically, the remaining maturities are split up based on the categories of interest rate swaps that are required to be cleared (e.g., fixed-to-float, basis (float-to-float), forward rate agreements and overnight index swaps) and Categories 1, 2 and 3.  The minimum remaining maturities range from six months to 50 years and frontloading is required either two months or five months after the Delegated Regulation enters into force.  Below is a summary of the minimum remaining maturities ranges.

Notably, ESMA recently commented[20] on the European Commission’s public consultation on EMIR, stating that the frontloading requirement should be removed.  The European Commission is likely to pay particular attention to ESMA’s comments.  However, it seems that there could be challenges in removing the frontloading obligation before compliance with the clearing obligation is required, given the timing involved and the process necessary to change the text of EMIR.

When are the requirements expected to become effective?

The Delegated Regulation has been sent to the European Parliament and the Council of the EU for review.  This review process can take about three months, after which the Delegated Regulation will be published in the Official Journal of the European Union and will become effective 20 days following such publication.  Upon the effective date, the phase-in timeframes will begin taking shape, with compliance with the mandatory clearing obligation for interest rate swaps (discussed herein) between clearing members beginning six months later.

What should market participants do to prepare?

NFC corporate groups should work to determine whether or not their corporate group exceeds the clearing threshold and whether or not they will become NFC+s and therefore subject to the mandatory clearing obligation for interest rate swaps.  To make such a calculation, NFC groups will need to calculate the gross notional amount of all of the non-hedging OTC derivatives activities (including non-EU exchange-traded derivatives) of all entities within the worldwide corporate group for each asset class specified to determine whether non-hedging activities exceed the thresholds for a particular asset class. 

Further, FC and NFC+ entities should begin determining the universe of swaps that may become subject to frontloading requirements.  As the frontloading requirements will begin on the relevant compliance dates, it will be important for entities that are subject to the clearing requirements to understand which OTC derivatives contracts must be frontloaded onto CCPs.

Finally, market participants, including non-EU counterparties that transact with European counterparties, should expect their European counterparties to request a representation of a particular entity’s status, either through completion of the International Swaps and Derivatives Association 2013 EMIR NFC Representation Protocol or through some other representation.  Swap dealer counterparties in particular will want to understand whether certain swaps need to be cleared or if they are exempt from clearing because their counterparties qualify as NFC‑s.  Making such representation will require an NFC entity to make the calculation described above for their worldwide corporate group.

   [1]   See European Commission, Commission Delegated Regulation supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation (Aug. 6, 2015), provisional version available at http://ec.europa.eu/finance/financial-markets/docs/derivatives/150806-delegated-act_en.pdf; see also European Commission, Annex to the Commission Delegated Regulation supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to the regulatory technical standards on the clearing obligation (Aug. 6, 2015), provisional version available at http://ec.europa.eu/finance/financial-markets/docs/derivatives/150806-delegated-act-annex_en.pdf.

   [2]   See Regulation (EU) No 648/2012 on OTC Derivatives, Central Counterparties and Trade Repositories, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF.  EMIR is also referred to as the European Market Infrastructure Regulation and can be compared to Title VII of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.

   [3]   See Commodity Exchange Act Section 2(h)(7).  Commodity Exchange Act Section 2(h)(7)(C)(i) defines the term "financial entity" to mean:  (i) a swap dealer; (ii) a security-based swap dealer; (iii) a major swap participant; (iv) a major security-based swap participant; (v) a commodity pool; (vi) a private fund as defined in section 80b-2 (a) of title 15; (vii) an employee benefit plan as defined in paragraphs (3) and (32) of section 1002 of title 29; (viii) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 1843 (k) of title 12.  

   [4]   See European Commission, Public consultation on the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (May 21, 2015), available at http://ec.europa.eu/finance/consultations/2015/emir-revision/docs/consultation-document_en.pdf.  The comment period for the consultation closed on August 13, 2015.

   [5]   The EEA is comprised of the countries within the European Union, plus Iceland, Liechtenstein and Norway.

   [6]   See ESMA/2014/799, Consultation Paper, Clearing Obligation under EMIR (no. 1) (July 11, 2014, amended July 17, 2014), available at http://www.esma.europa.eu/system/files/esma-2014-799_irs_-_consultation_paper_on_the_clearing_obligation_no__1____.pdf.

   [7]   See ESMA/2014/1184, Final Report, Draft technical standards on the Clearing Obligation – Interest Rate OTC Derivatives (Oct. 1, 2014), available at http://www.esma.europa.eu/system/files/esma-2014-1184_final_report_clearing_obligation_irs.pdf.

   [8]   See Article 5 of EMIR.  According to the procedure set forth in paragraph 1 of Article 10 of Regulation (EU) No 1095/2010, within 3 months of receipt of the draft RTS from ESMA, the European Commission shall decide whether to endorse it and has the ability to endorse it with amendments.  The European Commission then sends the amended draft RTS back to ESMA and ESMA may amend the draft RTS on the basis of the European Commission’s proposal and resubmit it as a formal opinion to the European Commission.

   [9]   See Letter from the European Commission to ESMA (Dec. 18, 2014), available at http://www.esma.europa.eu/system/files/rts_for_irs_-_lettre_signee.pdf. 

  [10]   See 2015/ESMA/223, Draft RTS on the Clearing Obligation on Interest Rate Swaps (Jan. 29, 2015), available at http://www.esma.europa.eu/system/files/2015-223_opinion_on_draft_rts_on_the_clearing_obligation.pdf.

  [11]   See 2015/ESMA/511, Revised Opinion, Draft RTS on the Clearing Obligation on Interest Rate Swaps (Mar. 6, 2015), available at https://www.esma.europa.eu/system/files/2015-511_revised_opinion_on_draft_rts_on_the_clearing_obligation.pdf.

  [12]   FCs are investment firms, banks, insurers, funds registered under the Undertakings for the Collective Investment of Transferable Securities Directive 2009/65/EC ("UCITS"), pension funds or alternative investment funds managed by an alternative investment manager (as defined by the applicable EU legislation authorizing those entities).  See Article 2(8) of EMIR.

  [13]   See Commission Delegated Regulation (EU) No 149/2013 (Dec. 18, 2012) supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP (Feb. 23, 2013) ("RTS No 149/2013"), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:052:0011:0024:en:PDF.

  [14]   Article 10(3) of EMIR.  Further, Article 10 of RTS No 149/2013 sets out the precise definition for derivatives contracts falling within the "hedging" definition, which (i) covers risks incurred in the normal course of business; (ii) covers risks arising from fluctuations in interest rates, inflation rates, foreign exchange rates, credit risk, etc.; or (iii) qualifies as a "hedging contract" pursuant to International Financial Reporting Standards. 

  [15]   See id.  Further, Article 2(16) of EMIR defines "group" very broadly as: "the group of undertakings consisting of a parent undertaking and its subsidiaries within the meaning of Articles 1 and 2 of Directive 83/349/EEC or the group of undertakings referred to in Article 3(1) and Article 80(7) and (8) of Directive 2006/48/EC".

  [16]   The derivatives activities of FCs within the corporate group would not be included in the calculation.

  [17]   Article 1(2) of the Delegated Regulation provides that the following criteria must be met with respect to covered bond issues or with cover pools for covered bonds in order to be excluded from the clearing obligation: "(a) They are used only to hedge the interest rate or currency mismatches of the cover pool in relation with the covered bond; (b) They are registered or recorded in the cover pool of the covered bond in accordance with national covered bond legislation; (c) They are not terminated in case of resolution or insolvency of the covered bond issuer or the cover pool; (d) The counterparty to the OTC derivative concluded with covered bond issuers or with cover pools for covered bonds ranks at least pari-passu with the covered bond holders except where the counterparty to the OTC derivative concluded with covered bond issuers or with cover pools for covered bonds is the defaulting or the affected party, or waives the pari-passu rank; and (e) The covered bond meets the requirements of Article 129 of Regulation (EU) No 575/2013 and is subject to a regulatory collateralization requirement of at least 102%.

  [18]   The calculation for these purposes would include all non-centrally cleared foreign exchange forwards, swaps and currency swaps.  See Article 2(2) of the Delegated Regulation.  When an applicable counterparty is either an alternative investment fund or an undertaking for collective investment in transferable securities as defined in Article 1(2) of UCITS, the EUR 8 billion threshold applies at the fund level.

  [19]   A third country is a country other than an EEA Member State.

  [20]   See ESMA, EMIR Review Report No. 4, ESMA input as part of the Commission consultation on the EMIR Review, pp. 11-14 (Aug. 13, 2015), available at http://www.esma.europa.eu/system/files/esma-2015-1254_-_emir_review_report_no.4_on_other_issues.pdf. 

Gibson, Dunn & Crutcher’s Financial Institutions Practice Group lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work, or the following:

Michael D. Bopp – Washington, D.C. (+1 202-955-8256, [email protected])
Arthur S. Long – New York (+1 212-351-2426, [email protected])
Patrick Doris – London (+44 (0)20 7071 4276, [email protected])
Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, [email protected])
Amy Kennedy – London (+44 (0)20 7071 4283, [email protected])

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