To increase transparency in the OTC derivatives markets, the European Market Infrastructure Regulation (“EMIR”) requires certain market participants (the “counterparties”) to centrally clear OTC derivative contracts of specified types (the “clearing obligation”) or to apply risk mitigation techniques set out in Art. 11 of EMIR (the “risk mitigation obligation”). Risk mitigation techniques include, amongst others, portfolio reconciliation, dispute resolution, valuation and margining.
Importantly, the clearing obligation and the risk mitigation obligation extend to OTC derivative contracts where both counterparties are established in one or more countries outside the EU (each, a “third country entity” or “TCE”) and:
- the relevant OTC derivative contract has “a direct, substantial and foreseeable effect“ within the EU; or
- it is “necessary or appropriate” to prevent the evasion of any provisions of EMIR.
The above is commonly referred to as “extraterritoriality” and this note outlines its potential consequences and current market developments.
The clearing obligation and the risk mitigation obligation only attach to TCEs that would be subject to the relevant obligation if established in the EU. Therefore, as with EU counterparties, the extent to which these obligations are to apply to a TCE will be driven by determining (by analogy) its status under EMIR. Whilst the clearing obligation is only imposed on counterparties classified as financial counterparties (“FCs”) or non-financial counterparties over the clearing threshold (as specified in Art. 11 of Regulation No. 149/2013) (“NFC+s”), some of the risk mitigation techniques also extend to all counterparties, including non-financial counterparties below the clearing threshold (“NFC-s”).
Although not strictly in the context of extraterritoriality, the European Securities and Markets Authority (“ESMA”) has expressed a view that status designations of TCEs should be assessed by counterparties in cooperation together, taking into account the nature of the activities undertaken by the relevant TCE counterparty. As this is not necessarily a clear-cut determination, the assumptions and conclusions drawn should be properly documented. Ultimately, the onus is on the relevant TCE to correctly determine its status designation under EMIR. In practical terms, counterparties are likely to seek representations regarding their TCE counterparty’s status designation. If it is not possible to assess what a TCE’s status under EMIR would be, ESMA has concluded that counterparties should assume that a TCE’s status designation is NFC+ and take approaches to reflect this.
The applicability of the clearing obligation and the risk mitigation obligation to TCEs should always be subject to Art. 13 of EMIR which sets out principles to avoid duplicative or conflicting rules (the “equivalence regime”).
What is the thinking behind “equivalence”? At its simplest, its effect is meant to be that if at least one of the counterparties to an OTC derivative contract is established in an “equivalent jurisdiction” (i.e., whose legal arrangements are declared by the EU Commission as equivalent to the relevant requirements under EMIR), the provisions of EMIR could be “disapplied” as that jurisdiction’s framework would allow for an outcome similar to that of EMIR. As a result, only TCEs located in non-equivalent jurisdictions would need to ensure compliance with any requirements of EMIR that apply in relation to their OTC derivative contracts.
However, the implementing acts on equivalence are still being developed by the EU Commission. To date, the EU Commission has mandated ESMA to provide technical advice on the equivalence of the legal regimes in Australia, Canada, Hong Kong, Japan, India, Singapore, South Korea, Switzerland and the United States. The EU Commission has yet to make any equivalence decisions based on ESMA’s advice. At this point, there is little clarity as to how the equivalence regime under EMIR will operate (and interact with related legislation – please see below). Going forward, many practical questions will need to be answered as to how TCEs can safely settle compliance issues relative to their derivative trading.
WHERE ARE WE NOW?
On 10 October 2014, the major provisions of regulatory technical standards (the “RTS”) on “the direct, substantial and foreseeable effect of [OTC derivative contracts] within the Union and to prevent the evasion of rules and obligations” came into force. Their central purpose is to shed light on what a “direct, substantial and foreseeable effect” is meant to capture to ensure consistent application of the clearing obligation and risk mitigation obligation in extraterritoriality scenarios.
We consider below the key features of these RTS and their impact on TCEs.
Direct, substantial and foreseeable effect
The RTS provide that an OTC derivative contract will have a “direct, substantial and foreseeable effect” within the EU in the circumstances as follows:
Firstly, when at least one TCE has (with respect to such OTC derivative contract) the benefit of a guarantee provided by an EU guarantor whose status is an FC (i.e., potentially holding a significant market position). The thinking behind this is that a default of such TCE under such OTC derivative contract would impact that EU guarantor - which would be obliged to assume the resulting liability - thereby importing risks to OTC derivatives markets in the EU. Such guarantee is to meet two cumulative thresholds in order to qualify. In broader terms, it must:
- cover the liability under one or more OTC derivative contracts for an aggregated notional amount of at least EUR 8 billion (or cover only a part of such liability, in which case the above threshold amount is to be proportionally reduced); and
- be at least equal to 5 per cent. of the EU guarantor’s total “current exposures” (as defined in the Capital Requirements Directive) under OTC derivative contracts. The RTS also require that the liability that arises from these OTC derivative contracts must itself at least reach the set threshold. If not, such OTC derivative contracts would not be considered to have a “direct, substantial and foreseeable effect” within the EU even where (i) the maximum amount of the guarantee reaches (or exceeds) that threshold, and (ii) the threshold regarding the EU guarantor’s current exposures is met.
Secondly, an OTC derivative contract will have a “direct, substantial and foreseeable effect” within the EU, if it has been entered into by two TCEs through their branches located in the EU and these TCEs would be FCs if established in the EU. This is to address the regulator’s concern that these branches may control a significant share of the OTC derivatives markets in the EU and so the inapplicability of the relevant EMIR rules with respect to OTC derivative contracts involving such branches could be a cause of potential market disruptions. For example, activities of these branches could significantly influence market liquidity due to their strong market position.
A possible implication of the above is that the clearing obligation or the risk mitigation obligation may extend to TCE subsidiaries of FCs established in the EU (if at least one of them benefits from a guarantee provided by its parent with respect to its OTC derivative contracts). However, the current market expectation is that it should be the TCE with the guarantee (in collaboration with the FC guarantor) that are to be responsible to ensure compliance with these obligations as these are the only entities that can assess whether the applicable thresholds with respect to the guarantee have been met at any given time.
The fact that the RTS anticipate an ongoing assessment of the thresholds raises a number of issues – in particular, pricing and valuation uncertainties (as a result of clearing obligation or risk mitigation obligation (primarily margining) being potentially applicable in the future) and difficulties in ensuring compliance if the other counterparty is not cooperative. The market practice around these issues (and possible mitigants) is yet to be settled and so it is currently not clear how the OTC derivatives market will respond to changes brought in by the RTS.
Evasion of rules
The RTS also establish cases where it is necessary to prevent the evasion of provisions of EMIR in the context of OTC derivative contracts between two TCEs. Briefly, the RTS apply to an OTC derivative contract if the way in which it has been concluded is considered (having regard to all relevant circumstances and arrangements related to it) as having the avoidance of the application of EMIR as its primary purpose. If an OTC derivative contract lacks a clear business rationale or economic justification, it could be taken as having defeated the object, spirit and purpose of any provision of EMIR that would otherwise apply and, therefore, be considered to be “evasive”.
EMIR inevitably also “bites” in the event of cross-border transactions (i.e., where a TCE is transacting with an EU counterparty). This is most obvious when it comes to the clearing obligation. EMIR makes it explicit that this obligation applies with respect to OTC derivative contracts between an EU counterparty (which is an FC or an NFC+) and a TCE which would be subject to this obligation if it were established in the EU (please see ‘TCE’s counterparty status’ above). However, ensuring compliance is of lesser concern for a TCE as the prevailing view across the OTC derivatives market is that the responsibility lies with an EU counterparty.
So far as the risk mitigation obligation is concerned, there is no such express authority in EMIR. Nevertheless, ESMA has advised that this obligation applies in the above context even though the TCE “would not itself be subject to EMIR” and it is an EU counterparty which is to take appropriate actions so that the relevant risk mitigation techniques are employed with respect to the relevant OTC derivative contracts.
The position should not be any different when it comes to any other requirement imposed by EMIR. TCEs are in practice required by their EU counterparties to agree arrangements ensuring compliance with EMIR - with EU counterparties being unlikely to trade derivatives with TCEs refusing to cooperate.
Jason Harding is a partner and Eva Valentova a senior associate, financial services and products, CMS Cameron McKenna