EMIR (European Market Infrastructure Regulation)

About EMIR (European Market Infrastructure Regulation)

EMIR came into force on 16 August 2012, although most of its requirements did not take effect immediately. The overarching objective of EMIR is to reduce systemic risk in derivative transactions. It imposes a number of requirements on counterparties to derivative transactions, CCPs and trade repositories.

The requirements on counterparties cover the following main aspects:

• central clearing of certain over-the-counter (OTC) derivative transactions
• risk mitigation obligations in respect of uncleared OTC derivative transactions
• reporting of OTC and exchange-traded derivative transactions to a trade repository

EMIR also introduces certain obligations on CCPs, including authorisation, prudential, organisational and conduct of business requirements, as well as obligations on trade repositories, such as registration, operational and transparency requirements.

EMIR applies to all OTC derivative transactions and also applies to exchange-traded derivative transactions in respect of transaction reporting, whether or not those transactions are entered into for the purposes of efficient portfolio management or for investment purposes.

EMIR applies differently depending on whether the relevant party is a financial counterparty (so called "FC") or a non-financial counterparty (so called "NFC"). EMIR further distinguishes between non-financial counterparties which do and which do not exceed the clearing thresholds set out in EMIR (so called “NFC+” and “NFC-”).

EMIR - clearing

The obligation to clear through CCPs will be mandatory for certain OTC derivatives which are entered into by FCs and NFCs. The process of clearing will involve a CCP standing behind every transaction and requiring margin in respect of each transaction.

The clearing obligation for each type of transaction will be phased in depending on the size and status of the relevant counterparty. 

Frontloading

Certain categories of market participants will be required to frontload their OTC transactions. This means that they will need to also clear those contracts which they have concluded before the respective starting date of the clearing obligation. The frontloading provisions are controversial since they are in effect a retroactive change.

Account Segregation

CCPs will have to offer at least a choice between individually segregated client accounts and omnibus client accounts. Additional types of segregation may be offered by the relevant CCP.

The main segregation models are:

Individual segregation

Individual client segregation requires the CCP to keep separate records and accounts enabling the clearing member to distinguish the assets and positions held for the account of each individual client. This means that each client’s assets are held separately from the assets of the clearing member and from the assets of any of its other clients. Clients in an individually segregated account should therefore not be exposed to the clearing member or any of its other clients where there is a default. This model therefore provides the highest level of protection for clients, but is in turn the most costly approach.

Omnibus segregation

Omnibus client segregation requires that the client account is fully segregated from the house account of the clearing member, but the positions of any non-segregated clients of the clearing member in the same account are commingled. The client’s assets in an omnibus account should therefore be protected if the clearing member is in default, but there is a risk that the client could be exposed to the clearing member’s other clients in the same account, as one client's assets may be used to cover another client's positions on default.

Net omnibus segregation

The distinction between net and gross omnibus accounts is not made in EMIR. For net omnibus accounts, the CCP will calculate collateral requirements across all client positions recorded in the account and will call the clearing member for collateral on a net basis. The clearing member will in turn call each client for collateral based on its exposure to the individual client (i.e. on a gross basis). This may result in the aggregate amount of collateral called by the clearing member being greater than that called by the CCP. EMIR permits that such excess may be held by the clearing member and need not be passed on to the CCP. Therefore, where another client of the clearing member fails to satisfy a collateral call from the clearing member, the clearing member will be able to use the excess to satisfy the corresponding collateral call from the CCP.

Gross omnibus segregation

In respect of gross omnibus accounts, the CCP’s collateral requirement will be determined by reference to each individual underlying client’s positions in isolation and there will therefore be no netting of exposures across clients. Whilst the level of collateral payable by a client to the clearing member will be the same as for a net omnibus account, this will be passed on to the CCP in its entirety and there will therefore be no excess held by the clearing member. Whilst the client’s positions will be commingled at CCP-level, the client will at least have comfort that its assets will be used to satisfy collateral calls by the CCP in their entirety.

EMIR - risk mitigation

Those transactions which are not required to be centrally cleared, either because the class of derivative is not subject to the clearing obligation or the counterparties to the transaction do not fall within the scope of the clearing obligation, must comply with certain risk mitigation rules. These rules impose requirements relating to confirmations, robust reconciliation processes, daily marking-to-market, exchange of margin and capital requirements.

The risk mitigation requirements apply to all counterparties, although additional requirements apply to FCs and NFC+s which exceed the clearing thresholds.

A summary of the risk mitigation techniques imposed by EMIR is set out below:

• Timely confirmations – EMIR requires all OTC derivatives transactions to be confirmed within the timeframes set out in EMIR. FCs must have the necessary procedures to report on a monthly basis to their competent authority any transactions which have been outstanding for more than five business days. A number of regulators have confirmed that they do not require FCs to provide them with this information regularly, but do expect them to have procedures in place to report such unconfirmed trades where requested.  
• Portfolio reconciliation – EMIR contains provisions whereby counterparties are required to reconcile their portfolios if the trades they have in place with each other exceed certain thresholds. Complying with this requirement can be achieved in one of two ways. Either the counterparties sign up to the ISDA 2013 EMIR Port Reconciliation, Dispute Resolution and Disclosure Protocol or they put in place bilateral arrangements.  
• Portfolio compression – EMIR requires FCs and NFCs with 500 or more outstanding OTC derivatives transactions to consider whether their portfolios can be compressed at least twice a year and, if so, to undertake such exercise. Such counterparties must be able to provide a reasonable and valid explanation to their competent authority for concluding that a portfolio compression exercise is not appropriate.  
• Dispute resolution – Counterparties must have in place detailed procedures and processes in relation to dispute resolution. Complying with this requirement can be achieved by signing up to the ISDA 2013 EMIR Port Reconciliation, Dispute Resolution and Disclosure Protocol or by putting in place bilateral arrangements. FCs must report to their competent authority any disputes relating to an OTC derivative transactions, its valuation or the exchange of collateral for an amount or a value higher than EUR 15 million and outstanding for at least 15 business days. 
• Record keeping – Each counterparty must keep a record of any derivatives transaction which has been concluded, modified or terminated for at least five years.  
• Valuations – OTC derivatives transactions of FCs must be marked-to-market daily, unless market conditions prevent this, in which case they must be marked-to-model. Such model must be duly documented and approved by the board of directors as frequently as necessary following any material change and at least annually.

EMIR - application of EMIR to non-EU entities

EMIR may apply to non-EU entities whether they are entering into transactions with EU or non-EU entities. If EMIR applies, the non-EU entity might be required to clear and might be required to comply with certain risk mitigation rules.

In order to determine whether EMIR applies to them, non-EU entities need to look at how they would be classified if they were established in the EU. In addition, where two non-EU entities are entering into transactions, they will need to establish whether such transaction has a direct and substantial effect in the EU. If so, EMIR may apply.

The European Commission has established a concept of equivalence, whereby non-EU entities trading in non-EU jurisdictions may be recognised by ESMA, where the regulatory regime governing the transactions meets certain conditions.

ESMA is preparing assessments of the regimes of certain countries, which the European Commission will use to make equivalence decisions.

Margin requirements under EMIR

Where financial counterparties and non-financial counterparties which exceed the thresholds set out in EMIR enter into non-cleared OTC derivative transactions, EMIR requires them put in place risk management procedures for the timely, accurate and appropriately segregated exchange of collateral. This requirement is commonly referred to as “margining” and aims to reduce counterparty credit risk.

To prevent the build-up of uncollateralised exposures, counterparties will be required to collect collateral in the form of initial margin and variation margin.

Initial margin will be collected “gross” (i.e., as a two-way payment without the possibility of netting initial margin amounts against each other) within the business day following the entry into a non-cleared OTC transaction. The idea is for initial margin to cover the potential future exposure of a party due to its counterparty’s default. To reflect movements in counterparties’ risk positions, initial margin will need to be recalculated following a change to the portfolio of non-cleared OTC transactions between the counterparties and otherwise every 10th business day.

Variation margin will be collected “net” on a daily basis to reflect current exposures resulting from actual changes in market price calculated in accordance with the daily valuation requirement under EMIR.

It is currently proposed that the margin requirements will enter into force on 1 September 2016, giving counterparties subject to the requirements time to prepare for the implementation. The initial margin requirements will be phased-in over a period of four years. Initially, the requirements will only apply to the largest market participants. Subsequently, after four years, more market participants will become subject to the requirements. Specifically, from 1 September 2016, market participants that have an aggregate month-end average notional amount of non-centrally cleared derivatives exceeding EUR 3.0 trillion will be subject to the requirements from the outset. From 1 September 2020, any counterparty belonging to a group whose aggregate month-end average notional amount of non-centrally cleared derivatives exceeds EUR 8 billion will be subject to the requirements. Similarly, but with a shorter timescale, the requirements for the implementation of variation margin will be binding for the major market participants from September 2016 and for all the other counterparties by 1 March 2017.

EMIR timeline