Swaps end-users that trade derivatives with counterparties that are established in the European Union (EU) (or that have affiliates established in the EU that trade derivatives) should be aware that they may be subject to the European Market Infrastructure Regulation (EMIR). Similar to Dodd-Frank (DF) in the U.S., EMIR imposes reporting, clearing and risk mitigation obligations on end-users of derivatives; however, an end-user’s EMIR obligations may be different from and potentially more burdensome than its DF obligations. McGuireWoods LLP is providing a series of updates for swaps end-users regarding their potential obligations under EMIR. This update describes risk mitigation techniques applicable to end-users under EMIR.
On July 4, 2012, the European Parliament and Council adopted EMIR to provide a framework for addressing the risks related to certain derivative contracts. EMIR requires, among other things, that:
- All derivative contracts be reported to a trade repository;
- OTC derivative contracts be cleared through a central counterparty (CCP), unless an exception or exemption applies; and
- Parties to derivative contracts employ certain risk mitigation techniques (RMTs) for uncleared OTC derivative contracts.
EMIR applies to a broad range of financial instruments and may impose obligations on end-users of those financial instruments not required by the DF swaps regime in the U.S. Under EMIR, an end-user is typically classified as a nonfinancial counterparty (NFC). Click on the link for our Swaps End-User Update regarding counterparty classifications under EMIR. If the gross notional value of the OTC derivative contracts for an NFC and the other members of an NFC’s group exceeds any EMIR clearing threshold, the NFC is considered an NFC+ and must clear all its OTC derivative contracts subject to the clearing requirement through a CCP. Click on the link for our Swaps End-User Update regarding clearing obligations under EMIR. Regardless of whether an end-user is classified as an NFC+ or NFC-, an NFC that trades uncleared OTC derivative contracts must comply with certain RMTs unless an exemption is available.
RISK MITIGATION TECHNIQUES
Under DF, swap dealers (SDs) and major swap participants must comply with swap documentation rules that include swap confirmation timelines, portfolio reconciliation and swap valuation dispute resolution methods in their swap trading relationship documentation. Under EMIR, end-users may be subject to RMTs that include timely confirmation, portfolio reconciliation, portfolio compression and dispute resolution. If applicable, these RMTs would apply to all the end-user’s uncleared OTC derivative contracts.
Timely Confirmation
Counterparties must execute, by electronic means if available, legally binding agreements that include all the terms of each OTC derivative contract as soon as possible, but in any event within certain time periods. Until Aug. 31, 2014, an NFC- must execute confirmations for interest rate and credit derivatives within three business days and from Aug. 31, 2014, within two business days. Until Aug. 31, 2014, an NFC- must execute confirmations for all other derivatives within four business days and from Aug. 31, 2014, within two business days. An NFC+ must comply with accelerated confirmation time periods for all asset classes of two business days until Aug. 31, 2014, and one business day from Aug. 31, 2014.
Portfolio Reconciliation
NFCs must agree in writing on the terms of a portfolio reconciliation process before entering into any OTC derivative contract. Portfolio reconciliation under EMIR is a process whereby counterparties:
- exchange the key terms of each OTC derivative contract in a portfolio between the counterparties;
- exchange the valuation attributed to each OTC derivative contract in a portfolio between the counterparties as of the close of business on the immediately preceding business day; and
- resolve any discrepancy in key terms or valuations.
An NFC- must perform portfolio reconciliation (i) once per quarter if the counterparties have more than 100 OTC derivative contracts outstanding with each other at any time during the quarter and (ii) once per year if the counterparties have 100 or less OTC derivative contracts outstanding with each other.
An NFC+ must perform portfolio reconciliation (i) once each business day if it has 500 or more OTC derivative contracts outstanding with its counterparty, (ii) once per week if it has between 51 and 499 OTC derivative contracts outstanding with its counterparty at any time during the week and (iii) once per quarter if it has 50 or less OTC derivative contracts outstanding with its counterparty at any time during the quarter.
Portfolio Compression
NFCs with 500 or more uncleared OTC derivative contracts outstanding at any time during a calendar year must have procedures in place to regularly, and at least twice a year, determine if a portfolio compression exercise would be appropriate. Portfolio compression is a procedure whereby two counterparties terminate or change the notional value of some or all of the OTC derivative contracts submitted by the counterparties for inclusion in the portfolio compression exercise and, depending on the methodology employed, replace the terminated OTC derivative contracts with other OTC derivative contracts whose combined notional value (or some other measure of risk) is less than the combined notional value (or some other measure of risk) of the terminated OTC derivative contracts included in the exercise. NFCs must provide a reasonable and valid explanation to the relevant competent authority for concluding that a portfolio compression exercise is not appropriate. Depending on the circumstances, NFCs may conclude that conducting a portfolio compression exercise is not appropriate if:
- the portfolio is purely directional and does not allow any offsetting transactions;
- multilateral compression services are not available in the relevant markets, for the relevant products or to the relevant participants, and compression on a bilateral basis would not be feasible; or
- compression would materially compromise effectiveness of the firm’s internal risk management or accounting processes.
Dispute Resolution
NFCs must have detailed procedures for the (i) identification, recording and monitoring of disputes relating to the valuation of an OTC derivatives contract and to the exchange of collateral between counterparties and (ii) resolution of disputes in a timely manner with a specific process for disputes that are not resolved within five business days. An NFC’s procedures and processes must include and record the length of time for which a dispute remains outstanding, the counterparty to the dispute and the notional amount of the OTC derivatives contract(s) in dispute.
ADDRESSING THE EMIR RMTS
End-users may amend their ISDA Master Agreements and other OTC derivatives documentation to address the processes, procedures, representations and agreements required by the EMIR RMTs.
ISDA EMIR Port Rec, Dispute Res and Disclosure Protocol
The ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol (the EMIR Protocol) enables end-users to amend their ISDA Master Agreements to address EMIR’s portfolio reconciliation and dispute resolution obligations. By adhering to the EMIR Protocol, end-users agree to written arrangements for performing portfolio reconciliation and to processes and procedures required for valuation dispute resolution. The EMIR Protocol also includes a disclosure waiver to help ensure that end-users can comply with their reporting and recordkeeping obligations under EMIR without breaching applicable confidentiality or non-disclosure agreements. However, due to the complexity of privacy laws in the EU, end-users should be aware that the waiver, consents and acknowledgements set out in the protocol are not necessarily sufficient to overcome every prohibition or impediment to disclosure under the laws of every jurisdiction in the EU. Click on the link for our Swaps End-User Update regarding reporting obligations under EMIR.
Bilateral Equivalent Agreement
Since most swap end-users have already adhered to the ISDA March 2013 DF Protocol (DF Protocol 2.0) and the CFTC has determined that certain requirements of the DF swap documentation rules are comparable to the EMIR obligations and RMTs, many financial counterparties (FCs) or SDs offer end-users a bilateral agreement that will “top-up” their DF Protocol 2.0 agreements to comply with the EMIR obligations and RMTs. These bilateral agreements with FCs or SDs may be an efficient manner for end-users to comply with the EMIR obligations and RMTs.
Next steps
Swap end-users with affiliates established in the EU, or who trade with EU counterparties, should:
- consider the impact of EMIR on their trading strategies;
- review their OTC derivatives documentation;
- determine their counterparty status under EMIR; and
- consider the most appropriate method to address the reporting, clearing and risk mitigation obligations imposed by EMIR on end-users.
A link to the European Securities and Markets Authority website for EMIR, which includes a quick guide to EMIR for NFCs, is available here.
Please contact one of the authors or your regular McGuireWoods lawyer if you have any questions regarding EMIR or other OTC derivatives matters.