EU and UK derivatives counterparties are now having to grapple with different sets of rules in the EU and the UK when trading derivatives with each other, following the end of the Brexit transition period on 31 December 2020. This article sets out some practical perspectives on how to navigate these rules and what impact this may have on documentation.
- On 31 December 2020 at 11pm, the UK ceased to be part of the European Economic Area (EEA).
- Prior to the above date, regulation of UK derivatives activities in many cases arose as a result of EU legislation which was directly applicable in the UK, for example the European Market Infrastructure Regulation (Regulation (EU) No. 648/2012, as amended and the associated delegated regulations (EU EMIR).
- For the most part, EU EMIR and other similar legislation affecting derivatives activity (and the associated delegated regulations) have been on-shored in the UK through the European Union (Withdrawal) Act 2018 (EUWA), as amended.
- Although this legislation broadly follows the equivalent EU rules, care is needed as there are certain differences between them and there will be cases where counterparties will now need to comply with two regimes. Future divergence is also possible and perhaps likely.
- Below are some practical considerations that derivatives counterparties should take into account when trading derivatives transactions in the EU and UK, including in terms of the impact on documentation.
EU EMIR: Temporary recognition of UK clearing houses
UK based clearing houses now require an equivalence decision from the European Commission (EC) in order to be recognised by EU regulators as central counterparties (CCPs) under EU EMIR. In the absence of equivalence, UK-based CCPs generally cannot be used to clear derivatives transactions that are subject to the clearing obligation under EU EMIR. Although no permanent equivalence decision has been made by the EU in respect of UK-based CCPs, temporary arrangements have been put in place, which allow counterparties to over-the-counter (OTC) derivatives transactions to continue using certain UK-based CCPs for a limited period until 30 June 2022.
UK EMIR: Recognition of EU clearing houses
Similarly to the above, under EU EMIR as on-shored in the UK pursuant to EUWA (UK EMIR), all OTC derivatives subject to the UK clearing obligation must be cleared by a UK authorised CCP or a CCP recognised by the Bank of England. Recognition can only be granted to CCPs in jurisdictions that HM Treasury has declared to be equivalent to the UK EMIR regime. HM Treasury has made an equivalence decision in respect of EEA states, including EU states, and so individual EU CCPs may be granted full recognition under UK EMIR, although this is a lengthy process. In the meantime, the Bank of England has introduced a temporary recognition regime that allows EEA CCPs that apply for recognition to continue to clear derivative transactions for three years (which can be extended). This means that UK counterparties that are subject to UK EMIR can continue to clear their OTC derivatives transactions through EEA CCPs for three years and this may be extended further.
EU Derivatives Trading Obligation
As from 1 January 2021, EU-based counterparties are no longer able to satisfy their trading obligation for OTC derivatives under Regulation (EU) 600/2014 (MiFIR) (EU DTO) by trading on UK trading venues. The EU DTO applies to (i) EU-based counterparties that are financial counterparties (FCs) and non-financial counterparties (NFCs) above the clearing threshold (NFC+s) under EU EMIR when trading in-scope OTC derivatives between them and (ii) FCs and NFC+s when trading in-scope OTC derivatives with third-country entities that would be subject to the EU DTO if they were established in the EU.
OTC derivative transactions subject to the clearing obligation under EU EMIR are generally within the scope of the EU DTO.
UK Derivatives Trading Obligation
Under UK EMIR, UK firms that are subject to the UK derivatives trading obligation (UK DTO) have to trade certain liquid derivatives on a UK trading venue. However, the UK has provided transitional relief for three months so the UK DTO will not apply in certain circumstances where UK firms are trading with EU firms subject to the EU DTO. This relief is to be reviewed by the Financial Conduct Authority (FCA) by 31 March 2021, although there is no indication that the FCA will necessarily change its approach.
EU EMIR: Characterisation of derivatives traded on UK regulated markets as OTC derivatives
EU EMIR defines OTC derivatives as derivatives that are not executed on a regulated market or a third-country market determined by the EC to be equivalent to a regulated market in accordance with the process specified in EU EMIR. In the absence of any equivalence decision taken by the EC with respect to UK regulated markets, derivatives traded on UK regulated markets and entered into on or after 1 January 2021 will be considered to be OTC derivatives for the purposes of determining whether EU-based counterparties are FCs that exceed the clearing threshold (FC+s) or NFC+s and whether third country entities, which now includes UK-based counterparties), would qualify as FC+s or NFC+s if they were established in the EU (equivalent FC+s or equivalent NFC+s, respectively).
Such re-characterisation of exchanged traded derivatives to OTC derivatives under EU EMIR will have an impact on the clearing threshold calculations, which are used to determine counterparties’ status (i.e. FCs, FC+s, NFCs, NFC+s, equivalent FC+s and equivalent NFC+s) in order to ascertain which clearing and margin requirements will apply to derivative transactions concluded by counterparties. The inclusion of derivatives traded on UK regulated markets in the calculation of clearing thresholds under EU EMIR might in some cases lead to the following adverse consequences:
- a counterparty being treated as an FC+ or a third country entity being treated as an equivalent FC+, resulting in its transactions being subject to mandatory clearing under EU EMIR and to the EU DTO;
- a counterparty being treated as an NFC+ or a third country entity being treated as an equivalent NFC+, resulting in its transactions being subject to mandatory clearing under EU EMIR and to the EU DTO or to margining obligations under EU EMIR; and
- as a result of a counterparty being treated as an NFC+, the counterparty not being able, when concluding derivative transactions with an FC, to rely on the regulatory requirement for the FC to report those transactions for both parties under EU EMIR.
UK EMIR: Characterisation of derivatives traded on EU regulated markets as OTC derivatives
Similarly, derivatives that are executed on an EU regulated market are in scope of the definition of “OTC derivative” under UK EMIR. However, HM Treasury has made an equivalence decision in respect of EEA states, which allows UK firms to continue to treat derivatives traded on EEA regulated markets as exchange-traded derivatives rather than OTC derivatives and exclude them from the calculation.
Under UK EMIR, all UK FCs and NFC+s must send a clearing threshold notification to the FCA by 17 June 2021. This new notification is required even if the UK FC or NFC has already submitted a clearing threshold under EU EMIR. For those firms that are already subject to the clearing obligation, this notification will be similar to the one-off notification that was sent to the FCA and the European Securities and Markets Authority (ESMA) in June 2019.
Counterparties should check whether there is any change to their existing representations as to their classification status under the applicable EU EMIR or UK EMIR regime and consequently, whether any policies and documentation need to be updated in the event of a change of counterparty classification. ISDA has published a revised ISDA Master Regulatory Disclosure Letter, including a new UK Appendix, which counterparties can use to communicate certain information including their classification status under EU EMIR and/or UK EMIR.
EU EMIR: Clearing exemption for pension funds
Certain EU pension schemes have benefited from a temporary exemption from the clearing obligation under EU EMIR where they enter into derivatives transactions that are objectively measurable as reducing investment risks directly relating to the financial solvency of that pension scheme. From 1 January 2021, UK-based pension schemes have no longer benefitted from this exemption under EU EMIR.
UK EMIR: Extension of pension scheme exemption
As far as the UK EMIR regime is concerned, HM Treasury has extended the exemption for certain pension schemes until 18 June 2023 and both UK and EU pension schemes are within the scope of the exemption so that trades between UK entities and EU entities will not have to be cleared under UK EMIR during that time. The FCA maintains a list of the types of pension schemes that have been granted an exemption.
EU EMIR: Clearing and margining exemptions for intragroup transactions
Existing intragroup exemptions related to clearing and margining obligations under EU EMIR (which have been extended until 30 June 2022) have ceased to apply for derivative transactions between UK-based and EU-based affiliated entities. To date, the EC has not adopted an equivalence decision declaring that the UK regime is equivalent for the purposes of the EMIR requirements in respect of clearing and/or margining, as applicable. EU-based counterparties entering into OTC derivatives with their UK-based affiliates may be required to clear, or to exchange margin in relation to, those transactions.
UK EMIR: Clearing and margining exemptions for intragroup transactions
UK entities can continue to benefit from an intragroup exemption from the clearing obligation with third country group entities that are (i) in jurisdictions that have been declared equivalent under EU EMIR, (i.e. Japan or the United States as the EU equivalence decisions have been on-shored in the UK) and (ii) in jurisdictions for which the related exemptions under EU EMIR are grandfathered under UK EMIR for three years until 2024 (except where an equivalence decision is made). UK entities that currently benefit from intragroup exemptions regarding the clearing and margining requirements in respect of their derivative transactions with EU group counterparties must notify the FCA within certain timeframes in order to continue to benefit from those exemptions, following an HM Treasury equivalence decision.
UK EMIR: The EU delegated Margin RTS is not on-shored under the UK regime
On 18 February 2021, the EU delegated margin Regulatory Technical Standards (RTS) entered into force. The RTS include the new initial margin phase-in dates (i.e. 1September 2021 for phase V and 1 September 2022 for phase VI) and the exemptions from the margin requirements for equity and index options and physically settled foreign exchange transactions.
As the RTS entered into force after the end of the Brexit transition period, they do not form part of retained EU law in the UK. The UK Prudential Regulatory Authority (PRA) has recently launched a joint consultation with the FCA to implement the revised margin phase-in dates and other amendments. According to the consultation paper, the proposed changes would be effective on 1 July 2021. In its Policy Statement in December 2020, the PRA acknowledged the differences between the current UK rules and the revised EU margin rules (they were in draft form) and said that pending the outcome of this consultation, it will apply forbearance.
UK EMIR: Risk mitigation techniques
Under UK EMIR, counterparties need to comply with certain risk mitigation techniques (which mirror those under EU EMIR) in respect of their derivatives trades. Although the requirements under UK EMIR and EU EMIR are similar, counterparties should check that documentation refers to UK EMIR where relevant and should also consider the confidentiality waiver in the context of UK EMIR.
UK entities may wish to adhere to the ISDA 2020 UK EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol (UK EMIR Protocol), which is the UK on-shored version of the ISDA 2013 EMIR Portfolio Reconciliation, Dispute Resolution and Disclosure Protocol (EU EMIR Protocol). This enables parties to amend the terms of their in-scope agreements to reflect the portfolio reconciliation and dispute resolution requirements under UK EMIR and includes a confidentiality waiver providing the parties’ consent to the disclosure of information as required to help parties meet the various reporting and record keeping requirements under UK EMIR. Where UK counterparties are trading with EU counterparties, the EU EMIR Protocol will also continue to apply; adhering to the UK on-shored EMIR protocol will not override or replace the amendments previously made by the EU EMIR Protocol. Non-UK entities may also wish to adhere to the UK EMIR Protocol if they are trading with a UK FC or UK NFC even though they may not be directly subject to the rules themselves.
EU EMIR: Reporting of derivative transactions
As from 1 January 2021, if an EU entity transacts with a UK entity, there will be dual reporting under the UK EMIR and EU EMIR reporting regimes. EU-based counterparties should ensure the continuous reporting of their derivative transactions to a trade repository established in the EU and registered under EU EMIR (EU TR) or a trade repository recognised under EU EMIR (EU Recognised TR) in order to comply with their reporting obligations under Article 9 of EU EMIR. From 1 January 2021, UK-based counterparties are not expected to report any derivative transactions concluded on or after 31 December 2020, or any amendment to derivative transactions concluded prior to 31 December 2020, to EU TRs or EU Recognised TRs. Furthermore, UK-based counterparties are no longer responsible for the reporting of derivative transactions for certain of their EU counterparties under Articles 9(1a) to 9(1d) of EU EMIR. While the UK was still considered an EU entity (i.e. up until 31 December 2020) (i) a UK-based FC had to report for its EU-based NFC- counterparties and (ii) a UK fund manager had to report on behalf of its EU funds (whether such managed funds were AIFs (Alternative Investment Funds) or UCITS (Undertakings for the Collective Investment in Transferable Securities) funds). As from 1 January 2021, the EU-based counterparties in the scenarios above became responsible for their own reporting of derivatives transactions.
UK EMIR: Reporting of derivative transactions
Similarly, UK entities in scope of UK EMIR need to report new transactions entered into on or after 11 pm on 31 December 2020, as well as any modifications or terminations of transactions after this date, to an FCA registered or recognised trade repository (UK TR). There is no transitional relief available although the FCA has said that it will act proportionately and, if firms are not fully prepared, enforcement action will not be initiated where the firm has taken reasonable steps to comply.
Counterparties that have delegated reporting arrangements in place should consider whether these arrangements need to be revisited and whether new reporting arrangements should be put in place.
EU EMIR: Novation of derivative transactions to address Brexit related issues
To address challenges resulting from the new status established in the UK following Brexit, counterparties can novate existing derivative contracts concluded with UK-based entities by replacing the counterparty established in the UK with a counterparty established in an EU Member State. The replacement might trigger the clearing obligation or the margining obligation under EU EMIR if it occurs on or after the date from which the clearing obligation or, as applicable, the margining obligation takes effect for that type of contract. In order to ensure the smooth functioning of the market and a level playing field between counterparties established in the EU, Delegated Regulations (EU) 2021/237 and (EU) 2021/236 of 21 December 2020 allow novation of derivative contracts for the purpose of replacing counterparties established in the UK with counterparties established in a EU Member State without triggering the clearing obligation or the margining obligation under EU EMIR.
EU SFTR: Reporting of securities financing transactions
EU-based counterparties and EU branches of UK-based counterparties should ensure the continuous reporting of their securities financing transactions (SFTs) to an EU TR or an EU Recognised TR in order to comply with their reporting obligations under Article 4 of Regulation (EU) 2015/2365 (EU SFTR). From 1 January 2021, a UK-based trade repository will no longer be an EU TR and counterparties will no longer be allowed to report to UK-based repositories for the purposes of EU SFTR unless those UK-based repositories become EU Recognised TRs. Similarly, UK-based counterparties are not expected to report any SFT entered into, modified or terminated on or after 31 December 2020 to EU TRs or EU Recognised TRs. Furthermore, UK-based counterparties are no longer responsible for the reporting of SFTs for certain of their EU counterparties under Article 4(3) of EU SFTR, in particular (i) UK FCs no longer need to report for EU-based NFCs below certain thresholds relating to the total of its balance sheet, its net revenue and its number of employees and (ii) UK fund managers no longer need to report on behalf of their funds (whether such managed funds are AIFs (Alternative Investment Funds) or UCITS (Undertakings for the Collective Investment in Transferable Securities) funds); in such situations, the EU-based counterparties and EU branches of UK-based counterparties become responsible for the reporting of those SFTs.
UK SFTR: Reporting of securities financing transactions
EU SFTR has been on-shored into UK law (UK SFTR) and applies to the UK-based SFTR counterparties, UK branches of third country FCs and third country branches (including EU branches) of UK-based FCs that enter into SFTs. Similar to UK EMIR, UK SFTR requires these entities to report details of their SFTs to a UK TR. It is worth noting that whilst UK branches of EU firms do not need to report their derivatives transactions to a UK TR under UK EMIR, they do need to report their SFTs to a UK TR under UK SFTR. The reporting requirements under UK SFTR started to apply from 31 December 2020 and there is no transitional relief available. It is also important to note that the UK did not onshore the SFTR reporting obligation for NFCs and, therefore, UK NFCs (including EU branches of UK NFCs) do not fall within the scope of the UK SFTR reporting regime.
Disclosure of short selling positions under Regulation (EU) 236/2012
From 1 January 2021, the notification requirements relating to the holding of net short positions as set out in article 1 of Regulation (EU) 236/2012 (EU SSR) no longer apply to derivatives on shares that are admitted to trading in the UK but not in the EU or derivatives on UK sovereign debt.
Derivatives on shares admitted to trading on both EU and UK trading venues may become subject to short position disclosure requirements under both EU and UK law, even if primary trading market is in the UK. Although EU national competent authorities might determine that the principal trading venue of such shares is in the UK i.e. outside the EU (which determine would, once effective, result in those shares and derivatives on those shares being excluded from the scope of the disclosure requirements under the EU SSR), such determination will only become effective when ESMA updates its list of shares for which the principal trading venue is located in a third country. The list is effective for a two year period and published every two years.
UK regime: The EU SSR has been on-shored into UK law (the UK SSR) and applies to the short selling of sovereign debt, shares that are admitted to trading on a UK trading venue (unless exempt) and related instruments and the use of credit default swaps. Holders of net short positions in shares admitted to trading on a trading venue in the UK (unless they are exempt) or UK sovereign debt are required to make notifications to the FCA once certain thresholds have been breached. If shares are admitted to trading outside the UK, they are exempt from the notification and disclosure requirements.
Commodity derivatives and “ancillary activity” exemption under Directive 2014/65/EU (EU MiFID II)
Entities dealing on own account in commodity derivatives are exempted from the requirement to obtain a license as an investment firm under EU MiFID II, provided that their main business does not consist of providing investment services, performing investment activities, operating the business of a bank or acting as a market maker in commodity derivatives.
One of the tests to be complied with by such entities in order for them to determine that their activity in commodity derivatives is ancillary to their main business is the overall market threshold test; this test is carried out by comparing the group’s commodity trading activity in the EU with the total commodity trading activity in the EU. Brexit will result in UK commodity trading activity being excluded from both the numerator and denominator of the calculations for the purposes of this overall market threshold test, which could in turn result in some firms ceasing to be able to rely on the ancillary activity exemption or becoming able to rely on that exemption for the first time.
UK regime: Currently, there is no explicit rule under UK law that excludes any trading activity in the EU from the corresponding overall market threshold test.
Commodity derivatives and position limit regime under EU MiFID II
EU MiFID II establishes a position limit regime for all commodity derivatives contracts traded on trading venues and economically equivalent OTC contracts (EEOTC contracts) to prevent market abuse and support orderly pricing and settlement conditions.
From 1 January 2021, commodity derivatives traded on UK venues are no longer aggregated with instruments traded on EU venues and EEOTC contracts for the purposes of compliance with the position limits regime under EU MiFID II.
UK regime: Position limits apply to commodity derivatives executed on UK trading venues and in EEOTC contracts. In a statement published on 2 October 2020, the FCA confirmed that it does not consider commodity derivatives traded on trading venues, whether in the EU or elsewhere, as EEOTC contracts so they will not count towards the UK commodity derivatives position limit regime.
Market participants will want to review their contracts and keep abreast of changing regulatory developments in the EU and UK, including any potential divergence between the two regimes. In particular, we would suggest that market participants should monitor the expiry of any temporary and transitional reliefs that they are currently taking advantage of and put in place plans to avoid any cliff edge risks that may occur when such reliefs expire.