The European Market Infrastructure Regulation (EMIR) sets out the requirements for the central clearing of standardised OTC derivatives, the exchange of collateral, post-trade reporting to trade repositories and risk mitigation procedures for non-cleared derivatives. The requirements apply to many stakeholders in the OTC derivatives market in the EU and, prior to Brexit and the expiry of the Brexit transition period, applied to stakeholders in the UK.
Now that the Brexit transition period has passed, EMIR has effectively been ‘on-shored’ into UK law by a number of statutory instruments, including the Over the Counter Derivatives, Central Counterparties and Trade Repositories (Amendment, etc., and Transitional Provision) (EU Exit) Regulations 2019/335, and has come to be referred to as UK EMIR in the derivatives market.
Consequently, the regime implemented by EMIR vis à vis OTC derivatives (broadly outlined below) continues in the UK under UK EMIR, with certain differences. UK EMIR substantially adopts the provisions of EMIR, save for (among other things) references to terms defined by reference to EU (rather than UK) legislation and transferring functions and supervisory roles currently undertaken by EU authorities to equivalent UK authorities. For example, certain matters that under EMIR are within the European Securities and Markets Authority’s remit will, under UK EMIR, fall under the remit of the relevant UK regulator. Depending on the obligation, this may be the Bank of England, the Prudential Regulatory Authority or the Financial Conduct Authority.
UK EMIR operates in parallel with EMIR to ensure that the OTC derivatives regime used by market participants in the UK continues to operate effectively now that we have emerged out of the Brexit transition period.
EMIR / UK EMIR – key requirements
Under EMIR and UK EMIR, occupational pension schemes are classified as ‘financial counterparties’ and required to comply with the margin requirements and the obligation to report transactions.
Trustees considering entering into OTC derivatives which are not cleared by a central counterparty (CCP) – also known as a clearing house- will need to provide collateral or ‘margin’ in respect of those transactions. The key requirements are initial margin and variation margin, each of which are subject to certain exemptions and thresholds which may affect whether a trustee is obliged to exchange margin for particular OTC derivatives contracts.
Variation margin: collateral regularly exchanged and calculated on a daily basis with counterparties to reflect changes to the market value of outstanding (i.e. continuing) OTC derivatives transactions.
Initial margin: collateral posted by each counterparty as an additional buffer to cover the risk of a default in the period between the last collateral exchange and the liquidation of the relevant transactions.
Most counterparties will be required to exchange variation margin. However, the initial margin requirements are being phased in (albeit later than originally planned as a result of the COVID-19 crisis) for counterparties trading derivatives for certain asset classes above a particular aggregated trading threshold. As such, depending on the volume of a scheme’s derivatives activity, a trustee may not be required to comply with the initial margin requirements where the scheme does not meet the relevant threshold. However, trustees whose schemes are subject to the initial margin requirements may find themselves having to review and agree a new suite of documentation when entering into the relevant derivatives contract due to the stringent requirements regarding the segregation and maintenance of initial margin.
If a scheme’s aggregated derivatives contracts for particular asset classes exceeds the relevant prescribed threshold, it will be required to clear those transactions through a CCP. Clearing is the process following trade execution which enables the availability of cash and/or the requisite financial instruments to settle the transaction. Clearing recalibrates the way that derivatives transactions are created and documented so that instead of being bilateral- with each participant directly exposed to the risk of its counterparty’s failure- transactions are structured so that each transaction is cleared through a CCP. The CCP stands at the centre of each transaction between each counterparty and acts as a risk buffer, because it is able to absorb the consequences of either party’s default. This is designed to shield the non-defaulting party to the transaction who will continue to deal, unaffected with the CCP and who would otherwise have suffered loss. The CCP is protected by rules requiring the mandatory posting of margin by parties to transactions which are cleared through that CCP, ensuring that the CCP has sufficient funds to meet all its obligations in the event that a clearing member defaults. Following the Brexit transition period, UK CCPs will require an equivalence decision by the EU Commission in order to be recognised as a CCP by EU regulators and to clear derivatives transactions which are subject to the EMIR clearing obligation. UK CCPs currently benefit from temporary equivalence where they are clearing OTC derivatives transactions which are subject to the EMIR clearing obligation. Temporary equivalence granted by the EU Commission for UK CCPs will expire on 30 June 2022.
Until now, certain UK and EU pension schemes benefitted from a temporary exemption from the EMIR clearing obligation until 18 June 2021. HM Treasury has extended the exemption for certain ‘within-scope’ pension schemes until June 2023 (including certain UK and EEA pension schemes). The rules as to which pension schemes are exempt from clearing are complex. It may be that if you are a UK pension scheme trading with an EU financial counterparty, as that EU entity may be subject to EMIR, the UK pension scheme may well be required to clear derivatives transactions as a result of the EU entity being subject to the clearing obligation under EMIR. We would be happy to discuss any clearing queries with you further.
Although the levels of derivatives trading activities will mean that many schemes fall below the mandatory clearing threshold, a number of the largest pension schemes are already centrally clearing transactions. The European Parliament has indicated that the pension scheme clearing exemption is not intended to be permanent. So, despite the continuation of the exemption (as it applies in the UK and the EU), it is likely that the market will move towards facilitating technical solutions for pension schemes to transfer non-cash collateral with CCPs sooner rather than later.
Under UK EMIR, UK entities entering into derivatives transactions on behalf of UK pension schemes are required to report derivatives transactions to a trade repository which is registered with the FCA or a trade repository operating under the temporary registration regime or the conversion regime. Under those regimes, trade repositories previously registered with ESMA can establish a new UK legal entity which benefits from a temporary registration while the FCA considers their application to register as a trade repository for the purposes of UK EMIR. UK trade repositories which were registered with ESMA pre-Brexit are able to benefit from the conversion regime provided that they notified the FCA of their intention to fall under the conversion regime prior to exit day. Any such UK trade repositories need not go through the formal application process with the FCA in order to obtain registration as an authorised trade repository for the purposes of the trade reporting obligations under UK EMIR.
There are a number of issues to consider in order to ensure compliance with the derivatives reporting obligation, which can be and is often delegated to the counterparty to the derivatives transaction, which are outside the scope of this note. Do get in touch if you would like to discuss further.