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EMIR: The Devil in the Detail

An interesting article from Risk magazine noting one of the inconsistencies thrown up by the EU’s interpretation of the rules on the margining of non-cleared derivatives trades, published on 14 April 2014 (see this blog post for more detail).

The draft EU rules require “EU entities to collect margin…regardless of whether they are facing EU or non-EU entities.  EU entities would have to collect margin from all third-country entities, unless explicitly exempted by the EMIR or under the EUR 8 billion threshold, even from those that would be classified as non-financial entities below the threshold if they were established in the EU.”

The result, as confirmed in a meeting held by the European Banking Authority on 2 June, appears to be that EU entities will be required to collect margin from third-country entities which would be classified as non-financial counterparties below the clearing threshold if they had been established in the EU (“Hypothetical NFCs-“) but not from non-financial counterparties below the clearing threshold which are actually established in the EU (“True NFCs-“).

Article 4(1)(a) of EMIR states that the clearing obligation applies to contracts concluded with either a Financial Counterparty (FC) or a Non-financial Counterparty above the clearing threshold (NFC+) on the one hand and a Hypothetical NFC+ on the other.  As such, contracts executed between FCs/NFCs+ and Hypothetical NFCs- are not subject to the clearing obligation.  In contrast, Article 11 of EMIR (which details risk mitigation techniques for non-cleared OTC derivative contracts) requires FCs and NFCs+ to have policies that require the “timely, accurate and appropriately segregated exchange of collateral”.  Therefore, by implication, True NFCs- are not required to have such policies in place.  Unfortunately, there is no explicit exclusion for Hypothetical NFCs (whether pluses or minuses) in their dealings with FCs or NFCs+ (although there are limitations on the extent to which the requirements apply to a contract entered into between two Hypothetical NFCs+[1]).  It is the absence of such an exclusion which has led regulators to conclude that they are constrained in their ability to interpret this as exempting Hypothetical NFCs-[2].

For counterparty types appearing in the first column in the table below, the obligation to collect collateral under the proposed EU rules can be summarised as follows:

FC NFC+ NFC- HNFC+ HNFC-
FC ×
NFC+ ×
NFC- × × × × ×
HNFC+ × × × [3] ×
HNFC- × × × × ×

Critics of the rule claim that this approach is inconsistent with EMIR and that Article 11 should be interpreted in line with Article 4.  They do have a point, and certainly the EU interpretation does not seem to be consistent with the BCBS/IOSCO “Margin requirements for non-centrally cleared derivatives” which do not apply to “non-centrally cleared derivatives to which non-financial entities that are not systemically important are a party, given that…such transactions are exempted from central clearing mandates under most national regimes”.  If the rules are finalised in their current form, this requirement would put EU banks at a significant disadvantage vis-à-vis their non-EU competitors.  The consultation ends on 14 July, so a response (and hopefully clarify) on this issue should follow soon thereafter.

[1] See EMIR, Article 11(12)

[2] In other words, this is the reason why red ticks currently appear instead of crosses in the first two rows of the table above

[3] If the contract has a direct, substantial and foreseeable effect in the EU or such obligation is necessary or appropriate to prevent the evasion of any provision of EMIR (see EMIR Article 11(12))

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