Strictly Confidential Professional / Institutional Investors Only
OTC Clearing Monthly Update April 2013
Importance Notice: UBS does not provide accounting, legal, tax or regulatory advice, and this material should not be construed as nor relied upon as advice of any kind. We accept no liability for this material nor any loss incurred in connection with any use made of it. We recommend that you discuss all accounting, tax and regulatory capital related matters with your own external auditors and such other advisers as you think fit. For further information, please don't hesitate to contact your clearing sales contact. Thank you.
Bloomberg sues CFTC over derivatives margin treatment1 Bloomberg LP filed a lawsuit regarding new exchange margin rules against the Commodity Futures Trading Commission (CFTC) on 16th April, following up on its previous letter to the regulator threatening legal action.
The principal objection is the new exchange margin rules that Bloomberg say, favour swap futures over OTC cleared swaps and therefore disadvantage Swap Execution Facilities (SEF’s). As commented in our March 2013 update, under new CFTC regulations standard interest rate and credit default swaps require margin to cover a five-day default window. By way of comparison, futures only require margin to cover a one-day default window.
Bloomberg is one of a dozen or so firms planning to become a SEF.
For additional information, please see FT.com article: “Bloomberg sues CFTC over derivatives rules” from 16 April 2013.
CFTC delays swaps reporting deadline for some users2 Manufacturers and other firms who do not use derivatives for speculative purposes were granted a last minute exemption to the new reporting rules. Originally, they would have had to start reporting their swaps positions to swap data repositories on 10 April 2013. Most now have until 1 July 2013 to comply with rules on reporting of interest rate and credit default swaps and until 19 August 2013 for equity, FX and commodity swaps.
For additional information, please see the Reuters.com article: “US watchdog gives more time on swaps used to hedge”, from 9 April 2013.
US persons definition still to be finalised3 4
CFTC Commissioner Scott O’Malia has suggested that they will need to provide relief when the current temporary exemption relating to the “US Persons” definition expires on 12 July 2013. The CFTC has not yet started work on the final definition of what constitutes a “US person.” Commissioner O’Malia is uncertain on whether to extend the relief as is, or whether to implement the entire cross border guidance and provide relief on certain elements. Commissioner O’Malia is erring towards an extension of the existing relief. This is set to be hotly debated.
In the meantime, finance ministers from around the world have warned the CFTC that the market is beginning to fragment amid a lack of regulatory co-ordination, and have requested the CFTC to avoid cross-border conflicts with other regulators. Some critics are concerned that the “US person “definition is too broad and may lead to duplication and potential conflicts and inconsistencies across global regimes.
For additional information, please see Risk.net article: “CFTC should extend US persons fix, says O’Malia” from 12 April 2013 and FT.com article: “US asked to finalise derivatives rules” from 20 April 2013.
Uncleared swaps margin concerns5
A letter signed by the International Swaps and Derivatives Association (ISDA), the Association for Financial Markets in Europe (AFME), the Securities Industry and Financial Markets Authority (SIFMA) and the Institute of International Finance (IIF) was sent on 12 April 2013 to the International Organization of Securities Commissions (IOSC) and the Basel Committee on Banking Supervision
1 Source: FT.com – Bloomberg sues CFTC over derivatives rules 2 Source: Reuters.com – US watchdog gives more time on swaps used to hedge 3 Source: Risk.net – CFTC should extend US persons fix, says O’Malia 4 Source: FT.com – US asked to finalise derivatives rules 5 Source: efinancialnews.com - Trade bodies in last-ditch bid to limit swaps margin
(BCBS). The letter urges regulators to reduce proposed collateral requirements for derivatives that remain outside central clearing.
The group is concerned that the proposed high levels of initial margin for uncleared swaps would create, “a severe cost burden on the global banking system and the global economy with minimal benefit.” They went on to detail concerns that the levels of initial margin would lead to less effective hedges or unhedged exposures rather than the intended increase in central clearing.
For additional information, please see FinancialNews.com article: “Trade bodies in last-ditch bid to limit swaps margin” from April 16 2013.
NEW FCA EMIR homepage On 1 April 2013, the Financial Conduct Authority (FCA) became the primary authority for implementing European Market Infrastructure Regulation (EMIR) in the UK. As such the Financial Services Authority (FSA) EMIR webpages have been transferred to the FCA website.
CRD IV package expected to come into force 1 January 2014 Council
The Committee of the Permanent Representatives in the European Union (COREPER) meeting of the Council endorsed the March agreement with no significant changes. The specific stance taken by certain member states are set out below:
European Parliament
In April 2013, the European Parliament, in plenary, adopted the Capital Requirements Directive (CRD) IV package (Directive & Regulation). The only key amendment agreed was the removal of the text prohibiting netting of payables and receivables for the leverage ratio calculation which could have had a material impact on securities lending and repo activity. It was agreed that the EU should not front-run Basel developments in this area.
Political assessment
Despite concerns raised by several member states, the agreement between the Irish Presidency and the European Parliament was endorsed by COREPER in March 2013.
Attention will now pass to the European Banking Authority (EBA) which has the enormous task of drafting hundreds of technical regulatory standards related to the CRD IV in order to flesh out the technical details on issues such as liquidity, remuneration, and corporate governance.
It is now considered likely that the text will be published in the EU Official Journal before 30 June 2013 which will enable CRD IV to come into force on 1 January 2014.
EMIR frequently asked questions document published by UBS The English version is detailed below, this is also available in French and German, please see the separate links on the covering e-mail for the alternate language versions.
This material is provided for informational purposes only and UBS makes no representations or warranties, express or implied, as to its accuracy, adequacy or completeness and accepts no liability for its use or for direct or consequential losses arising from its use. The information below is not intended to be a complete statement or summary of the matters covered herein and is subject to change and UBS accepts no obligation to update you regarding such changes. In particular, you should note that the information below is subject to on-going regulatory developments. This information does not constitute legal, tax, regulatory, investment or accounting advice and you should consult with your own independent professional advisors with respect to its application to your specific circumstances.
1. What is EMIR and what does it seek to do?
The European Markets Infrastructure Regulation of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties (“CCPs”) and trade repositories (“TRs”) entered into force on 16 August 2012. EMIR seeks to shift the derivatives market from a largely OTC bilateral market to a centrally cleared market that is more transparent. The obligations which are set out under EMIR can be broken down into three broad categories:
(i) The Reporting Obligation in respect of all OTC derivative contracts or ETDs (see Question 6); (ii) The Mandatory Clearing Obligation in respect of all OTC derivative contracts of a class declared subject to mandatory clearing and changes to existing OTC and ETD clearing offerings (see Question 7); and (iii) The Risk Mitigation Obligations in respect of all uncleared OTC derivative contracts (including collateral margining) (see Question 8).
The scope and impact of the requirements depend both on the classification of the counterparty and on the asset class of the contract, which are considered in more detail below.
2. Does EMIR apply to me? EMIR applies directly to any entity established in the EU6 that is a legal counterparty to a derivative contract. It may also apply to those entities which are not established in the EU. 1. EMIR identifies the following categories of counterparty to a derivative contract: (i) Financial Counterparties (“FCs”). A FC is broadly defined and includes authorised financial institutions within the Union such as banks, insurers, investment firms, UCITS funds and, where appropriate, their management companies, occupational pension schemes and alternative investment funds (such as hedge funds and any other non- UCITS funds) managed by a manager authorised or registered under AIFMD7. (ii) Non-Financial Counterparties (“NFCs”) or (“NFC+s”).
6 Direct application to EU. However EMIR is intended to be adopted in the additional EEA jurisdictions of Iceland, Norway and Liechtenstein 7 As no manager can yet be so authorised or registered, until that time any such alternative investment funds should consider whether they are an NFC/NFC+ (if in the EU) or a third country entity (which may be in scope).
A NFC means an undertaking established in the Union other than a FC or CCP. The classification as an NFC or NFC+ depends on whether the counterparty is above or below the relevant outstanding notional value of derivative trades threshold. (iii) Third Country Entities (i.e. entities established outside of the Union). (iv) Others, including individuals and other non-undertakings (by exclusion—as only “undertakings” are considered to be NFCs. If carrying out economic activity, it is possible that individuals could be “undertakings” but regulators have informally indicated that individuals will not be in scope. However, the position is not yet finalised). EMIR makes no distinction in respect of SPVs and Funds and therefore these will also need to be classified into one of the above categories. As mentioned, the EMIR classifications apply to the legal counterparties to a derivative contract. Accordingly, if you are a Wealth Management client and UBS AG enters into a derivative contract as your agent and on your behalf, you will need to be classified into one of the above categories and it is your classification which will determine whether the derivative contract is subject to the obligations under EMIR. For more details on each of these classifications refer to the Appendix. 3. Is EMIR still applicable to me even though I am incorporated outside of the EU? The industry is awaiting further regulatory technical standards (“RTS”) on the extra-territorial scope of EMIR although it is expected that certain contracts entered into by entities outside the EU will be subject to requirements under EMIR8. EMIR obligations will impact Non-EU entities where either: (i) The Non-EU entity enters into OTC derivative contracts with a FC or NFC+ and would itself be
an FC or NFC+ if it were established in the EU, in which case, the contract will be subject to the mandatory clearing set out under EMIR9; or
(ii) The Non-EU entity enters into OTC derivative contracts with another Non-EU entity, and the contract has a direct, substantial and foreseeable effect10 within the Union or where necessary or appropriate to prevent the evasion of any provision of EMIR, in which case, the contract will be subject to the mandatory clearing and the risk mitigation requirements set out under EMIR.
4. How are UBS entities classified and what does this mean for me? UBS Investment Bank primarily trades OTC derivatives through either UBS Limited or UBS AG: (i) UBS Limited is expected to be a Financial Counterparty for the purposes of EMIR. Accordingly
to the extent you contract with UBS Limited, the contract will be subject to the regulatory requirements under EMIR even where you are incorporated outside of the EU and therefore potentially not subject to the EMIR obligations directly (as to which see Question 3 above).
(ii) UBS AG (including its EU branches) is expected to be a Third Country Entity for the purposes
of EMIR. Accordingly, to the extent you contract with UBS AG, London Branch, we would not consider ourselves to be directly subject to the requirements under EMIR (aside from in respect of those contracts highlighted in Question 3 (ii) above) but, to the extent you are an EU entity, the contract will be subject to, and we will seek to assist you in complying with, the regulatory obligations. Other EU UBS entities which trade OTC derivatives (such as SPV’s and Funds and Wealth Management entities) and are established within the EU will also be directly subject to EMIR.
8 Independent advice should be sought on this topic. 9 This is explicitly stated in respect of the clearing obligation. However it is expected that further regulatory guidance will clarify that this approach should also apply in determining the applicability of the risk mitigation obligations to contracts between EU and Non-EU entities. 10 The meaning of “direct, substantial and foreseeable” is expected to be set out in a further RTS.
5. Will EMIR apply to products that I trade? EMIR applies to all derivative products as defined in MiFID (this is generally understood to include all derivatives other than Spot transactions11). The obligations primarily apply to OTC products but ETD products are also in scope for the purposes of reporting and certain of the clearing member and CCP obligations, which will impact both their OTC and ETD clearing offerings (see Question 7 below). An OTC derivative product will only become subject to clearing once the class of OTC derivative contracts which it is part of becomes subject to mandatory clearing under EMIR. 6. What are my Reporting Obligations? All counterparties incorporated within the EU which are FCs, NFC+s or NFCs must report the “conclusion, modification or termination” of any derivative contract (which includes both OTC and ETD derivative contracts), to a registered or recognised Trade Repository. The details are to be reported no later than the working day following any such event. Regulators have informally indicated that individuals and Third Country Entities are likely to be out of scope of the reporting obligation, but the position is not yet finalised. Every EU counterparty is responsible for ensuring that both their own entity details and the common details of the trade are reported to the Trade Repository, although both parties are obliged to ensure reports are made without duplication. The minimum details will include the parties to the contract and the main characteristics (such as type, underlying maturity, notional value, price and settlement date). 6.1 Can reporting be delegated? / Will UBS report on my behalf? Reporting can be delegated to the other counterparty or third parties; however, the liability remains on the counterparty subject to the requirement. UBS is currently considering what, if any, services it will be able to offer in this regard. 6.2 When must I begin reporting? The reporting start date is dependent on the registration of a EU Trade Repository or recognition of a Non-EU Trade Repository (as relevant) in respect of the relevant asset class, and shall be 90 days following the date of such registration/recognition. This is likely to fall in autumn 2013 for CDS and interest rate swaps and early 2014 for other transaction types. EMIR also requires the back reporting of those derivative contracts which: (a) were entered into before 16 August 2012 and remain outstanding on that date; and (b) are entered into on or after 16 August 2012. 7. What are the OTC derivatives clearing obligations? EMIR requires OTC derivative contracts of a class declared subject to the clearing obligation by ESMA and concluded between counterparties which are classified as either an FC or NFC+ or a Third Country Entity which would be an FC or NFC+ if it were established in the EU (including potentially, where both are Third Country Entities (see Question 3(ii) above)) to be cleared by an authorised or recognised CCP. 7.1 What products will be subject to the clearing obligation and from
when?
11 Although it is understood that Spot is not considered a derivative product under MiFID there is some uncertainty as to the impact of EMIR on physically settled FX forwards, other spot transactions, repos and securities lending.
ESMA will determine that a class of OTC derivatives is subject to the clearing obligation only once a CCP is authorised to clear that certain class of OTC derivatives and ESMA has been notified of the same by the national competent authority. Once ESMA has made such a determination and released related RTS, then all OTC derivatives contracts of such class entered into from such date and any existing OTC derivative contracts entered into after the date that ESMA was notified of the authorisation of the CCP will be required to be cleared12. It is expected that plain vanilla derivatives, which are already cleared by CCPs today, such as interest rate swaps and certain swaps on certain CDS indices, will be the first products subject to the clearing obligation. This is likely to increase over time, though the initial requirement for central clearing is not expected to be in force until Q2 2014. 7.2 Will EMIR compliant clearing be permitted on a non-EU CCP? In order for products to be cleared under EMIR on any non-EU CCP, ESMA will need to have determined that the applicable legal and supervisory arrangements of the jurisdiction in which such CCP is established are equivalent to the respective requirements under EMIR and the CCP will need to be recognised by ESMA. There is provision for this under EMIR, and existing non-EU CCPs which were recognised by the relevant Member State as of 15 March 2013 can continue to offer clearing services on an uninterrupted basis while their application for recognition under EMIR is being processed. 7.3 Will existing clearing offerings be impacted? For the purposes of EMIR, clearing members and CCPs will be required to offer clients at least the choice between omnibus client segregation and individual client segregation and provide transparent disclosure on the risks and costs associated with these offerings. In addition, CCPs are required to have detailed procedures in place to be followed where clearing members default. In particular, a CCP must be able to transfer the assets and positions held by a defaulting clearing member for the account of its clients to another clearing member designated by the clients without the consent of the defaulting clearing member. 7.4 Is indirect clearing EMIR compliant? EMIR permits clients to satisfy their OTC clearing obligations by using indirect clearing arrangements. However, these arrangements must not increase counterparty risk and must ensure that the assets and positions of the client benefit from the same level of protection as if they were a direct client of the clearing member. Note: although this is currently being considered, there is no viable solution within the industry to facilitate this approach at present. 8.0 What risk mitigation steps are required for uncleared OTC derivative contracts? EMIR imposes various risk mitigation procedures and techniques relating to operational and credit risk applicable to non-centrally cleared OTC derivatives, namely: Timely confirmation • FCs and NFCs must confirm transactions by set deadlines by electronic means where available:
– with effect from the compliance start date confirmations must be executed by T+2 for all Credit and Rates OTC uncleared transactions and T+3 for Equities, FX or Commodities OTC uncleared transactions (subject to longer timeframes for NFC-s and a phasing in period, see note on counterparty classifications in the Appendix)
– all FCs will be required to have procedures in place to report, if required, on a monthly basis those confirmations which are not executed within five days on request to the national regulator in each Member State
– the compliance start date was 15 March 2013
12 There are certain exemptions available for intra-group contracts, provided certain criteria are met.
Portfolio recognition/compression • FCs and NFCs must agree processes for regular portfolio reconciliation with counterparties and
have processes to address portfolio compression opportunities • The compliance start date is 15 September 2013 Dispute resolution • FCs and NFCs must agree procedures for identification, recording, monitoring and resolution of
disputes in relation to valuation or exchange of collateral (and FCs must report on unresolved disputes relating to amounts in excess of EUR15 million where the dispute remains unresolved for 15 business days)
• The compliance start date is 15 September 2013 Marking-to-market • FCS and NFC+s must carry out daily mark-to-market or, where market conditions prevent this,
mark to model • The compliance start date was 15 March 2013 Margining of collateral • FCs and NFC+s must have procedures for the exchange of collateral. Note: The Commission has
not yet issued the regulatory technical standard regulation (“RTS”) setting out the details of how this collateral is to be calculated
• The compliance date is to be confirmed Capital • FCs must have appropriate capital for uncollateralised risks. The Commission has not yet issued
a RTS on this • The compliance date is to be confirmed 9. Are there any exemptions available under EMIR? Exemptions are available from some of the requirements: (i) Intra-group transactions may qualify for exemptions from the clearing obligation and
margining requirements when certain conditions are met13; and (ii) There is a three-year delay to the clearing obligation available to certain transactions entered
into by pension schemes14 In order to take advantage of these exemptions, EU counterparties must apply to the relevant national regulator with evidence that they meet the specified criteria. In addition, the application of EMIR to Third Country Entities will be prescribed in the extra-territorial RTS to be published by ESMA. This is expected to be dependent on “equivalent” legislation (such as Dodd-Frank in the USA) and requirements being in place in the jurisdiction of the Third Country Entity. 10. What should I do now? The implementation of EMIR is well underway with entities identifying their entities and products within the scope of EMIR and determining what obligations will apply to them and when. Initially, we would expect the following action points are relevant. Notification of your status
• ISDA has published the “ISDA EMIR Non-Financial Counterparty Representation Protocol” that NFCs may adhere to in order to notify counterparties of their status. Until such time as an NFC counterparty adheres to the Protocol, UBS will treat such counterparty as if it were
13 Note that where the any such transaction is with a group entity incorporated outside of the EU, the granting of any exemption will be dependent on such entity’s jurisdiction being considered “equivalent” for the purposes of EMIR. 14 Independent legal advice should be sought in this regard.
a NFC+ for the purposes of our application of the EMIR obligations. Available on the ISDA website at http://www2.isda.org/functional-areas/protocol-management/protocol/11
• You should consider whether you are a FC, a NFC or a Third Country Entity, or entirely out of scope (on the basis that you are not an “undertaking”). If you are a NFC, are you a NFC+ or do your positions in derivative contracts which are not subject to a relevant exemption fall below the relevant clearing threshold? You should also consider the status of your counterparties
• If you are a NFC and you have an ISDA in place with us, we would request you adhere to the ISDA EMIR Non-Financial Counterparty Representation Protocol so as to represent your status to us and other counterparties with whom you trade derivative products
• If you are a NFC+, you must notify ESMA and your national regulator • You should consider whether you will you be applying to your national regulator for
exemption from any of the requirements of EMIR
Confirmation timeliness (effective 15 March 2013) • Consider which timely trade confirmation deadlines apply to your transactions • Are you in a position to confirm your trades with your counterparties within the deadlines
set? • Are you in a position to confirm your trades electronically?
Marking to market (effective 15 March 2013) • If you are a FC or NFC+, you will be required to mark-to-market on a daily basis the value
of outstanding OTC derivative contracts (or, where market conditions prevent this, mark to model)
Reporting • Regardless of your classification above, you should consider your approach to reporting,
including data sourcing, your infrastructure and outsourcing options • Do you have a relationship with a Trade Repository? If not, you need to consider
establishing one before the first reporting obligation applies • If you are a FC, you need to put in place procedures to enable you to report unconfirmed
OTC derivative transactions that have been outstanding for more than five business days to your relevant national regulator on a monthly basis
Clearing models • You should consider the different offerings provided by each CCP and your preferred
Appendix—Counterparty Classification 1. What is a Non-Financial Counterparty (“NFC”)? A NFC means an undertaking established in the Union other than a FC or CCP. ESMA has set a threshold amount to determine the scope of the requirements NFCs are subject to, this threshold is based on the volume of OTC derivatives that they, and their group, trade. If an NFC is above this threshold, it is an NFC+ and subject to more extensive and onerous requirements under EMIR. 1.1 What are the relevant thresholds? The relevant thresholds are as set out in the table below: Asset Class Clearing Threshold (gross notional amount)
(EURbn)
Credit derivatives 1
Equity derivatives 1
Interest rate derivatives 3
FX derivatives 3
Commodity and other derivatives 3
A NFC will be subject to the mandatory clearing obligation if it (together with any non-financial entity within its group) takes positions in derivative contracts (in aggregate) the rolling 30 day average position of which exceeds the clearing threshold in respect of any one asset class. Where the threshold is exceeded in any one asset class, it will trigger the obligations on all derivatives traded by the entity, including those entered into for hedging purposes (see below). 1.2 Are hedging transactions excluded when calculating the volumes against
the threshold? Yes. For the purposes of measuring an entity's derivative volumes against the threshold, an entity can ignore those positions which are “objectively measureable as reducing risk”. Certain conditions are set out in EMIR which can be used to determine whether this test is met. 1.3 What actions are required by an NFC if its status changes? Immediately on the occurrence of the relevant threshold for the NFC being exceeded, the NFC is required to immediately notify ESMA and the relevant competent authority. On the occurrence of the rolling average position over 30 working days exceeding the relevant threshold, the NFC will become subject to the additional obligations set out below. To the extent that the NFC’s derivative activities subsequently cause it to be under the threshold, there is scope for it to re-classify. 2. How does the application of EMIR differ between NFCs and FCs?
2.1 What obligations are imposed on NFCs?
Under EMIR, all NFCs are subject to the following requirements15: • The obligation to report any derivative contract • The timely confirmation of uncleared OTC derivative contracts • The reconciliation of portfolios • The compression of portfolios; and • The resolution of disputes
15 However the scope of the requirement may differ depending on whether above or below the threshold.
2.2 What additional obligations are imposed on FCs and NFCs over the threshold? In addition to those requirements which are set out above to apply to all NFCs, all NFC+s and FCs are also subject to the additional requirements: • The obligation to clear OTC derivative contracts subject to mandatory clearing • The daily valuation of contracts on a mark to market/model basis; and • The timely exchange of collateral 2.3 How does the NFC clearing threshold impact on the timely confirmation
requirements and what is the phase in period? See table below:
FC & NFC+ NFC
CDS
and
IRS
≤28-Feb-14
T+2
>28-Feb-14
T+1
≤31-Aug-13
T+5
1-Sep-13–
31-Aug-14
T+3
>31-Aug-14
T+2
All
other
types
≤31-Aug-13
T+3
1-Sep-13–
31-Aug-14
T+2
>31-Aug-14
T+1
≤31-Aug-13
T+7
1-Sep-13–
31-Aug-14
T+4
>31-Aug-14
T+2
Anticipated EMIR timeline and Dodd-Frank clearing determination dates
* CCPs can apply for authorisation from entry into force of the first set of RTS and have six months to apply. Uncertainty remains around individual CCP authorisation timelines within the six month period
** Trades that have been declared subject to the Clearing Obligation and are entered into after the first CCPs are authorised but before the date from which the Clearing Obligation takes effect ( the “Frontloading Period”) will be
required to clear, subject to a threshold minimum remaining maturity.
