EMIR Refit, also referred to as EMIR 2.1, was signed off in the European Parliament plenary on 18 April, paving the way for it to enter into force, potentially as soon as this month.

Refit makes some targeted revisions to the clearing, risk mitigation, reporting and trade repository rules in the European Market Infrastructure Regulation (EMIR). It should not be confused with EMIR 2.2, which makes revisions to EMIR CCP supervision rules and was also signed off at the European Parliament plenary. While some of the Refit revisions aim to make rules simpler and more proportionate, others in effect are likely to increase the regulatory burden already faced by firms. How significant the impact of these modifications is likely to be will depend on a firm’s derivatives trading model, as well as other factors, such as whether it transacts with non-financial counterparties (NFCs), is a clearing member, or has EU-established Alternative Investment Funds (AIFs) in the group.

This blog provides an overview of some of the key requirements in Refit and the potential impact they will have on firms. Please see here for a more comprehensive look at the EMIR Refit changes.

Key areas likely to increase requirements for firms

1. Expansion of the definition of a financial counterparty (FC)

Refit will expand the definition of an FC to include certain additional AIFs (e.g. funds established in the EU but managed by non-EU Alternative Investment Fund Managers (AIFMs)) and Central Securities Depositories (CSDs). There will be a new carve-out for UCITS and AIFs that are set up exclusively for the purpose of serving one of more employee share purchase plan, or where the AIF is a securitisation special purpose entity and, where relevant, its AIFM is established in the EU. The expansion of the definition may significantly increase the regulatory burden for certain AIFs and CSDs, as they may become subject to more stringent requirements, most notably around risk mitigation and clearing. This, in turn, may mean building or implementing new systems and infrastructures, data assessment, contract analysis and re-negotiation, and training staff. Their counterparties will also be affected.

2. Risk management procedures for uncleared derivatives

Refit introduces a requirement that firms’ risk management procedures - and any significant changes to those procedures - which use internal models for the segregation and exchange of collateral should be validated by competent authorities before they are applied. As the supervisory procedures are to be set out in a Regulatory Technical Standard (RTS) due within 12 months after Refit enters into force, it is unclear what these rules will require in practice and how similar they may be to existing US requirements. However, we expect greater supervisory scrutiny, process formalisation, potentially some degree of standardisation of internal modelling, and back-testing of how the model performs in the context of the uncleared portfolio. Currently, collateral modelling is within firms’ discretion, so this requirement adds an additional layer of complexity to the management of uncleared derivatives. Our recent report gives an overview of the current trends in the supervision of model risk management.

3. Delegation of reporting

Refit aims to streamline regulatory reporting by introducing an obligation for FCs to report on behalf of NFCs which fall below the clearing threshold (NFC-). While the NFC- firms will have to provide the reporting FC with all the details the latter “cannot be reasonably expected to possess” and ensure data correctness, FCs transacting with NFCs- will still face a greater reporting burden as they will become solely responsible and legally liable for reporting on behalf of both counterparties. To facilitate delegated reporting, FCs will have to implement process changes and reconfigure their systems, which means additional costs.

Key areas likely to reduce requirements for firms

1. Introduction of an exemption from clearing for small financial counterparties (SFCs)

EMIR introduced a mandatory clearing obligation for standardised OTC derivatives, with a phased implementation timetable depending on the derivative class and the market participant category. The Commission concluded in its 2016 review of EMIR that SFCs, although numerous, account for only very small volumes of OTC derivatives activity, and by extension for low levels of systemic risk. As a result, Refit will permit FCs that fall below the clearing threshold in all asset classes and calculate their positions to be exempt from the clearing obligation (although the margining requirements will still apply). This is good news for firms that do fall below the thresholds as it will potentially exempt them from the Category 3 clearing obligation due to come into effect on 21 June 2019. However, there are some timing considerations in relation to this (see the “Timing of application” section below).

2. Selective clearing for NFCs

NFCs, or, broadly speaking, corporates, use OTC derivatives to hedge risks directly linked to their commercial or financing activities. Under the current EMIR rules, NFCs must clear all derivatives subject to the clearing obligation as soon as they exceed the prescribed threshold in any relevant asset class. Refit amends this so that NFCs need only clear the derivatives in the asset class for which they have breached the threshold, provided they calculate their position as proposed in Refit, i.e. every 12 months. This will reduce costs and responsibilities associated with clearing, as these counterparties will only have to clear centrally those instruments in which they are most active. The new, annual position assessment will also be welcomed by NFCs, which currently have to calculate their positions on a rolling average over 30 working days. Alternatively, in order to eliminate the costs involved in monitoring their derivatives exposures, NFCs can elect not to calculate their positions, with the downside that they would be subject to the clearing obligation in all relevant classes of derivatives.

3. Variation Margin (VM) on physically-settled FX products

Statements by the European Supervisory Authorities (ESAs) and the Financial Conduct Authority (FCA) in 2017, and the December 2017 draft RTSon margin requirements, set out that the VM exchange rules for physically-settled FX forwards should target only transactions between institutions, namely credit institutions and investment firms. Refit adds a recital that the exchange of VM in relation to physically-settled FX swaps, as well as forwards, should be limited to transactions between the most systemic counterparties (i.e. credit institutions and investment firms). This provides additional certainty for firms regarding margining obligations on FX products.

Timing of application

The majority of the new rules will apply when the legislation enters into force. However, there are some exceptions to this. For example, the delegated reporting requirement will apply 12 months after entry into force. Level two measures will also need to be developed for certain provisions, such as in relation to internal model validation, for which the European Banking Authority will have 12 months.

There is also misalignment between the application date of some of the new rules and the original EMIR requirements. For example, the deadline for reporting certain historical transactions, which falls away under Refit, passed on 12 February this year. Similarly, while some SFCs will soon become exempt from clearing, under the current rules they would have to start putting processes in place now to be ready to meet the 21 June 2019 clearing deadline for Category 3 firms. To remedy these two issues, on 31 January, ESMA issued a statement requesting that national supervisors enforce EMIR “in a proportionate manner”. Even so, according to a recent ESMA statement on the implementation of the clearing obligation, financial and non-financial counterparties (which would include SFCs) choosing to calculate their positions would need to do so on the day Refit enters into force.

What should firms do now?

We expect EMIR Refit to be published in the Official Journal (OJ) potentially as soon as this month (although it is more likely to be in June/July), with entry into force twenty days later. On 11 March, the FCA announced that the UK will implement the Refit amendments as soon as they are implemented in the EU, through the Withdrawal Act or the Financial Services (Implementation of Legislation) Bill, which means UK firms will still be under the obligation to implement the Refit requirements.

In order to prepare for the new regime, especially considering the short application timelines, firms should undertake impact assessments and gap analyses to ascertain how these wide-ranging rules will affect their businesses. Firms should then look to start implementation work, while keeping track of the publication timetable of level two measures. This all implies a considerable effort for firms in a relatively short space of time. EMIR might have been “refitted” but it remains to be seen how well it really fits.