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Understanding EMIR: A guide for funds and their managers

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20 February 2013

Why should I care about EMIR?

Do you manage a private equity fund, real estate fund, investment fund, hedge fund or any other alternative investment fund, a UCITS or work for a company that does? Are the fund or your company or both established in the European Economic Area (the EEA) or does the fund trade with derivatives with counterparties based in the EEA? If so, please read on for a summary of important changes that are being made to the regulation of derivatives in the EEA.


Under the definitions of the Regulation on OTC derivatives, central counterparties and trade repositories (Regulation (EU) 648/2012) also known as the European Markets Infrastructure Regulation (EMIR), an alternative investment fund (an AIF) managed by an alternative investment fund manager (an AIFM) authorised or registered in accordance with the Alternative Investment Fund Management Directive (Directive 2011/61/EU) as well as UCITS and, where relevant, its management company, authorised in accordance with the UCITS Directive (Directive 2009/65/EC) are classified as financial counterparties and therefore subject to the full range of obligations imposed by EMIR. This includes the clearing, the OTC risk mitigation and the reporting obligations. These obligations are likely to start coming into effect from March onwards.

Frequently Asked Questions

1. Why do funds and managers need to consider EMIR?

EMIR is relevant for EEA fund managers because all AIFs with authorised or registered AIFMs under AIFMD, and all UCITS funds, will be classified as financial counterparties under EMIR and will be subject to the full array of EMIR's obligations (explained below). In addition, funds (and other vehicles) established in the EEA which are not UCITS or AIFs will also become subject to certain risk management obligations under EMIR.

Much of the detail concerning how EMIR will be implemented is in secondary legislation (technical standards), which are currently with the European Parliament for consideration. Our description is based on the draft technical standards available.

2. The funds I manage are not based in the EEA – does EMIR still apply?

The application of EMIR to non-EEA entities is unclear. Non-EEA AIFs are caught if managed by an EEA AIFM. Other entities may be in scope of certain EMIR requirements which apply where the derivative "has a direct, substantial and foreseeable effect within the EU" or if it is considered "necessary or appropriate to prevent the evasion" of EMIR. The extent of this extra-territorial effect is similar to Dodd-Frank language in the US and the market is awaiting further guidance as to how these provisions might operate in practice. Consequently, assessment of the entities outside the EEA may be necessary.

3. What obligations does EMIR impose?

EMIR can be broken down into three broad categories: the clearing obligation, OTC risk mitigation requirements, and reporting obligations for derivatives transactions.

4. What is the clearing obligation?

Article 4 and 5 of EMIR require OTC derivative contracts that have been declared subject to the clearing obligation are to be cleared where concluded between:

(a) a financial counterparty and another financial counterparty;

(b) a financial counterparty and a non-financial counterparty that is subject to the clearing     requirement (commonly referred to as a "NFC+");

(c) two NFC+s;

(d)      (i) a financial counterparty or a NFC+; and

           (ii) a third country entity that would be subject to the clearing obligation if it was established in the EU; and

(e) between two third country entities that would be subject to the clearing obligation if the    two entities were established in the EU, BUT ONLY if the contract "has a direct, substantial and foreseeable effect within the EU" or if it is considered necessary or appropriate to prevent the evasion" of EMIR.

5. What is a 'financial counterparty'?

'Financial counterparty' is defined in Article 2(8) of EMIR and includes UCITS funds and AIFs managed by an EEA AIFMs. Any AIF managed by an AIFM authorised or managed under AIFMD is caught, no matter what the size of the AIF. Once non-EEA AIFMs are required to become authorised or registered under AIFMD, the funds they manage will also become financial counterparties.

6. What is a 'non-financial counterparty'?

'Non-financial counterparty' means any entity established in the EU which is not a financial counterparty. A non-financial counterparty will be subject to the mandatory clearing obligation if it takes positions in derivative contracts and, in aggregate, the rolling average position exceeds a clearing threshold for 30 working days – in this case, it will be deemed to be an NFC+. For the purposes of measuring an entity's business against the clearing threshold, an entity can ignore any positions which are for "commercial hedging purposes".

Any holding or operating companies owned by an AIF, whether established in the EEA or outside of it, are likely to be NFCs or third country equivalents with the same obligations and will need to consider whether they fall within the NFC+ definition. The threshold applicable to become an NFC+ is based on the gross notional value of all derivatives traded by the relevant entity or any other non-financial entities within its group which are not objectively measurable as reducing risks directly relating to commercial activities or treasury financing activities of that entity or the group. This means that, for example, all holding or operating companies owned by a particular AIF may become NFC+s (or third country equivalents with the same obligations) on the basis of a single large total return swap entered into by one of them.

7.Which products will be subject to the clearing obligation?

Precisely which products will be subject to the clearing obligation will develop over time as new products become available for clearing and are approved by ESMA. The market expectation is that plain vanilla derivatives, such as many interest rate swaps and certain swaps on certain CDS indices, will be the first products subject to the clearing obligation. The number of products subject to the clearing obligation will expand over time, driven primarily by the range of products for which clearing houses seek to develop clearing services.

8. Will the clearing obligation apply to the funds I manage?

In light of the above, it is not yet possible to be definitive as to the application of the clearing obligation. It will be necessary to examine each entity, its trading activities and its counterparties when ascertaining whether trades would be subject to the obligation. Each AIF managed by an authorised or registered AIFM will be a financial counterparty. However, funds which are not managed by an authorised AIFM and become counterparties to "standardised derivatives", whether or not incorporated in the EU, will need to assess whether they are (i) an NFC+ or (ii) a third country entity that would be deemed a financial counterparty or an NFC+ if established in the EU. To the extent that any such fund falls within one of these categories, the identity of its counterparty will dictate whether or not the trade in question will be subject to the clearing obligation (assuming it is a standardised derivative transaction). This will be true where the fund in question is not in scope but is contracting with a counterparty which is within scope itself. In addition, the forthcoming RTS on extra-territoriality will also need to be taken into account.

9. What are the OTC risk mitigation requirements?

Article 11 imposes various risk mitigation procedures and arrangements relating to operational and credit risk applicable to uncleared transactions. These include requirements for

- timely confirmations;

- portfolio reconciliation;

- dispute resolution;

- valuation; and

- collateralisation.

These will impose significant regulatory obligations on in-scope funds.

The scope and timing of the application of a number of these requirements remains subject to some uncertainty.

10. What are the reporting requirements?

The reporting obligations in Article 9 of EMIR have wide application and will apply to all derivatives types (whether or not they fall within the clearing obligation) to which an in-scope fund, or other EEA established entity, is a party. Reports will need to be made to a trade repository.

It is clear from Article 9 that 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). The implementation of an RTS on this point will specify more clearly the details the reports amount contain.

Reporting can be delegated to third parties – it is anticipated that the buy-side will have the sell-side report on their behalf, but this may pose challenges when dealing with non-EEA counterparties (as they may not have their own EMIR reporting infrastructure in place).

11. When is EMIR effective?

The implementation timing for EMIR is complex, but for in-scope funds some obligations are expected to come into effect in March.

12. What should I do next?

AIFMs will need to run EMIR implementation in parallel with their AIFMD projects. In practice, institutions are now commencing EMIR implementation in earnest – starting with mapping their entities within scope and their categorisation, the products within scope and what will apply when.

There is a strategic element to this which potentially dovetails with any drivers to structural change under AIFMD. Whilst the majority of the r

equirements under EMIR are an administrative rather than a financial burden, the clearing requirement and the collateralisation requirement are financial and potentially impose very substantial incremental costs on continued derivatives dealings (albeit that those costs remain unknown until the detail of the clearing mandate and the collateralisation requirements emerge). Given the (apparent) application of these requirements to non-EEA funds managed by authorised AIFMs, there may be additional incentives (over and above those arising directly from AIFMD) to consider reshaping business structures – specifically by moving management of non-EU AIFs out of the EEA.

Your legal team may want to consider joining the ISDA working group (which we are leading) working through appropriate amendments to ISDA documentation arising from EMIR, and various other EMIR-related issues (including trading confirmations) which is legally driven.


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