Derivatives margin and clearing – proposed extensions, exemptions and grandfathering

ESMA has published two final reports which set out proposed legislation in respect of margining and clearing. The proposed legislation includes formalised extensions to certain margin deadlines, broadened and time-extended exemptions for certain types of derivatives and trading relationships, and grandfathering of regulatory treatment for certain legacy derivatives. The UK has also taken steps to preserve exemptions under UK law, following the end of the Brexit transition period.

Margin

On 23 November, ESMA published a final report presenting new draft regulatory technical standards (the Margin Amendment RTS) on the risk mitigation techniques (focussing on bilateral margining) for uncleared OTC derivative contracts. The Margin Amendment RTS proposes amendments to EMIR’s current margin rules (set out in Commission Delegated Regulation (EU) No 2016/2251, (the Margin RTS)).

The proposed Margin Amendment RTS contains the following key changes.

Key change Summary Margin Amendment RTS provision
Confirmation of extended
initial margin deadlines

Formal extension of the implementation timetable for regulatory initial margin requirements, following the deferral proposed by Basel Committee on Banking Supervision and the International Organization of Securities Commissions in April this year. 

The result would be that:

  1. the Phase 5 implementation deadline would be formally delayed from 1 September 2020 to 1 September 2021. Phase 5 catches trading relationships where both counterparties have, or belong to groups each of which has, an aggregate average notional amount of non-centrally cleared derivatives that is above €50bn across the last business day of March, April and May in the year of implementation (i.e. 2021, following the delay); and
  2. the Phase 6 implementation deadline would be formally delayed from 1 September 2021 to 1 September 2022. Phase 6 catches trading relationships where both counterparties have, or belong to groups each of which has, an aggregate average notional amount of non-centrally cleared derivatives that is above €8bn across the last business day of March, April and May in the year of implementation (i.e. 2022, following the delay).
Proposed article 1(3)(a) of the Margin Amendment RTS amending articles 36(1)(e)-(f) of the Margin RTS
Broadened exemption from variation margin requirements
for physically settled FX
forwards and physically settled
FX swaps

The proposed Margin Amendment RTS provides that counterparties should not be obliged to post or collect variation margin in respect of physically settled FX forward contracts and physically settled FX swap contracts where one of the counterparties is not (i) a “credit institution” (as defined in article 4(1)(1) of MiFID), (ii) an “investment firm” (as defined in article 4(1)(2) of MiFID), or (iii) a third country equivalent of (i) or (ii).

This formalises the physically-settled FX forward exemption under the margin rules that has been informally in place since its technical expiry back in 2018, and widens it so that it applies to physically-settled FX swaps as well (in line with recital 21 of Regulation (EU) 2019/834 of the European Parliament and of the Council of 20 May 2019 (known as EMIR Refit)).

Proposed article 1(1) of the Margin Amendment RTS inserting a new article 31a into the Margin RTS

Extended temporary exemption from margin requirements for single-
stock equity options and index options

Extension of the temporary exemption (from both the variation margin and initial margin requirements) for single-stock equity options and index options until 4 January 2024.

Proposed article 1(5) of the Margin Amendment RTS replacing article 38(1) of the Margin RTS
Extended temporary exemption from margin requirements for intragroup transactions

Extension of the intragroup margin exemption to cover transactions between EEA
and non-EEA counterparties
(where no equivalence decision has been adopted) until
30 June 2022.

This will help deal with one of the Brexit-related issues that had been due to occur – UK-EEA groups losing the margin exemption in December 2020.

Proposed articles 1(3)(b) and 1(4) of the Margin Amendment RTS replacing articles 36(2)(a) and 37(3)(a) of the Margin RTS (respectively)

Grandfathered margining requirements for Brexit novations

In respect of non-centrally cleared OTC derivative
contracts which:

  1. were entered into or novated prior to the earlier of (i) the application of the relevant margin requirements, or (ii) the date of entry into force of the Margin Amendment RTS;
  2. are novated for the sole purpose of replacing a UK counterparty with an EEA counterparty; and
  3. are novated between 1 January 2021 and the later of (i) the application of the relevant margin requirements, or (ii) 1 January 2022,

counterparties may continue to apply the risk-management procedures that they have in place on the date of entry into force of the Margin Amendment RTS.

In order to benefit from this grandfathering, counterparties that intend to novate transactions to an EEA counterparty should therefore start negotiating the novations of their transactions which are in the scope as soon as possible, given the limited time period to benefit from it. If the counterparties agree on the terms of a novation before the date of entry into force of the Margin Amendment RTS, they should provide that any such novations take effect only upon the date of entry into force of the Margin Amendment RTS, in order to benefit from the grandfathering.

Operationally, this means that legacy pre-regulatory margin trades that are novated during the timeframe outlined above in order to replace a UK counterparty with an EEA counterparty (that is, due to Brexit), can continue to benefit from their current regulatory position in respect of risk-management procedures (i.e. they will not have to start exchanging margin purely by virtue of the novation).

Proposed article 1(2) of the Margin Amendment RTS replacing article 35 of the Margin RTS

Clearing

On 23 November, ESMA also published a final report presenting new draft regulatory technical standards (the Clearing Amendment RTS) on the clearing obligation. The Clearing Amendment RTS proposes amendments to Commission Delegated Regulation (EU) 2015/2205 (the First Clearing Commission Delegated Regulation), Commission Delegated Regulation (EU) 2016/592 (the Second Clearing Commission Delegated Regulation) and Commission Delegated Regulation (EU) 2016/1178 (the Third Clearing Commission Delegated Regulation and, together with the First Clearing Commission Delegated Regulation and the Second Clearing Commission Delegated Regulation, the Clearing RTS).

The proposed Clearing Amendment RTS contains the following key changes.

Key change Summary Clearing Amendment RTS provision
Extended temporary exemption from the clearing obligation
for intragroup transactions

Extension of the intragroup clearing exemption to cover transactions between EEA
and non-EEA counterparties
(where no equivalence decision has been adopted) until
30 June 2022.

As above, this will help deal with another of the Brexit-related issues that had been due to occur – UK-EEA groups losing the clearing exemption in December 2020.
 

Proposed article 1(1)(i) of the Clearing Amendment RTS amending article 3 of the First Clearing Commission Delegated Regulation

Proposed article 2(1)(i) of the Clearing Amendment RTS amending article 3 of the Second Clearing Commission Delegated Regulation

Proposed article 3(1)(i) of the Clearing Amendment RTS amending article 3 of the Third Clearing Commission Delegated Regulation

Grandfathered clearing obligation
for Brexit novations

The clearing obligation will not apply to any OTC derivatives created by a novation to an
EEA counterparty from a
UK counterparty that:

  1. while entered into with the UK counterparty were not subject to the clearing obligation by the date of entry into force of the Clearing Amendment RTS (e.g. they are legacy trades entered into before the clearing obligation came into force);
  2. are novated for the sole purpose of replacing the UK counterparty with the EEA counterparty; and
  3. are novated in the period 12 months from the date of application of the Clearing Amendment RTS.

In order to benefit from this grandfathering, counterparties that intend to novate transactions to an EEA counterparty should therefore start negotiating the novations of their transactions which are in the scope as soon as possible, given the limited time period to benefit from it. If the counterparties agree on the terms of a novation before the date of application of the Clearing Amendment RTS, they should provide that these novations take effect upon the date of application of the Clearing Amendment RTS, in order to benefit from the grandfathering.

Proposed article 1(1)(ii) of the Clearing Amendment RTS amending article 3 of the First Clearing Commission Delegated Regulation

Proposed article 2(1)(ii) of the Clearing Amendment RTS amending article 3 of the Second Clearing Commission Delegated Regulation

Proposed article 3(1)(ii) of the Clearing Amendment RTS amending article 3 of the Third Clearing Commission Delegated Regulation

Reflecting the removal of the frontloading requirement

Amongst other things, EMIR Refit removed the so-called “frontloading” requirement.

“Frontloading” was the
obligation to clear OTC derivative contracts (pertaining to a class of OTC derivatives that had been declared subject to the clearing obligation) entered into or novated on or after notification by a
competent authority to ESMA
on the authorisation of a CCP
but before such clearing
obligation took effect, if they
had a remaining maturity at
least equal to the “minimum
remaining maturity” determined in the relevant Clearing RTS.

In order to align the Clearing RTS with EMIR (as amended
by EMIR Refit), the Clearing Amendment RTS includes amendments to remove the “minimum remaining maturity” requirements from the Clearing RTS.

 

Proposed article 1(2) of the Clearing Amendment RTS amending article 3 of the First Clearing Commission Delegated Regulation

Proposed article 2(2) of the Clearing Amendment RTS amending article 3 of the Second Clearing Commission Delegated Regulation

Proposed article 3(2) of the Clearing Amendment RTS amending article 3 of the Third Clearing Commission Delegated Regulation

Next steps

The final reports (including the proposed Margin Amendment RTS and Clearing Amendment RTS) have been sent to the European Commission for endorsement. Following the endorsement, they are then subject to non-objection by the European Parliament and the Council.

Such a process can take time and, whilst the European Supervisory Authorities (the ESAs) cannot disapply EU law, the final reports state that “the ESAs expect competent authorities to apply the EU framework in a risk-based and proportionate manner with regards to the requirements related to the measures contained in the draft RTS until the amended RTS enter into force”. In other words, in respect of (i) the bilateral margin requirements and the treatment of physically settled FX forward and swap contracts, intragroup contracts, equity option contracts, the implementation of the last phases of the initial margin, and OTC derivative contracts novated from the UK to the EEA, and (ii) the clearing requirements and treatment of intragroup OTC derivatives and OTC derivative contracts novated from the UK to the EEA, national competent authorities are expected to exercise regulatory forbearance.

Brexit

The UK has also taken steps to preserve temporary exemptions under UK law. Pursuant to regulations 80-83 of the Over the Counter Derivatives, Central Counterparties and Trade Repositories (Amendment, etc., and Transitional Provision) (EU Exit) Regulations 2019, SI 2019/335, HM Treasury established a temporary intragroup exemption from margin and clearing requirements for OTC derivative transactions. This meant that any existing intragroup exemptions between UK firms and both their EU and third country group entities (where no equivalence decision has been adopted) before exit, could continue in the case of a no-deal exit. In line with the general approach set out in HM Treasury’s guidance, the UK’s temporary intragroup exemption regime is being amended, pursuant to regulation 52 of the Securities Financing Transactions, Securitisation and Miscellaneous Amendments (EU Exit) Regulations 2020, to come into force at the end of the transition period.

This has been reinforced by HM Treasury announcing, on 9 November, The European Market Infrastructure Regulation (Article 13) Equivalence Directions 2020, which grants equivalence to EEA states with regard to the intragroup exemption pursuant to article 13 (Mechanism to avoid duplicative or conflicting rules) of EMIR, which will form part of UK law at the end of the Brexit transition period. The direction means that UK counterparties may apply to the Financial Conduct Authority for exemptions from the clearing obligation and the requirement to exchange margin in respect of the UK’s derivatives regulation in respect of some intragroup OTC derivative transactions between the UK counterparty and EEA counterparties.