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Upcoming changes to initial margin rules mitigate their impact

Date:
June 24, 2020

Summary

Regulators have split the final phase (Phase 5) of the initial margin rules into two parts — now Phases 5 and 6 — to mitigate the impact of the upcoming expansion.

European regulators have recently enacted changes to EMIR that could impact fund-level hedging, including but not limited to REITs. Specifically, regulators have expanded the financial counterparty definition to directly or indirectly include all funds, and consequently, these funds may now be required to comply with the margin, clearing and daily valuation requirements.

These regulatory changes have arisen through a years-long process whereby European regulators have reviewed the European derivatives regulation, a process known as the EMIR Refit. As discussed further below, the EMIR Refit has made several significant changes to EMIR, and most of these changes will become effective on June 17, 2019. Any (i) entities directly subject to EMIR, and (ii) any entities facing European counterparty banks, whether or not domiciled in Europe, should review EMIR Refit to determine its impact on their future hedging strategies.

Although there are many other revisions, we have summarized some of the most important amendments that will impact funds and fund-level hedging. For more information, please contact your Chatham relationship manager.

Expansion of financial counterparty (FC) definition:

  • The definition of FC will be expanded to include all alternative investment funds (AIFS) established in the European Union, as well as all AIFs formed outside of the European Union that are trading with European banks. This includes funds and REITs domiciled in the United States.
  • Impact: Unless a product exemption applies, financial counterparties are required to comply with the margin and clearing rules as well as submit daily valuations of their derivative transactions.

Exemption of deliverable FX forwards and swaps from margin rules:

  • The EMIR Refit declares the intention of regulators that deliverable FX forwards and swaps should be exempted from the margin rules for all market participants except credit institutions and investment firms.
  • Impact: This change mitigates some of the impact of the change to the financial counterparty definition as deliverable FX forwards are not required to be margined even by counterparties classified as financial counterparties.

New small FC clearing category:

  • A new small FC (or FC-) clearing category is being created. An FC will be considered an FC- and will be exempt from the clearing obligation if its average month-end notional value of trades in derivatives over the prior 12 months does not exceed any of the statutory thresholds (€1 billion for credit or equity derivatives; €3 billion for IR, FX, and commodities).
  • Hedging contracts are not excluded from the clearing calculation for FCs (unlike for non-financial counterparties (NFCs)).
  • If an FC’s calculation is above the threshold in any class of OTC derivatives, it will be subject to the clearing obligation for all classes of OTC derivatives (unlike NFCs above the clearing threshold (NFC+s)), which will only be subject to the clearing obligation for the specific class for which they have exceeded the applicable threshold).
  • Impact: Funds with low levels of derivatives trading activity are exempted from the mandatory clearing requirement when trading products subject to mandatory clearing (i.e., vanilla interest rate swaps and certain credit default products). The FC- clearing exemption does not alter the applicability of requirements pertaining to the exchange of margin under EMIR.

Changes to the clearing calculation:

  • FCs and NFCs will need to run the clearing calculation every 12 months (starting from the date EMIR Refit goes into force), and the calculation will be based on the aggregate month-end position for the previous 12 months (versus the existing pre-EMIR Refit calculation, which was based on the rolling average position over 30 working days).
  • Impact: FC-s and NFC-s will now need to be able to show that they are under the clearing thresholds. Once EMIR Refit goes into effect, NFCs and FCs will become subject to the clearing obligation if they either (i) do not calculate their average position to determine whether they’re over the clearing threshold, or (ii) do the calculation and determine that they are over the clearing threshold.

New mandatory delegation of reporting obligation:

  • 12 months after the rest of EMIR Refit cames into force (June 17, 2020), the reporting obligation will be greatly reduced for many portfolio companies as the financial counterparty will become solely responsible and legally liable for reporting on behalf of portfolio company and for ensuring the correctness of the reported details as long as the portfolio company provides the financial counterparty with all relevant details that the bank would not be reasonably expected to possess.
  • The EMIR Refit also eliminates the requirement to report intergroup derivative transactions.
  • The EMIR Refit transitions the responsibility and legal obligation to report derivative transactions from funds to their respective fund managers.

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