Author: Isobel Wright, Nora Bullock
Hogan Lovells explains how alternative investment funds that enter into derivatives transactions may judge the interaction between Emir and AIFMD
The European Market Infrastructure Regulation (Emir) came into force on August 16, 2012, and sets out new requirements, including clearing obligations, risk mitigation techniques for uncleared trades and trade reporting, for all over-the-counter derivatives. The extent to which the new requirements will apply will depend on how parties are classified under Emir.
This article looks at how these requirements may affect alternative investment funds that enter into derivatives transactions and the interaction between Emir and the alternative investment fund managers directive (AIFMD). In the UK, existing alternative investment fund managers have been able to rely on a one-year transitional period, but need to be AIFMD-compliant by July 22, 2014. Under AIFMD, an internal or external AIFM must be appointed for each fund. This is the entity responsible for compliance with AIFMD and the entity that should be authorised or registered under AIFMD, if required. It must have appropriate substance and retain sufficient portfolio management or risk management functions so it is not considered a letter-box entity.
Emir will have an impact on the structure of funds and, in particular, on the choice of AIFM. This is because AIFs managed by funds authorised or registered under the directive will need to comply with the most stringent requirements under Emir and cannot benefit from the clearing thresholds and associated hedging exemptions. These AIFs, regardless of domicile, will be classified as financial counterparties (FCs) under Emir, along with banks, insurers, investment firms established in the European Union, and Ucits funds.
AIFMs established in the EU have to be authorised under AIFMD or subject to a lighter registration regime if they fall below the de minimis thresholds. At present, AIFMs established outside the EU cannot be AIFMD authorised or registered, but they can still market funds in the EU under national private placement regimes and, if so, be subject to certain AIFMD obligations relating to transparency, reporting and, if applicable, the rules preventing asset-stripping and any additional requirements of the member state where the investor is based. The European Securities and Markets Authority (Esma) has initiated a consultation on the possibility for third-country AIFMs to become authorised under AIFMD and use the associated marketing “non-EU” passport. However, this is not expected to be available until 2015 at the earliest.
In its Q&A on Emir, last updated on June 23, 2014, Esma clarified that all of the following funds would be FCs:
- EU AIFs managed by authorised or registered EU AIFMs;
- Non-EU AIFs managed by authorised or registered EU AIFMs; and
- EU AIFs managed by authorised or registered non-EU AIFMs, subject to the extension of the non-EU passport.
Any entity established in the EU that is not an FC will be a non-financial counterparty (NFC) and is subject to less stringent Emir requirements. EU AIFs will be treated as NFCs until their AIFM becomes authorised or registered under AIFMD, at which point they will be treated as FCs. EU AIFs that are marketed in the EU without a passport by non-EU AIFMs will be considered NFCs as they are not managed by authorised or registered AIFMs.
Esma has also clarified that special purpose vehicles (SPVs) created by real estate and private equity AIFs will be classified as NFCs. Entities whose aggregate positions in OTC derivatives trades on a worldwide basis exceed certain clearing thresholds are known NFC+s and are subject to similar requirements as FCs. Other entities incorporated outside the EU – third-country entities (TCEs) – may also need to consider certain requirements of Emir that may apply to them. Esma has clarified that non-EU AIFs that are marketed in the EU by non-EU AFIMs will be considered TCEs.
As Emir treats AIFs differently from other fund-related entities, such as acquisition vehicles, it is necessary to identify the AIFs within fund structures, which are often complex and multi-tiered. It will be necessary to seek local legal advice to determine if an entity is deemed to be an AIF in the relevant jurisdiction. For example in the UK, the Financial Conduct Authority handbook, Perimeter Guidance, clarifies when an entity is deemed to be an AIF and contains guidance on how to distinguish AIFs from other fund-related entities, which are either specifically exempted, or do not fall within the AIF definition in AIFMD, such as joint ventures and holding companies.
Which Emir obligations apply to funds?
Funds, whether classified as FCs or NFCs, are subject to the requirements to report derivatives trades to a trade repository and put in place risk mitigation techniques for uncleared OTC derivatives trades. Funds that are FCs or NFC+s will be subject to requirements to clear new, but not existing, trades with a central clearing counterparty (CCP) when the clearing obligation becomes effective for a class of OTC derivatives traded by an entity.
How do I determine if the fund is an NFC or an NFC+?
In order to establish whether an NFC could in fact be an NFC+ and thereby be subject to more stringent requirements, it is necessary to calculate the nominal value of all outstanding OTC derivatives contracts of both it and the other NFCs within the group, excluding those contracts that are entered into for specified hedging purposes. The clearing threshold values in respect of each asset class that, if exceeded, would subject NFCs to the clearing obligation are:
- Interest rate derivatives – €3 billion in gross notional value;
- FX derivatives – €3 billion in gross notional value;
- Credit derivatives – €1 billion in gross notional value;
- Equity derivatives – €1 billion in gross notional value; and
- Commodity and any other OTC derivatives – €3 billion in gross notional value.
In determining the amount of derivatives measured against the clearing thresholds, OTC derivatives transactions that are entered into for hedging purposes and meet specified requirements as being “objectively measureable as reducing risks directly in relation to the commercial activity or treasury financing of the NFC or that group” will not count towards the clearing threshold.
Which products are likely to be subject to the clearing obligation?
Emir contemplates that clearing will apply to contracts that are standardised and suitable for clearing. Before the clearing obligation applies with respect to any individual OTC derivatives contract, CCPs must be authorised and the relevant class of derivatives must be declared by Esma to be subject to the clearing obligation. Esma suggests interest rate derivatives, then possibly foreign exchange and credit derivatives contracts, are the products that should be given the highest priority for authorisation. To date seven CCPs – Nasdaq OMX, EuroCCP, KDPW_CCP, Eurex Clearing, Cassa di Compensazione e Garanzia, LCH.Clearnet and Keler CCP – have been authorised to clear certain classes of equity, interest rate and commodity derivatives. Esma will now conduct a public consultation to determine which classes of OTC derivatives should be subject to the clearing obligation.
Trade reporting
Funds also need to comply with the trade reporting obligation that came into force on February 12, 2014. Counterparties and CCPs now need to ensure that each derivatives contract they have entered into, as well as any modifications or early terminations, is reported to a trade repository that is recognised or registered in accordance with Emir no later than the next working day. This includes derivatives – whether traded on or off exchange – as well as intra-group transactions. Certain derivatives contracts entered into prior to this date also need to be reported. In many instances, trade reporting for investment funds will be performed by the investment manager or other service provider, although the fund will still be legally responsible for reporting the trade under Emir. From August 12, 2014, FCs and NFC+s will need to report data on posted collateral and valuations to trade repositories.
Funds will generally be considered the counterparty to a derivatives transaction in the context of Emir, rather than the AIFM or delegated manager, unless it executes trades on its own account. If the derivatives contract is concluded at the sub-fund level, the counterparty should be the sub-fund and not the umbrella fund.
Risk mitigation
All uncleared OTC derivatives trades are subject to risk mitigation techniques – timely confirmation, portfolio reconciliation and compression, dispute resolution, daily mark-to-market and margin requirements – which came into effect on September 15, 2013, other than the timely confirmation requirements that came into effect on March 15, 2013 and the margin requirements, which are explained further below.
All uncleared trades must be confirmed, where available, by electronic means as soon as possible and, at the latest, by specific deadlines determined by the status of the counterparties entering into the trades. FCs should also have procedures in place to report on a monthly basis to their competent authority the number of unconfirmed OTC derivatives transactions that have been outstanding for more than five business days.
Margin requirements
Funds may need to comply with requirements to post highly liquid assets or cash margin against uncleared trades.
The rules for these provisions are not yet established, although the joint committee of the European Supervisory Authorities published draft regulatory standards on April 14, 2014, that follow the recommendations of the final report of the joint working group of the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.
They include the proposal that initial margin requirements should be phased in over a four-year period from 2015, starting with the largest derivatives market participants. At the end of the phase-in period in 2019, the initial margin requirements would apply to uncleared derivatives transactions where at least one counterparty belongs to a group whose aggregate month-end notional amount of uncleared derivatives is more than €8 billion.
The standards also state that EU entities would have to collect margin from all TCEs, unless they were explicitly exempt from Emir or under the €8 billion threshold, even if they would be NFCs below the clearing threshold if they were established in the EU. There will be a threshold of €50 million that should generally be counted per single fund in respect of investment funds.
Counterparties will also need to exchange variation margin on a daily basis. Eligible collateral broadly includes cash, allocated gold, debt securities issued by government entities, multilateral development banks, credit institutions or investment firms, corporate bonds, the most senior tranche of a securitisation provided it is not a re-securitisation, convertible bonds and equities.
The margin requirements will be particularly onerous for entities such as real estate funds, which have traditionally secured the derivatives they enter into against their property portfolio.
What about TCEs?
There are certain circumstances where TCEs might also need to consider Emir.
Broadly, a TCE:
- may be subject to the clearing obligation where its EU counterparty is an FC or NFC+. However, this obligation would only apply to funds that would be classified as an FC or NFC+ if they were established in the EU;
- may be subject to the clearing obligation where it contracts with another TCE, where both entities would be hypothetical FCs/NFC+s and the contract has a direct, substantial and foreseeable effect within the EU or such obligation is necessary to prevent the evasion of any provision of Emir; and
- may need to comply with the risk mitigation techniques for uncleared trades if it contracts with another TCE where both entities would be hypothetical FC/NFC+s and the contract has a direct, substantial and foreseeable effect within the EU or such obligation is necessary to prevent the evasion of any provision of Emir.
Even if a third-country AIF is not subject to Emir requirements directly, it is likely to have to put in place procedures to facilitate its EU counterparties’ Emir compliance. For example, its EU counterparties may require a representation as to their FC/NFC+/NFC or hypothetical FC/NFC status, and they may need to identify such funds in their trade reports and may require the fund to provide certain information such as a legal entity identifier.
What should funds be doing now?
It is expected that in many cases the fund will delegate its Emir obligations to its AIFM, which in turn may appoint other service providers, for example to manage collateral. It is essential that the relevant Emir obligations are set out in any agreement for the appointment of the AIFM, service provider agreement and/or delegation agreement, so it is clear which entity is performing the required tasks under Emir. It should, therefore, be examined whether the AIF has its own master agreements and clearing documentation. Also, in order to determine whether an NFC is above or below the clearing threshold, it will be necessary that the derivatives activity of the AIF’s group is monitored and communicated to the relevant service providers.
If funds are entering into new trades with an existing counterparty, the parties can enter into a bilateral agreement that would amend the existing derivatives documentation between the parties to ensure compliance with the relevant requirements under Emir. Counterparties currently negotiating derivatives documents are likely to include the relevant provisions into the documentation directly. The International Swaps and Derivatives Association (Isda) has proposed language to address many of the issues under Emir and, although some firms have taken different approaches, most documentation is based on the Isda model language.
The implementation regulations under Emir are not yet fully finalised and are evolving constantly. Investment funds and their advisers will need to ensure that all of their derivatives activity complies with the regimes as implemented over the next few years and should also note related requirements for the Market in Financial Instruments Directive and the Dodd-Frank Act in the US.
Isobel Wright and Nora Bullock are lawyers at Hogan Lovells.
