10.1 Definition and Scope

The European Market Infrastructure Regulation (EMIR) deals with issues related to derivatives contracts, notably (Art 1):

• clearing and bilateral risk management requirements for OTC derivatives
• reporting requirements for derivatives contracts generally
• rules on central counterparties and trade information repositories

Derivatives in this context are financial contracts like swaps, options, and futures. OTC stands for ‘over the counter’, meaning a derivative contract that is negotiated directly between two counterparties (dealer/customer or dealer/dealer) and not on a derivatives exchange. Trade repositories are institutions that gather and make available information about all derivatives transactions in the market, both OTC and exchange‐traded.

ESMA is required to publish a number of items related to this regulation on their website, including contracts eligible for clearing obligations, and authorised CCPs and repositories (Art 88).

10.2 Central Counterparties

Central counterparties (CCPs) are the equivalent of securities‐markets clearing houses, but for derivatives contracts—they get inserted in the contract between the two counterparties in a process called novation. Once this is done, the legal counterparty for both sides is the CCP, so they no longer have a default risk against their original trading counterparty. They of course now have default risk against the CCP, but this is being dealt with by margining, which makes the CCP a highly secure entity.

Margining means that CCPs require all derivatives trades to be over‐collateralised on both sides of the transaction, meaning that every counterparty is owed money by the CCP at all times in net‐present value terms. To give an example, if the transaction is such that in net present value terms A owes $5m to B, then the clearing house would, say, demand $6m in collateral from A and $1m from B so that not only the current liability is protected, but there is some protection against market moves. If markets move, then the clearing house will demand additional collateral from one of the counterparties, and return the same amount to the other side. If a counterparty does not post sufficient collateral after a move, the clearing house closes out the contract, and goes out to the market to replaces it. The other side is not impacted by that—once a contract has been novated, any relationship to the original counterparty is broken.

The entire process of novation is also often referred to as clearing, so a clearing obligation for certain transactions means that they have to be novated with a clearing house. In other words, if there is a clearing obligation for a certain derivatives transaction then counterparties are not allowed to keep facing each other during the life of the contract; they both must face a clearing house instead.

EMIR establishes a clearing obligation for a large number of transactions (Art 4). This obligation depends on (a) that particular class of derivative being cleared on a recognised clearing house—not all possible contracts are—and designated by ESMA as being subject to clearing obligation (Art 5), and (b) the type counterparties facing each other. The rules are slightly complex, but essentially the only exemptions to clearing obligation are

• intra‐group transactions, which includes transactions between some loosely associated companies, eg the savings bank associations in Germany (Art 3.3)
• transactions involving one or two private counterparties, neither of which exceeds a certain clearing threshold in terms of the amount of business they do, ie light users of derivatives (Arts 4, 10).

ESMA keeps a public register of all classes of derivatives subject to clearing (Art 6). A CCP that is clearing certain contracts must clear them on a non‐discriminatory basis regardless of where they have been traded (Art 7). Vice versa, all trading venues must provide CCPs with the relevant data they need to perform their clearing operation (eg price feeds) on a non‐discriminatory basis (Art 8). All trades must report to trade repositories, and it is the responsibility of both the counterparties and the CCP to do so (Art 9).

Where contracts are not cleared via a CCP—either because of the counterparties involved, or because of the underlying instrument—there must be certain risk mitigation techniques in place. At the very minimum, there must be a timely confirmation of all trades, and formalised processes dealing with reconciliation and possible disputes in this respect. If a financial counterparty is involved, it must provide a daily mark‐to‐market, or mark‐to‐model if no market prices are available. Financial counterparties must have procedures for collateral exchange in place as if the contract was cleared in a clearing house, but non‐financial counterparties must only engage in collateral exchange if they exceed the aforementioned clearing threshold. Also, many intra‐group transactions (as defined above) are exempt (Art 11).

CCPs that are legally resident in a Member State mostly apply for authorisation to their home regulator, ie the regulator in the country where they are incorporated, who then organises a college of all supervisors concerned to review the application (Arts 12, 18). Third‐country CCPs can also operate in the Single Market under certain conditions, provided they are authorised by ESMA (Art 25). Prior to this being possible, the Commission must have established that the third country in question has a regulatory framework that is equivalent. Equivalence can—and must, under certain circumstances—be withdrawn with 30 days' notice (Art 13). Once a CCP is authorised, it is authorised across the entire Single Market. Whether it is EU‐resident or from an equivalent third country does not make a difference here (Art 12).

CCPs are subject to minimum capital requirements, with the absolute minimum being €7.5m (Art 16). They must have a robust governance structure in place, and shall be subject to frequent independent audits (Art 26). This structure must include effective conflict‐of‐interest procedures (Art 33), business continuity plans (Art 34) and risk management procedures (Art 49). There are certain requirements that senior management, the board members, and shareholders with significant influence must fulfil (Arts 27, 30). There is a requirement to establish a risk committee (Art 28), and for adequate record‐keeping (Art 29). Regulators must be updated of any significant changes, and acquisitions especially must be pre‐cleared (Arts 31, 32). CCPs can outsource some of their tasks to third parties, but the CCP itself remains responsible for ensuring that all rules and regulations are followed (Art 35).

CCPs must admit clearing members on a non‐discriminatory basis. They must verify on an ongoing basis that clearing members do not pose a risk to its financial stability, and they must reject—or terminate as the case may be—clearing members if they don't meet the requirements (Art 37).

A CCP must be transparent about the services it provides, and about the associated prices and fees (Art 38).

There are some rules about segregation of assets and adequate record keeping as to asset ownership. In particular, clearing members are obliged to offer their clients individual asset segregation, and this segregation must also be respected by the CCP (Art 39).

CCPs must measure exposure and credit to its members—and other CCPs where applicable—on a near real‐time basis (Art 40). CCPs shall hold margin covering at least 99% of the possible moves over a time period commensurate to the time it takes them to obtain additional margin. They must be able to execute intra‐day margin calls (Art 41). They must also maintain a pre‐funded CCP default fund that socialises losses due to insufficient margin to all clearing members. The default fund must at least be able to cover the losses if the largest clearing member defaults (Art 42). A CCP must also have sufficient pre‐funded financial resources to cover losses that exceed those mitigated by margins and the default fund (Art 43), and it must have adequate liquidity arrangements (Art 44). There are certain requirements as to what CCPs can accept as collateral and where they can invest their funds. For non‐financial counterparties, bank guarantees can be an acceptable collateral (Arts 45, 46).

CCPs may enter into interoperability agreements with other CCPs provided certain conditions are met. This allows, for example, counterparties to a derivatives trade to each deal with the CCP of their choice, instead of having to agree on a common CCP (Arts 51–54).

10.3 Trade Repositories

Trade repositories that are legally resident in a Member State must register with ESMA (not their local regulator). After successful registration, they gain the right to operate across the Single Market (Arts 55–61). Registered trade repositories are subject to ongoing ESMA supervision, including examination of records and on‐site visits (Arts 62, 63). ESMA can delegate some supervisory responsibilities to local regulators (Art 74). It can impose fines and penalties (Arts 64–69). It can also issue public notices, and withdraw registration (Art 73).

Trade repositories from countries recognised as equivalent by the Commision can apply for recognition with ESMA and can—once they have been recognised—act like repositories resident in the EU (Arts 75–77).

Trade repositories must have robust governance structures in place. They must grant access to their services in a non‐discriminatory manner and must be transparent about services offered and fees. If a repository offers ancillary services, they must be operationally separate from the reporting business (Art 78). They must be operationally reliable, and must have a business continuity and a disaster recovery plan in place (Art 79). They also must have robust data protection policies in place, and can only use the data they have received for commercial purposes if the relevant counterparties have consented (Art 80).

A trade repository shall regularly, and in an easily accessible way, publish aggregate positions by class of derivatives on the contracts reported to it. It also must make their data available to a number of relevant authorities including ESMA, ESRB and the regulators overseeing trading venues and CCPs (Art 81).