The European Market Infrastructure Regulation (‘EMIR’) No 648/2012, as amended, has entered into force in August 2012 with the objective of increasing the transparency of the derivatives market and reducing the systemic as well as counterparty and operational risk in the derivatives market. EMIR applies to undertakings established in the EU who enter into financial derivative contracts, including Funds and their Managers.
Pursuant to EMIR, a counterparty that enters into derivative transactions should ensure that (i) derivative contracts are reported to a Trade Repository (‘TR’), (ii) Over-The-Counter (‘OTC’) derivatives subject to the clearing obligation are cleared with a Central Counterparty (‘CCP’) and (iii) in respect of OTC derivative contracts not cleared by a CCP it applies appropriate risk mitigation measures.
The extent to which the above requirements apply to Funds depends on how Funds are classified under EMIR.
How are Funds in Cyprus classified under EMIR?
In broad terms, all Funds established in Cyprus are categorised as Financial Counterparties (‘FCs’) and are therefore subject to the full range of obligations imposed by EMIR.
AIFs and AIFLNPs whose manager is not authorised or registered in accordance to Directive 2011/61/EU (‘AIFMD’) are classified as Non-Financial Counterparties (‘NFC’) and are subject to fewer obligations compared to FCs.
However, a Cyprus/EU AIF which is managed by an authorised non-EU AIFM (subject to extension of the passport) should be classified as an FC whereas if marketed in Cyprus/EU without a passport by a non-EU AIFM it should be classified as an NFC, as it would be an undertaking established in the EU not managed by authorised or registered AIFM.
1) Reporting to a trade repository
Due to the fact that Funds are generally the counterparties to a derivative transaction, they are expected to report the details of the derivative contract to a TR authorised by the European Securities and Markets Authority (‘ESMA’). This information should be reported no later than the next working day following the conclusion, modification or termination of the contract. In this respect, each Fund is expected to obtain a Legal Entity Identifier (LEI) in order to fulfil its reporting obligations. In practice, the Fund Manager will usually report the transaction(s) to a TR on behalf of the Funds it manages (without prejudice to the Fund’s liability to meet its reporting obligations); in this case, the counterparty ID (i.e. LEI) should be the ID of the Fund whilst the ID of the Manager will be provided as the report-submitting entity.
It is noted that the EMIR reporting obligation applies equally to both FCs and NFCs in regards to exchange-traded and OTC derivative transactions whether cleared or not.
2) Clearing obligation
As of January 2018, the derivatives which have been declared by ESMA as being subject to the clearing obligation are certain categories of swaps (e.g. on LIBOR), forward rate agreements (e.g. on EONIA, FedFunds, SONIA etc.) and credit default swaps. ESMA may include additional classes of financial instruments as subject to the clearing obligation in the future. Counterparties to OTC derivative contracts are obliged to clear those contracts through a CCP authorised by an EEA regulator or recognised by ESMA.
This abovementioned clearing obligation applies to OTC contracts concluded between:
- Two FCs;
- One FC and one NFC that exceeds the pre-defined clearing thresholds (hereinafter referred to as “NFC+”);
- Two NFCs+;
- One FC/NFC+ and a third country entity that would be subject to the clearing obligation if it was established in the EU; or
- Two third country entities that would be subject to the clearing obligation if they were established in the EU but only in case the contract has ‘a direct, substantial and foreseeable effect within the Union’ or where it is ‘necessary or appropriate to prevent the evasion’ of EMIR.
3) Risk Mitigation Techniques
FCs and NFCs that enter into an OTC derivative contract not cleared by a CCP need to have appropriate procedures to mitigate operational and counterparty credit risk, including:
- the timely confirmation of the terms of the relevant OTC derivative contract;
- procedures to reconcile portfolios;
- processes to identify and resolve disputes between parties and monitor the value of outstanding contracts.
FCs and NFCs+ shall mark-to-market on a daily basis the value of outstanding contracts, have risk-management procedures that require the segregated exchange of collateral with respect to OTC derivative contracts whilst FCs shall also hold adequate capital to manage the risk not covered by exchange of collateral.
The European Commission has published a proposal for amending EMIR which is likely to affect the status and obligations of certain Funds that trade derivatives. Among others, the proposal broadens the definition of an FC to include all AIFs established in the Union, rather than the existing definition which covers only AIFs managed by AIFMs authorised or registered in accordance with AIFMD. As a result, some Funds will move from NFC to FC status having, in this way, additional obligations under EMIR.