OTC derivatives reform: European Market Infrastructure Regulation (EMIR) InCube Advisory Birkenstrasse 12

New challenges for financial and non-financial institutions

CH-6003 Lucerne Switzerland [email protected] www.incubeadvisory.com

June 2013

Contents 1

Executive summary

3

2

Introduction

4

3

Reporting obligation

14

4

Clearing obligation

18

5

Risk mitigation for uncleared trades

27

6

Extraterritorial application

37

7

Exemptions from EMIR

38

8

Situation in Switzerland

40

9

Implementation timetable

41

10

Glossary

42

11

Your contacts

44

2

Executive summary  The European Market Infrastructure Regulation (EMIR) came into force on 16 August 2012.  The majority of the detailed legislation entered into force on 15 March 2013.  EMIR applies to any entity established in the EU that is a legal counterparty to a derivative contract.  It also applies to EU firms even when trading with non-EU firms. In some circumstances, EMIR has extraterritorial effect.  Key requirements: − Reporting of OTC and exchange trade derivatives to trade repositories − Central clearing of certain eligible classes of OTC derivatives − Application of risk-mitigation techniques for non-centrally cleared OTC derivatives  Although the first clearing obligation may not apply until the summer/fall of 2014, some requirements will already apply in 2013: − In March 2013, some risk mitigation requirements already applied: daily valuation and timely confirmation (subject to phase-in). − Further risk mitigation obligations are likely to apply on 23 September 2013. − It currently appears that the first reporting obligations (IRS and CDS only) will also not take effect before 15 September 2013. − Clearing obligations are likely to start not before summer/fall 2014 and may be subject to phase-in.

3

Introduction Background and objectives  The financial crisis has brought to light some weaknesses in OTC derivatives markets, such as their intransparency or inherent counterparty risks.  In reaction to the financial crisis, there has been an international effort to increase stability in financial markets, including OTC derivatives markets. In 2009, G20 Leaders agreed the following:

 These changes are set to improve the efficiency and transparency of OTC derivatives markets with a view to reducing counterparty and operational risk involved in these markets as well as overall systemic risk.  The EU intends to deliver the G20 commitments with the introduction of the European Market Infrastructure Regulation (EMIR).

4

Introduction Implementation status  EMIR was adopted on 4 July 2012 and published in the Official Journal (OJ) on 27 July 2012. It came into force on 16 August 2012.  Following a public consultation, the European Securities and Markets Authority (ESMA) published the EMIR Level 2 draft technical standards on 27 September 2012 necessary to implement the regulation. These standards specify the detail of obligations.  On 19 December 2012, the European Commission adopted these Regulatory Technical Standards (RTS) and Implementing Technical Standards (ITS) proposed by the ESMA without modifications.  The RTS were published in the OJ on 23 February 2013. The RTS came into force 20 days after the date of publication  Consequence: Some of the EMIR obligations already applied on 15 March 2013, but in some cases obligations are deferred or subject to compliance schedules.  As with any other EU regulation, the EMIR provisions will be directly applicable, i.e. legally binding in all EU Member States without implementation into national law, from the day of entry into force.  Under EMIR, there are still technical standards that have to be finalized: − Legislation related to margin and capital for non-centrally cleared trades (responsibility: joint ESAs) − Legislation specifying the contracts between third country counterparties that have a direct, substantial and foreseeable effect within the EU and the cases where it is necessary or appropriate to prevent the evasion of the provisions of EMIR (responsibility: ESMA) In these respects, further international coordination is necessary before EU rules can be developed.

5

Introduction Legislative framework

Level 1

Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (known as “EMIR”)

Level 2

Regulatory Technical Standards (RTS)

Implementing Technical Standards (ITS)

1. RTS on capital requirements for central counterparties (CCPs)

1. ITS on requirements for CCPs

2. RTS on requirements for CCPs 3. RTS on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, risk mitigation techniques for OTC derivatives contracts not cleared by a CCP

2. ITS on the minimum details of the data to be reported to TRs 3. ITS specifying the details of the application for registration as a TR

4. RTS on the minimum details of the data to be reported to trade repositories (TRs) 5. RTS specifying the details of the application for registration as a TR 6. RTS specifying the data to be published and made available by trade repositories and operational standards for aggregating, comparing and accessing the data

6

Introduction Overview of requirements

1

Reporting obligation for OTC derivatives

2

Clearing obligation for eligible OTC derivatives

3

Risk mitigation rules for uncleared OTC derivative trades

4

Requirements for trade repositories (TRs)

5

Requirements for central counterparties (CCPs)

6

Rules on the establishment of interoperability between CCPs

Relevant for financial and for non-financial institutions

7

Introduction Counterparties in scope (1/4)  EMIR applies to any entity established in the EU that is a legal counterparty to a derivative contract, including interest rate, foreign exchange, equity, credit and commodity derivatives.  It applies to EU firms even when trading with non-EU firms and has extraterritorial effect in some circumstances.  EMIR identifies two main categories of counterparties to a derivatives contract:

Financial Counterparties (FCs)

Non-Financial Counterparties (NFCs)

The following institutions authorized or registered in accordance with the relevant EU directive:

Any undertaking established in the EU which is not an FC or a central counterparty (CCP), including entities not involved in financial services.

 Investment firms  Credit institutions

However, EMIR will not apply to EU central banks, certain EU public bodies and the Bank for International Settlements.

 Insurance/reinsurance undertakings  UCITS  Pension schemes  Alternative investment funds managed by an alternative investment manager

8

Introduction Counterparties in scope (2/4)  The provisions in EMIR apply differently to Qualifying NFCs than to NFCs.  A Qualifying NFC is a NFC whose rolling average positions in OTC derivative contracts over 30 working days exceed one of the clearing thresholds.  The thresholds differ according to the type of derivative contract and are determined by taking into account the systemic relevance of the sum of the net positions and exposures per counterparty and per class of OTC derivative.  Size of the thresholds: Type of contracts

Threshold size in billion EUR gross notional

OTC credit derivatives

EUR 1 billion

OTC equity derivatives

EUR 1 billion

OTC interest rate derivatives

EUR 3 billion

OTC foreign exchange derivatives

EUR 3 billion

OTC commodity derivatives and other OTC derivatives (combined)

EUR 3 billion

 The calculation of positions must include all OTC derivative contracts entered into by the NFC itself or other NFCs within its group “which are not objectively measurable as reducing risks directly related to the commercial activity or treasury financing activity” of the counterparty or of its group.

9

Introduction Counterparties in scope (3/4)  This means that not all OTC transactions count towards the clearing thresholds: Hedging transactions that meet one of the following criteria do not count towards the clearing thresholds: − OTC derivative contract reduces the risk of a potential change in value of an item directly related to the business; − OTC derivative contract reduces the potential indirect impact of the fluctuation of interest rates, inflation rates, foreign exchange rates or credit risk; or − OTC derivative contract qualifies as a “hedging contract” under the International Financial Reporting Standards (IFRS). This hedging definition under EMIR also includes contracts relating to portfolio hedging, stock options and acquisition risks.  However, intragroup transactions that do not fall within the hedging definition will be counted for the purpose of the clearing threshold.  The clearing thresholds will be reviewed on a regular basis following public consultation.

10

Introduction Counterparties in scope (4/4)  It is the responsibility of the NFC to determine whether or not its positions exceed the clearing threshold and to immediately notify the ESMA and the relevant national regulator if this is the case.  In general, Qualifying NFCs are treated in the same way as FCs.  General overview of the provisions applicable to the different types of counterparty:

Requirement

FCs

Qualifying NFCs

Other NFCs

Reporting obligation

Yes

Yes

Yes

Clearing obligation

Yes

Yes

No

Risk-mitigation rules

Yes

Yes, except for the rules related to increased capital requirements and to the reporting of unconfirmed trades

Yes, but only certain riskmitigation rules will be applicable:  Timely confirmation  Portfolio reconciliation  Portfolio compression  Dispute resolution

11

Introduction Derivative instruments in scope (1/2) EMIR applies to all types of derivative contracts as defined in points (4) to (10) of Section C of Annex I to Directive 2004/39/EC (MiFID): C (4)

Options, futures, swaps, forward rate agreements and any other derivative contracts relating to securities, currencies, interest rates or yields, or other derivatives instruments, financial indices or financial measures which may be settled physically or in cash

C (5)

Options, futures, swaps, forward rate agreements and any other derivative contracts relating to commodities that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event)

C (6)

Options, futures, swaps, and any other derivative contract relating to commodities that can be physically settled provided that they are traded on a regulated market and/or an MTF

C (7)

Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in C.6 and not being for commercial purposes, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are cleared and settled through recognized clearing houses or are subject to regular margin calls

C (8)

Derivative instruments for the transfer of credit risk

C (9)

Financial contracts for differences

C (10)

Options, futures, swaps, forward rate agreements and any other derivative contracts relating to climatic variables, freight rates, emission allowances or inflation rates or other official economic statistics that must be settled in cash or may be settled in cash at the option of one of the parties (otherwise than by reason of a default or other termination event), as well as any other derivative contracts relating to assets, rights, obligations, indices and measures not otherwise mentioned in this Section, which have the characteristics of other derivative financial instruments, having regard to whether, inter alia, they are traded on a regulated market or an MTF, are cleared and settled through recognized clearing houses or are subject to regular margin calls

12

Introduction Derivative instruments in scope (2/2)  FX forwards are treated as derivatives under EMIR whereas under the US derivatives regulation (Dodd-Frank Act Title VII) they are not.  The following transactions are excluded from EMIR (examples): − FX spot transactions − Energy spot transactions − Certain types of physically settled commodity transactions

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Reporting obligation Introduction  The reporting obligation applies to all derivative contracts: − Cleared and uncleared derivative contracts − Exchange traded and OTC derivative contracts  All counterparties have the reporting obligation, i.e. no activity threshold applies.  All counterparties and CCPs must ensure that the details of any derivative contract they have concluded (and any modification or termination of that contract) is reported to a registered – or recognized if in a third country – trade repository (TR), or where no relevant trade repository is in place, to the European Securities and Markets Authority (ESMA).  What is a TR? − A TR is a database to provide transparency. − They are currently organized per asset class. − Examples: − For multiple asset classes: Depository Trust & Clearing Corp (DTCC), Regis-TR − For some commodity and energy contracts: ICE Trade Vault − Some CCPs may also offer TR services in the future. − EMIR provides for the registration of EU TRs and the recognition of non-EU TRs for reporting purposes. − Authorized and recognized TRs as well as the type of contracts they accept will be available on the website of ESMA. − Currently, TRs are not yet registered by ESMA. 14

Reporting obligation What must be reported?  The following information has to be reported under EMIR: − Parties to the contract, including broker, reporting entity, beneficiary (if different) − Trading capacity, clearing threshold, transaction type (hedge/non-hedge) − Information on valuation and collateral − Main details of the contract: Type of contract, underlying, maturity, notional value, price, settlement date − Information on confirmation and clearing − Asset class specific information: interest rates, currencies, commodities − Information on options: type, style, strike price − Action type (new, modify, error, cancel, compression, valuation update, other)  Overall, reporting includes nearly 70 data fields for each derivative transaction  EMIR provides that a counterparty or CCP that reports the details of a derivative contract (or any entity that reports on behalf of a counterparty or CCP) to a TR in the EU (or a TR in a third country that has been recognized by EU authorities) shall not be considered to be in breach of any restriction on disclosure of information imposed by that contract or by any legislative, regulatory or administrative provision (e.g. restrictions relating to privacy, etc.).  All intra-group derivatives – including those between an EU company and a group company outside the EU – will also need to be reported; therefore, counterparties will need to ensure that they are already capturing sufficient data fields on intra-group transactions (and have done since 16 August 2012) so as to be able to fulfill the reporting once the TRs eventually go live.

15

Reporting obligation Responsibility and timing Responsibility  Once the reporting obligation has come into effect, both counterparties must report the details of every derivative contract they have concluded, modified or terminated.  It is possible to delegate the reporting obligation or to make one report on behalf of both counterparties but each counterparty remains legally responsible for the report. It remains responsible for ensuring that contracts are reported without duplication.  This means that by prior arrangement, one party can report on behalf of both counterparties.

Timing  Reporting has to be done within one working day of the conclusion, modification or termination of the contract.

16

Reporting obligation Implementation timeline  Credit and interest rate derivatives: − Start of reporting obligations depends on TR registration and authorization/recognition. − It is currently planned that reporting obligations will start on 23 September 2013 (however, it is still open if this deadline can be met)  For all other derivatives: − If a TR is registered for a particular derivative class by 1 October 2013: reporting begins on 1 January 2014 − If no registered TRs by 1 October 2013: 90 days after registration of TR − If no TR for derivative class registered by 1 July 2015: 1 July 2015 (reports made to ESMA)  Backloading existing trades: − If derivative contracts outstanding on 16 August 2012 and still outstanding on the reporting start date: must be reported within 90 days of reporting start date − The reporting obligation to derivative contracts applies if (a) contracts were entered into before 16 August 2012 and remain outstanding on that date; and (b) are entered into on or after 16 August 2012  Note: The reporting start date will be deferred by 180 days for certain information on collateral.

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Clearing obligation Introduction (1/2)  OTC derivatives contracts that the ESMA has determined subject to a mandatory clearing obligation must be cleared by a central counterparty (CCP).  A CCP stands between the two original counterparties to a contract and guarantees the performance of obligations, i.e. removing counterparty risk.  The clearing obligation applies to contracts entered into between: A) two Financial Counterparties (FCs); B) a FC and a Qualifying Non-Financial Counterparty (Qualifying NFC); or C) two Qualifying NFCs; or D) a FC or a Qualifying NFC and a third country entity that would be subject to the clearing obligation if it was established in the EU. E) two non-EU entities that would be subject to the clearing obligation if the two entities were established in the EU, but only if the contract “has a direct, substantial and foreseeable effect within the EU” or if it is considered necessary “to prevent evasion” of EMIR (criteria to be determined by ESMA).

18

Clearing obligation Introduction (2/2)  Qualifying NFCs: − The clearing obligation applies to all OTC derivative contracts once the rolling average position over 30 working days exceeds one of the thresholds, i.e. breaching one threshold mandates to clear in all asset classes. − Qualifying NFCs must clear all relevant future contracts within four months of becoming subject to the clearing obligation. − If the rolling average position does no longer exceed the clearing thresholds, the NFC is no longer subject to the clearing obligation. − See “Introduction” for the definition of FCs and Qualifying NFCs

19

Clearing obligation Derivatives subject to mandatory clearing (1/3)  EMIR requires mandatory clearing of OTC derivatives for all classes of derivatives declared “subject to the clearing obligation” by ESMA.  Asset classes subject to clearing will be determined through both a “bottom-up” and “top-down” approach:

Bottom-up approach

Top-down approach

 National regulator authorizes a central counterparty (CCP).

ESMA may decide (after consultation) that a class of derivatives is mandatory for clearing (even if no CCP has been authorized to clear it).

 The national regulator notifies ESMA that a CCP is allowed to clear a class of derivatives.  ESMA to decide within 6 months whether the class of derivatives should be subject to mandatory clearing requirement.

20

Clearing obligation Derivatives subject to mandatory clearing (2/3)  The criteria for mandatory clearing include: − Degree of standardization − Volume − Liquidity − Availability of fair, reliable and generally accepted prices − Interconnectedness between counterparties − Impact on competition in the EU  There are no explicit exemptions for any asset class.  ESMA will maintain an on-line public register of the contracts subject to the clearing obligation. It will include: − Dates from which the clearing obligation will take effect − Information on notifications to clear (before ESMA’s assessment) so that the market is kept informed of any possible clearing obligations − Details on authorized/recognized CCPs − Information on any phase-in arrangements by categories of counterparties

21

Clearing obligation Derivatives subject to mandatory clearing (3/3)  Which products will be subject to the clearing obligation will develop over time as new products become available for clearing and are approved by ESMA.  Markets expect that plain vanilla derivatives, such as many interest rate swaps and certain swaps on certain CDS indices, will be the first products subject to the clearing obligation.  The number of products subject to the clearing obligation will expand over time, driven primarily by the range of products for which clearing houses seek to develop clearing services.

22

Clearing obligation Process for the introduction (1/3)  Before the clearing obligation procedure can begin, central counterparties (CCPs) must be authorized (or recognized in case of a CCP from a third country).  This is necessary to ensure that the CCPs used to comply with the clearing obligation are safe and sound.

Authorization of CCPs

 Existing CCPs have 6 months after RTS come into force to apply to national competent authorities for authorization under EMIR. Step 1

 Within 30 working days of receipt, competent authority assesses whether application is complete and may require more information.  Competent authorities have up to 6 months from receiving a complete application to grant or refuse authorization.  There is significant uncertainty as to when the first CCPs will submit their formal applications and receive authorization under EMIR. Different CCPs may be authorized for different products on different dates.

…

23

Clearing obligation Process for the introduction (2/3)

Start of clearing obligation  After authorization/recognition of a CCP to clear OTC derivatives, ESMA consults on whether to impose mandatory clearing and, if so, drafts regulatory technical standards (RTS) for the European Commission endorsement.  ESMA takes into account criteria, such as the degree of standardization of the relevant class of OTC derivatives, liquidity and the availability of reliable pricing determining which classes of OTC derivatives are to be cleared. Step 2

 The European Commission has 3 months to endorse the RTS.  The European Council/European Parliament can object within 1 month of adoption, extendible by a further month (or 3+3 months if the European Commission amends ESMA’s draft).  The RTS must be published in the Official Journal (OJ) and will specify start date and any phase-in period.  Therefore, there will be a gap of 6 to 8 months between authorization of a CCP to clear OTC derivatives and the start of the clearing obligation.  In a speech on 4 December 2012 the Executive Director of ESMA indicated that ESMA projects that the first clearing obligation should start to apply “during the summer of 2014”.

24

Clearing obligation Process for the introduction (3/3)  However, in order to expedite the assessment of products for the clearing obligation, national authorities must notify ESMA of any existing clearing services for OTC derivatives in their jurisdictions within one month of entry into force of the technical standards defining the relevant details to be included in the notification, in accordance with EMIR (Article 89(5)). In this context, ESMA will be in a position to start its assessment of products within the first quarter of 2013 and the first clearing obligation could enter into force very soon after the first authorizations/recognitions of CCPs under EMIR.  ESMA can also identify contracts for clearing even if no CCP currently clears the contract.  ESMA can call for clearing proposals but cannot compel CCPs to clear the contracts.  ESMA will maintain a public register of the contracts subject to the clearing obligation including the date when the clearing obligation will take effect and any phase-in by categories of counterparties.

25

Clearing obligation Effective date / frontloading Effective date  The clearing obligation will apply to contracts entered into or novated on or after the date from which the clearing obligation takes effect, or (if the contract has a remaining maturity higher than a threshold to be specified), on or after a CCP is authorized to clear those contracts but before the clearing obligation takes effect.

Frontloading  OTC derivatives entered into after a CCP is authorized may later become subject to mandatory clearing  Applies to all FCs, Qualifying NFCs (i.e. NFCs above the clearing thresholds) and Third Country Entities (TCEs)

26

Risk mitigation for uncleared trades Introduction Requirements to put in place arrangements to measure, monitor and mitigate operational and credit risk, in particular: Requirements

Counterparties in scope

Derivatives in scope

Introduction timelines

Timely confirmation

Confirm transactions by set deadlines

Phasing-in depending on counterparty and derivative type

Portfolio reconciliation

Agree processes for regular portfolio reconciliation with counterparties

6 months after relevant RTS come into force (September 2013)

Portfolio compression

Introduce processes to address portfolio compression opportunities

Dispute resolution

Agree procedures for the identification, recording, monitoring and resolution of disputes on derivatives

Daily valuation

Carry out daily mark-to-market or, where market conditions prevent this, mark-to-model

Initial and variation margin

Introduce procedures for the timely, accurate and appropriately segregated exchange of collateral

All counterparties (FCs and NFCS)

6 months after relevant RTS come into force (September 2013) All uncleared OTC derivatives trades

6 months after relevant RTS come into force (September 2013)

At the time of entry into force of the relevant RTS (March 2013) FCs and Qualifying NFCs

International coordination ongoing, RTS still pending, entry into force currently appears unlikely before H2 2014

27

Risk mitigation for uncleared trades Timely confirmation (1/2)  EMIR requires that OTC derivative contracts not centrally cleared have to be confirmed: − “where available via electronic means” − “as soon as possible”, at the latest by the deadlines stated below  FCs and Qualifying NFCs (i.e. NFCs above clearing threshold): Derivative type

Phasing until 31 August 2013

Phasing until 28 February 2014

Phasing until 31 August 2014

Final confirmation deadline

Credit and interest rate

T+2

T+2

T+1

T+1

All others

T+3

T+2

T+2

T+1

 Other NFCs (i.e. NFCs below clearing thresholds): Derivative type

Phasing until 31 August 2013

Phasing until 28 February 2014

Phasing until 31 August 2014

Final confirmation deadline

Credit and interest rate

T+5

T+3

T+3

T+2

All others

T+7

T+4

T+4

T+2

 Confirmation is allowed on an additional business day (however, as soon as possible) if execution occurs after 16.00 local time or if trade is done with a counterparty in a different time zone which does not allow confirmation by the set deadline. Key: T+1: by the end of the next business day following the date of execution of the OTC derivative contract; T+2: by the end of the second business day following the date of execution of the OTC derivative contract; etc. 28

Risk mitigation for uncleared trades Timely confirmation (2/2)  In addition, FCs must have in place the procedures to report to their relevant national regulator on a monthly basis the number of unconfirmed trades that have been outstanding for more than five business days.  The timely confirmation requirements must be applied since 15 March 2013 (entry into force of the relevant RTS).

29

Risk mitigation for uncleared trades Portfolio reconciliation  FCs and NFCs must agree processes for regular portfolio reconciliation with counterparties.  The frequency of portfolio reconciliation depends on the number of outstanding contracts which are not centrally cleared and whether the counterparty is a FC, a Qualifying NFC (i.e. NFC above the clearing threshold) or a NFC below the clearing threshold.  FCs and Qualifying NFCs: Number of outstanding OTC derivatives contracts

Frequency of portfolio reconciliation

≥ 500

Each business day

51-499

Once per week

≤ 50

Once per quarter

 Other NFCs: Number of outstanding OTC derivatives contracts

Frequency of portfolio reconciliation

> 100

Once per quarter

≤ 100

Once per year

 The portfolio reconciliation requirements apply from 6 months after the RTS come into force. They are therefore likely to apply in September 2013.

30

Risk mitigation for uncleared trades Portfolio compression  All counterparties with 500 or more OTC derivative contracts outstanding with a counterparty which are not centrally cleared must have in place procedures so that they can determine regularly (at least twice a year) whether to conduct a portfolio compression exercise in order to reduce their counterparty credit risk.  They must also be able to justify to their national regulator why they have not carried out a portfolio compression exercise.  What is portfolio compression? − Portfolio compression is a risk-mitigation technique to reduce the overall gross notional size and number of outstanding contracts in derivative portfolios without changing the overall risk profile or present value of the portfolios. − Portfolio compression is achieved by terminating existing trades and replacing them with a smaller number of new replacement trades that carry the same risk profile and cash flows as the initial portfolio. − Potential benefits from portfolio compression: − Lower capital charges: By reducing the amount of gross notional in the market, each participant has lower capital charges, a function of the amount gross notional exposure a given participant has in inventory. − Trade count reduction: By reducing the number of trades outstanding, compression reduces operational risk.  The portfolio compression requirements under EMIR apply to all FCs and all NFCs (above and below the clearing threshold).  They apply from 6 months after the RTS come into force. They are therefore likely to apply in September 2013.

31

Risk mitigation for uncleared trades Dispute resolution  FCs and NFCs must have agreed detailed procedures and processes in relation to: − the identification, recording, and monitoring of disputes relating to the recognition or valuation of the contract and to the exchange of collateral between counterparties. Those procedures shall at least record the length of time for which the dispute remains outstanding, the counterparty and the amount which is disputed. − the resolution of disputes in a timely manner with a specific process for those disputes that are not resolved within five business days.  In addition, FCs must report to the competent authority any disputes between counterparties relating to an OTC derivative contract, its valuation or the exchange of collateral for an amount or a value higher than EUR 15 million and outstanding for at least 15 business days.  The dispute resolution requirements apply from 6 months after the RTS come into force. They are therefore likely to apply in September 2013.

32

Risk mitigation for uncleared trades Daily valuation  FCs and Qualifying NFCs (i.e. NFCs over the clearing threshold) must mark-to-market on a daily basis the value of outstanding contracts.  They may mark-to-model when market conditions prevent marking-to-market.  Under EMIR, market conditions prevent marking-to-market of an OTC derivative contract when: − the market is inactive; or − the range of reasonable fair values estimates is significant and the probabilities of the various estimates cannot reasonably be assessed.  The daily valuation requirements must be applied since 15 March 2013.

33

Risk mitigation for uncleared trades Margining (Initial Margin and Variation Margin) (1/3)  EMIR requires FCs and Qualifying NFCs (i.e. NFCs over the clearing threshold) to have procedures for the “timely, accurate and appropriately segregated exchange of collateral” with respect to OTC derivative contracts.  Level and types of eligible collateral: − The level and type of collateral to be exchanged and the segregation arrangements will be determined in subordinate legislation to be drafted jointly by the three European Supervisory Authorities (ESMA, EBA and EIOPA) and adopted by the European Commission. − There are no details available yet: EU regulators have paused progress on margin requirements (including types of eligible collateral) pending the outcome of the consultation of the Working Group on Margining Requirements (WGMR) of the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commissions (IOSCO) on common international standards. − The WGMR issued a first consultative paper “Margin requirements for non-centrally-cleared derivatives” in July 2012. The document includes key principles and proposals for margin requirements for non-centrally-cleared derivatives. − On 15 February 2013, the WGMR published a second consultative paper, presenting “near-final” minimum standards for margin requirements for non-centrally cleared derivatives. According to the WGMR, these standards consider the responses to the first consultative document and the results of a quantitative impact study. The key principles are presented on the following pages.  It is not yet clear when the EU standards will be developed and thus when the exchange of collateral will be mandated.  It currently appears unlikely that the margining requirements will apply before H2 2014.

34

Risk mitigation for uncleared trades Margining (Initial Margin and Variation Margin) (2/3) Key principles of BCBS’s/IOSCO’s near-final policy for margin requirements for non-centrally cleared derivatives: 1. Appropriate margining practices should be in place with respect to all derivative transactions that are not cleared by CCPs. 2. All financial firms and systemically-important non-financial entities (“covered entities”) that engage in non-centrally cleared derivatives must exchange initial and variation margin as appropriate to the counterparty risks posed by such transactions. 3. The methodologies for calculating initial and variation margin that must serve as the baseline for margin that is collected from a counterparty should (i) be consistent across entities covered by the requirements and reflect the potential future exposure (initial margin) and current exposure (variation margin) associated with the portfolio of non-centrally cleared derivatives at issue and (ii) ensure that all counterparty risk exposures are covered fully with a high degree of confidence. 4. To ensure that assets collected as collateral for initial and variation margin purposes can be liquidated in a reasonable amount of time to generate proceeds that could sufficiently protect collecting entities covered by the requirements from losses on noncentrally cleared derivatives in the event of a counterparty default, these assets should be highly liquid and should, after accounting for an appropriate haircut, be able to hold their value in a time of financial stress. 5. Initial margin should be exchanged by both parties, without netting of amounts collected by each party (ie on a gross basis), and held in such a way as to ensure that (i) the margin collected is immediately available to the collecting party in the event of the counterparty’s default; and (ii) the collected margin must be subject to arrangements that fully protect the posting party in the event that the collecting party enters bankruptcy to the extent possible under applicable law. 6. Transactions between a firm and its affiliates should be subject to appropriate regulation in a manner consistent with each jurisdiction’s legal and regulatory framework. (continued on the next page) In bold: changes against the first consultative document Source: “Margin requirements for non-centrally-cleared derivatives”, Second Consultative Document, Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions, February 2013 35

Risk mitigation for uncleared trades Margining (Initial Margin and Variation Margin) (3/3) Key principles of BCBS’s/IOSCO’s near-final policy for margin requirements for non-centrally cleared derivatives: (continued) 7. Regulatory regimes should interact so as to result in sufficiently consistent and non-duplicative regulatory margin requirements for non-centrally cleared derivatives across jurisdictions. 8. Margin requirements should be phased-in over an appropriate period of time to ensure that the transition costs associated with the new framework can be appropriately managed. Regulators should undertake a coordinated review of the margin standards once the requirements are in place and functioning to assess the overall efficacy of the standards and to ensure harmonisation across national jurisdictions as well as across related regulatory initiatives.

In bold: changes against the first consultative document Source: “Margin requirements for non-centrally-cleared derivatives”, Second Consultative Document, Basel Committee on Banking Supervision, Board of the International Organization of Securities Commissions, February 2013 36

Extraterritorial application Application of EMIR to third country entities Clearing obligation: Obligation also extends to transactions between a FC or a Qualifying NFC (i.e. an NFC above the clearing threshold) in the EU and an entity established in a third country that would be subject to the clearing obligation if it were established in the EU.

Clearing and risk mitigation obligations: Both the clearing obligation and the risk mitigation requirements also apply to contracts between two entities established in non-EU jurisdictions that would be subject to the clearing obligation if they were established in the EU provided that the contract has a “direct, substantial and foreseeable effect” within the EU or “or where such an obligation is necessary or appropriate to prevent the evasion of any provisions of” EMIR. We await draft subordinate legislation on the contracts that have such a direct, substantial and foreseeable effect and the cases where it is necessary or appropriate to prevent evasion of EMIR. There is no timetable yet for the introduction of such technical standards.

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Exemptions from EMIR Intragroup transactions

Intragroup transactions clearing exemption

Intragroup transaction margin exemption

 Trades may be exempt from clearing if certain conditions are met, including:

 Trades may be exempt from margin requirements for uncleared trades if certain conditions are met, including:

− The EU Commission has recognized the equivalence of requirements in a non EU country − Subject to same consolidation on a full basis − Appropriate centralized risk evaluation, measurement and control procedures are in place

− The risk management procedures of the counterparties are adequately sound, robust and consistent, with the level of complexity of the derivatives contract. − There are no practical or legal impediments to the prompt transfer of own funds or repayment of liabilities between counterparties.  Parties using exemption from the margin rules for intragroup transactions are subject to ongoing public disclosure requirements  Risk mitigation techniques other than the margin requirements, such as those related to timely confirmation, portfolio reconciliation, portfolio compression and dispute resolution apply in accordance with EMIR

 In order to take advantage of these exemptions, counterparties must apply to their national regulators with evidence that they meet the relevant criteria.

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Exemptions from EMIR Pension scheme arrangements  Temporary 3-year exemption from the clearing obligation available to certain transactions of pension schemes  This temporary clearing exemption is extendable by 2 years, and then by another year, subject to the European Commission’s assessment.  However, pension scheme arrangements will be treated as FCs and as such will therefore be subject to the other EMIR requirements in full, irrespective of size. Therefore, pension schemes may question the practical value of the clearing obligation exemption as they are not exempt from the risk mitigation requirements that are applied in respect of non-cleared trades.

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Situation in Switzerland

 Switzerland also plans to implement the G20 obligations and the FSB recommendations on OTC derivatives trading as fully as possible. Further, it plans to adapt regulation in the area of financial market infrastructure to international standards.  According to the State Secretariat for International Financial Matters (SIF), regulation equivalent to that in the EU will be sought in the areas of OTC derivatives trading and financial market infrastructure.  With its resolution of 29 August 2012, the Federal Council instructed the Federal Department of Finance to prepare a corresponding consultation draft of a Financial Market Infrastructure Act.  Publication of the consultation draft is expected in late Q2 2013 or Q3 2013.  Reporting obligation (FSB, OTC Derivatives Market Reform, 5th Progress Report on implementation, 15 April 2013): Reporting information about a third party (i.e. a counterparty to a transaction) to Trade Repositories (TRs) could trigger violations of privacy laws unless the reporting is required in accordance with national law or a waiver from the client is obtained. In addition, under the Swiss regime, disclosure to a foreign authority, be it directly or through a TR, is not permitted until the Swiss legislation providing a basis for such reporting is in place.  Our current expectations: − Requirements for trading, execution and clearing will be largely equivalent to the requirements under EMIR. − The reporting requirements will most probably follow the principles of CPSS-IOSCO (“Report on data reporting and aggregation requirements”) whereas the information of the beneficial owner will not be required. − Issues related to privacy laws and blocking statutes will be addressed in the Financial Market Infrastructure Act. − Legislation will not enter into force before 1 January 2015.

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Implementation timetable Current estimates  H1 2013: Consultation on the implementation of the rules for the margining of uncleared OTC derivatives after the final results of the BCBS-IOSCO consultation are published  Q3 2013: Consultation in Switzerland on the planned Financial Market Infrastructure Act  Mid-/end of September 2013: − Portfolio reconciliation − Portfolio compression − Dispute resolution − Reporting to TRs for interest rate and credit derivatives  Q4 2013: − Frist CCPs authorized – Clearing Member obligations become effective − Frontloading period begins (frontloading: OTC derivatives entered into after a CCP is authorized may later become subject to mandatory clearing)  1 January 2014: Reporting to TRs for asset classes other than interest rate and credit starts  Summer/fall 2014: Clearing obligation starts – may be subject to phase-in  1 January 2015 (earliest): Entry into force of the Financial Market Infrastructure Act in Switzerland

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Glossary (1/2)

BCBS

Basel Committee on Banking Supervision

CCP

Central counterparty, i.e. a legal entity that interposes itself between the counterparties to the contracts traded within one or more financial markets, becoming the buyer to every seller and the seller to every buyer

Clearing threshold

the threshold size of derivatives positions specified for the purposes of determining whether a non-financial counterparty is subject to the clearing obligation under EMIR

Derivative

As defined in EMIR, i.e. a financial instrument as set out in points (4) to (10) Section C, Annex 1, MiFID, as implemented by the MiFIDimplementing regulation

EMIR

EU regulation on OTC derivatives, central counterparties and trade repositories

ESA

European Supervisory Authority (i.e. EBA, EIOPA or ESMA)

ESMA

European Securities and Markets Authority

ET

Exchange Traded

EU

European Union

FC

Financial Counterparty as defined in EMIR, i.e. an investment firm, credit institution, insurance/reinsurance undertaking, UCITS, pension scheme and alternative investment fund managed by an alternative investment manager, in each case where authorized or registered in accordance with the relevant EU directive

IOSCO

International Organisation of Securities Commissions

ITS

Implementing Technical Standards proposed by an ESA and adopted by the European Commission under powers conferred by an EU regulation or directive

MiFID

EU Markets in Financial Instruments Directive

NFC

Non-Financial Counterparty as defined in EMIR, i.e. an undertaking established in the EU which is not a Financial Counterparty or CCP

OJ

Official Journal

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Glossary (2/2)

OTC derivative

Over-the-Counter derivative as defined in EMIR, i.e. a derivative executed outside a regulated market (as defined in MiFID) or equivalent non-EU market

RTS

Regulatory technical standards proposed by an ESA and adopted by the Commission under powers conferred by an EU regulation or directive

TCE

Third Country (i.e. non-EU) Entities who would be subject to the relevant EMIR obligation if they were established in the EU

TR

Trade Repository

Trading venue

A regulated market or multilateral trading facility

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Erich Felder

Andreas Felber

Partner

Partner

CFA, lic. oec. HSG

Dr. phil. II

E-mail: [email protected]

E-mail: [email protected]

Mobile: +41 (0)79 527 26 76

Mobile: +41 (0)79 662 82 22

InCube Advisory Birkenstrasse 12 CH-6003 Lucerne

[email protected] www.incubeadvisory.com

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This publication has been written in general terms and therefore cannot be relied on to cover specific situations; application of the principles set out will depend upon the particular circumstances involved and we recommend that you obtain professional advice before acting or refraining from acting on any of the contents of this publication. InCube Advisory GmbH would be pleased to advise readers on how to apply the principles set out in this publication to their specific circumstances. InCube Advisory GmbH accepts no duty of care or liability for any loss occasioned to any person acting or refraining from action as a result of any material in this publication. © June 2013

InCube Advisory GmbH. All rights reserved.

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