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Working Paper

Regulation on OTC derivatives, central counterparties and trade repositories -- status as at 15 April 2012

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20120418 [Working Paper EMIR] E.P.M. Joosen BJ/2012/0150 2.0

Confidentiality: For discussion purposes only Date: 18 April 2012

Financial Markets Lawyers Amsterdam B.V. (FMLA) is registered with the Trade Register of the Chamber of Commerce under number 52120996. FMLAs Terms of Business are available on the firms website (www.fmlawfirm.eu) and have also been deposited with the Civil Clerks Office of the District Court of Amsterdam. A copy of FMLAs Terms of Business is available on request, free of charge. Among other provisions, FMLAs Terms of Business contains a limitation of liability clause.

Table of contents INTRODUCTION .....................................................................................................................................................................................................3 1 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 1.10 1.11 1.12 1.12.1 1.12.2 1.12.3 1.12.4 1.12.5 1.12.6 1.12.7 1.12.8 1.12.9 Contents of EMIR .............................................................................................................................................................................3 Defined expressions ................................................................................................................................. 3 Key requirements of EMIR ........................................................................................................................ 3 Role of ESMA ............................................................................................................................................. 4 Parties subject to Clearing Obligations ................................................................................................... 4 Clearing obligation procedure.................................................................................................................. 5 Regulating CCPs ........................................................................................................................................ 5 Post-trade reporting and record keeping obligations ............................................................................. 7 Risk Mitigating for non-CCP-cleared transactions ................................................................................... 7 Participation by clearing members........................................................................................................... 8 Transparency requirements...................................................................................................................... 8 Segregation and portability ...................................................................................................................... 8 Further prudential requirements .............................................................................................................. 9 Exposure management for CCPs .............................................................................................................. 9 Margin requirements for CCPs ................................................................................................................. 9 Default fund for CCPs ............................................................................................................................. 10 Other financial resources for CCPs ........................................................................................................ 11 Liquidity risk controls for CCPs .............................................................................................................. 11 Default waterfall for CCPs ...................................................................................................................... 11 Collateral requirements for CCPs ........................................................................................................... 11 Investment policy CCP ............................................................................................................................ 12 Default procedures -- portability ............................................................................................................ 13

1.12.10 Review of models, stress testing and back testing ............................................................................... 14 1.12.11 Settlement ............................................................................................................................................... 15 1.13 1.14 1.15 1.16 Interoperability arrangements relations with other CCPs .................................................................. 15 Trade repositories ................................................................................................................................... 16 Transitional provisions for pension scheme arrangements .................................................................. 16 Other transitional provisions .................................................................................................................. 17

ANNEX A: DERIVATIVES CONTRACTS WITHIN THE MEANING OF EMIR ............................................................................ 17 2 Draft Technical Standards EMIR ......................................................................................................................................... 19

For discussion purposes only | Working Paper | E.P.M. Joosen

INTRODUCTION This Working Paper is prepared by FMLA for the purposes of tracking the developments in respect of EMIR and summarise positions as they develop in the period towards introduction of this new piece of legislation. This document is published on the website of FMLA www.fmlawfirm.eu for free consultation by interested parties. The Working Paper does not contain concrete advice and contains information collected by FMLA based on best efforts. FMLA waives any responsibility as regards the completeness, accuracy or consistency of the information contained in this Working Paper. 1 1.1 CCP: EMIR: ESMA: ESRB: Derivative: Contents of EMIR Defined expressions Central Counter Party Regulation (EU) No /2012 of the European Parliament and of the Council on OTC derivatives, central counterparties and trade repositories European Securities and Markets Authority; European Systemic Risk Board; any financial instrument listed in points (4) to (10) of Section A of Annex I to the Markets for Financial Instruments Directive (as implemented in article 38 and 39 of the MiFID implementation Regulation. The concrete list of types of contracts stemming from this definition is set out in Annex A to this Working Paper. 1.2 Key requirements of EMIR

The key requirements under EMIR are: A. (certain classes of) derivative transactions will have to be accepted by a CCP, and must also be cleared on that CCP. This means that a CCP would contractually position itself between the two counterparties to a transaction. Market counterparties entering into transactions will need to become established as clearing members of a CCP, obtain access to a CCP as a client of a clearing member or become an indirect client in relation to trades subject to the clearing obligation; B. there will be reporting of derivative trades to trade repositories in relation to both cleared and uncleared derivatives. A minimum set of reporting requirements will be introduced, this includes (i) the parties to a contract; (ii) the beneficiary of the rights and obligations arising from the contract and (iii) the characteristics of a contract, such as type, maturity date and investment. Reporting must be made by both financial and non-financial counterparties or CCPs, observing certain reporting timelines and information thresholds; and C. CCPs are required to impose on clearing members (and other CCPs where the CCP has entered into interoperability agreements), call and collect from these parties margin as security collateral for credit risk mitigation to the trade of derivatives. It is intended that the margin collected by a CCP should be sufficient to cover losses that result from a least 99 percent. of the exposure movements.

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1.3

Role of ESMA

The European Securities and Markets Authority (ESMA) is the European supervisory authority for CCPs and trade repositories. As regards the CCPs the competent (college of) supervisory authori(y)(ties) of the member states where the CCPs are established/active will have the lead role, but with a close relation of scrutiny by ESMA. ESMA will have direct supervisory authorities with respect to trade repositories. ESMA will maintain registers on the types of derivatives to be cleared and the CCPs authorised to clear them. ESMA will have the ability to directly impose sanctions for breaches of the EMIR rules on trade repositories. ESMA shall establish and maintain a public register including:

the classes of derivatives contracts that are subject to the clearing obligation; the CCPs that are authorised or recognised for the purpose of the clearing obligation; the dates from which the clearing obligation takes effect, including any phased-in implementation; the classes of derivatives identified by ESMA that are required to be subject to clearing obligations and that should be included in the register, but for which no CCP is authorised to perform the clearing; the minimum remaining maturity of derivatives contracts that are entered into on or after the notification of a CCP to become an authorised CCP and before that class of derivatives is made subject to clearing and that is required to be included into the phased-in implementation of derivatives in a transitory regime;

CCPs that have been notified to ESMA by the competent EU authority for the purpose of (executing the) clearing obligations (including the date of notification to permit application of the phased-in rules for clearing of classes of derivatives cleared by the CCP that submitted the notification).

1.4

Parties subject to Clearing Obligations

EMIR imposes mandatory clearing requirements through a CCP if certain criteria are met. (a) they have been concluded in one of the following ways: 1. 2. 3. 4. 5. between two financial counterparties (defined as banks, investment firms, insurers, pension schemes, UCITS and alternative investment funds if established in the EU); between a financial counterparty and a non-financial counterparty (defined as parties trading in derivatives for speculative reasons and passing a certain trading threshold); between two non-financial counterparties; between a financial counterparty or a non-financial counterparty and an entity established in a third country that would be subject to the clearing obligation if it were established in the EU; or between two entities established in one or more third countries 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 where such an obligation is necessary or appropriate to prevent the evasion of any provisions of EMIR; and

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(b) they are entered into or novated either: 1. 2. on or after the date from which the clearing obligation takes effect; or on or after a CCP has notified the ESMA that it intends to clear certain (classes) of derivatives but before the date from which the clearing obligation takes effect if the contracts have a remaining maturity higher than the minimum remaining maturity determined by the European Commission. Derivatives transactions that are intra-group transactions (either between two financial counterparties, two non-financial counterparties or a combination of such parties if they are belonging to the same group) are exempt from the mandatory clearing obligation. In stead of this obligation they are subject to risk management techniques from non CCP cleared trades in derivatives. See paragraph 7 of this Working Paper. 1.5 Clearing obligation procedure

Clearing of a class of derivatives contracts by CCPs is subject to prior authorisation by the competent authority that supervises the CCP. The competent authority notifies ESMA that it has permitted the relevant CCP to clear a class of derivatives. Upon such notification received (and ultimately six months thereafter) ESMA shall develop regulatory technical standards (for endorsement by the European Commission that shall cast a Commission Regulation to that effect) in which (a) The class of derivatives that should be subject to mandatory clearing is determined; (b) The date or dates from which the clearing obligation takes effect, including (potential) phase-in periods and arrangements and the category counterparties to which the obligation applies; and (c) The minimum remaining maturity of OTC derivatives entered into prior to the notification of the competent authority to ESMA that it permits a CCP to clear a class of derivatives but before the entry into force of the obligation as set out under (a) of this list, that will be subject to mandatory clearing after the entry into force of the clearing obligations.

ESMA can also take own initiative after conducting a public consultation and after consulting the ESRB and (where appropriate) the competent authorities of third countries identify classes of derivatives that should be subject to mandatory clearing and inclusion in the public register held by ESMA but for which no CCP has yet received authorisation. For these classes of derivatives proposals will be published for the clearing of those classes of derivatives. ESMA shall prepare draft regulatory technical standards for the subject matter of bringing classes of derivatives not subject to mandatory clearing into the system of mandatory CCP cleared derivatives. 1.6 Regulating CCPs

The requirement to clear derivatives through a CCP shifts the risk of default from counterparty to a CCP. EMIR therefore establishes a new regime for the authorisation of CCPs. CCPs will be required to maintain adequate liquidity and meet minimum capital requirements. Such liquidity will result either from access to central bank facilities or to facilities of creditworthy and reliable commercial banks finance. Each member state will be required to elect the competent authority responsible for authorising and supervising CCPs. In the Netherlands

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it is expected that this role will be assumed by the Dutch Central Bank as the authority competent for prudential supervision. CCPs will be subject to authorisation requirements if they intend to provide clearing services as a CCP (clearing eligible classes of derivative contracts). Authorisations of CCP will be effective in the entire European Union and European Economic Area. The authorisation requirements can be summarised as follows: CCPs will need to have a homogeneous business (model) and should have a focus on clearing activities. Extension of activities beyond clearing is subject to supervisory review; CCPs will need to maintain a minimum initial capital of 7.5 million euro; Capital shall be proportionate to the risk stemming from the CCPs activities and at all times sufficient to ensure an orderly winding down or restructuring of the business of the CCP within a reasonable time-frame; Capital shall be adequate to cover for credit, counterparty, market, operational, legal and business risks in addition to the margin requirements and default fund requirements imposed on CCPs (for the latter see paragraph 11 of this Working Paper); CCPs shall have robust governance arrangements in place; CCPs shall have sufficient effective policies and procedures to ensure compliance with EMIR; CCPs shall have proper organisation structures ensuring business continuity; Risk management of the CCP shall be separated from other functions; Remuneration policies promote sound and effective risk management avoiding the creation of incentives to relax risk standards; Information technology of the CCP shall be adequate to ensure high standards of security, integrity and confidentiality of information (exchanges) within and outside the firm; CCPs shall be managed by senior management of good repute and senior management shall be experienced. At least one third of the board members are independent from (clearing members and/or owners); CCPs need to establish a risk committee composed of representatives of clearing members, independent members of the CCP board and representatives of clients of the CCP; Record keeping by CCPs is subject to strict requirements. Records must, f.i. be kept for a period of at least 10 years; Shareholders of CCPs are vetted by the authority that is competent to grant the authorisation to the CCP; Conflicts of interest between CCP, its managers, employees, controllers, clearing members or clients are properly identified and managed; Business continuity (contingency) management is subject to strict requirements as is outsourcing of (relevant and critical) functions by the CCP to third parties.

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Apart from the rules for CCPs as regards the prudential and organisational requirements, CCPs are subject to a wide range of conduct of business rules to facilitate access to the clearing on a non-discriminatory, transparent, fair basis. CCPs are in this respect regulated as if they are part of the public interest functions. 1.7 Post-trade reporting and record keeping obligations

CCPs and counterparties have the obligation to report trades conducted (i) before EMIR enters into force but are outstanding after EMIR enters into force and (ii) after EMIR enters into force. The reporting obligations carried out by CCPs and counterparties must be well structured in order to avoid duplications. Market practice is likely tending to develop a system of Unique Contract Identifiers (as promoted in Europe) to avoid such duplication and to facilitate the reporting and record keeping. 1.8 Risk Mitigating for non-CCP-cleared transactions

EMIR also provides that for all other uncleared derivative trades by a CCP, risk mitigation techniques must be applied. Those techniques will vary depending on the party involved, this however means that entities, regulated or not, will have to have in place proper procedures (whether in-house or otherwise) for measuring, monitoring and mitigating credit risk stemming from uncleared trades in derivatives. Parties that trade in derivatives that are not subject to mandatory clearing shall ensure that appropriate procedures and measures are in place to measure, monitor and mitigate operational risk and counterparty credit risk. These measures include (at least): Timely confirmation of trades (electronically) so as to avoid backlogs of unconfirmed trades; Formalised processes (that are robust, resilient and eligible for (external) audits) to: o o o o o Reconcile portfolios of derivatives held as positions by the party; Manage the associated risk with the portfolios of derivatives held; Identify disputes between parties early; Resolve disputes between parties; Monitor the value of the outstanding contracts by means of a daily mark-to-market valuation or if such marking is not possible due to market conditions have a reliable and prudent markto-model method available. Exchange of segregated collateral requirements for both financial parties as non-financial parties trading in derivatives for speculative reasons and passing a certain trading threshold. Such collateral requirement is not applicable for intra-group transactions of parties established in the same member state of the EU (provided that there is no existing or foreseen practical or legal impediment to the prompt transfer of own funds or repayment of liabilities by such parties). Further relaxation is offered for intra-group transactions between financial parties of the same group with establishment in different member states of the EU, provided that such parties meet the risk management procedures are sound, robust and consistent and there is no existing or foreseen practical or legal impediment to the prompt transfer of own funds or repayment of liabilities by such parties. Non-financial parties benefit from the same exemption provided that they submit a notification to the (domestic) authorities

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supervising CCPs. Exemptions are available to intra-group transactions between financial parties or non-financial parties if one of them is established in a third-party country provided certain conditions are met. Capital requirements for financial parties for risks not covered by collateral exchange;

Similar obligations may apply for derivative contracts between two entities established in one or more third countries 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 where such an obligation is necessary or appropriate to prevent the evasion of any provisions of EMIR. 1.9 Participation by clearing members

EMIR imposes on CCPs detailed requirements as regards the admission, on-going compliance by and exit of clearing members. The rules to imposed on clearing members intend to safeguard that clearing members have sufficient financial resources and operational capacity to participate in the clearing system as a member of CCP. The requirements also address the need for measurement of potential concentration risks with clearing members as relates the services clearing members provide to their clients. Clearing members permitting their clients to use the services of the CCP directly shall remain responsible for the compliance by such clients with the requirements. CCPs need to have proper procedures in place to enable an orderly suspension of services to clearing members and if need be exit of such clearing members if the criteria of EMIR are no longer met by such clearing member. These procedures shall particularly be relevant in the vent of financial distress with clearing members and the procedures should ensure prevention of systemic risks building up if one of the clearing members is financially distressed. 1.10 Transparency requirements

Public disclosure of costs of clearing, fees charged and other financial and other information important to measure the performance and terms and conditions of service of CCPs is at the forefront of the disclosure requirements for EMIR regulated CCPs. Another obvious set of rules in the context of EMIR concerns the disclosures of cleared transactions for each class of instruments cleared by CCPs on aggregated basis. 1.11 Segregation and portability

A complex set of rules of EMIR concerns the segregation and portability requirements. These requirements aim at creating a framework permitting the swift and harmless isolation of assets and positions held by individual clearing members with the CCP for their own account and for the account of all of their clients and where this is needed transfer such assets and positions outside the legal and economical environment of the CCP (omnibus client segregation). Comparable segregation and portability rules apply for positions held by individual clearing members with the CCP for their own account and for that of individual clients (individual

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client segregation), albeit that these rules may be applied voluntarily (ie at the request of a clearing member to the CCP). Clearing members have obligations that mirror the mandatory segregation rules for CCPs as regards the assets and positions held with CCPs for clients and their own assets and positions held with the same CCP. Clearing members are required to offer their clients the choice between a system of omnibus client segregation or individual client segregation. EMIR provisions suggest that assets and positions held with the CCP if a client has opted for individual client segregation, should be held distinct form the assets and positions of other clients of the same clearing member, also if it concerns excess margin for instance. In accordance with the relevant provisions of EMIR the requirement to distinguish in accounts assets and positions with the CCP is satisfied if the following conditions are met: (a) the assets and positions are recorded in separate accounts; (b) the netting of positions recorded on different accounts is prevented; and (c) the assets covering the positions recorded in an account are not exposed to losses connected to positions recorded in another account. Pursuant to Dutch (bankruptcy) law the first condition (a) shall be possible to realise, however, as the law currently stands, it is not feasible to create the consequences (in or out of bankruptcy proceedings of CCP or clearing member) of requirements under (b) and (c). As noted in Dutch literature by leading authors, a change of Dutch law is required to address these consequences. This is also and a fortiori relevant given the further definition of assets provided for in EMIR where it is stated: Assets refer to collateral held to cover positions and includes the right to the transfer of assets equivalent to that collateral or the proceeds of the realisation of any collateral, but does not include default fund contributions. 1.12 1.12.1 Further prudential requirements Exposure management for CCPs

CCPs are subject to strict rules on exposure management, where there is a requirement on a near to real time monitoring of exposures with clearing members and other CCPs where the CCP concerned has entered into an interoperability agreement. 1.12.2 Margin requirements for CCPs

Detailed rules are contained in EMIR on margin requirements to be imposed by CCPs on clearing members and on other CCPs with whom the CCP has entered into interoperability agreement. The relevant rules may be summarised (taken over parts of the text of the relevant paragraphs in EMIR, with emphasis by FMLA) as follows:

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CCPs shall impose, call and collect margins to limit their credit exposures from its clearing members, and where relevant, from CCPs which have interoperability arrangements; Margins shall be sufficient to cover potential exposures that the CCP estimates will occur until the liquidation of the relevant positions; Margins shall be sufficient to cover losses that result from at least 99 per cent of the exposures movements over an appropriate time horizon; Margins shall ensure that a CCP fully collateralises its exposures with all its clearing members, and where relevant with CCPs which have interoperability arrangements, at least on a daily basis; A CCP shall regularly monitor and, if necessary, revise the level of its margins to reflect current market conditions taking into account any potentially procyclical effects of such revisions; A CCP shall adopt models and parameters in setting its margin requirements that capture the risk characteristics of the products cleared and take into account the interval between margin collections, market liquidity and the possibility of changes over the duration of the transaction;

The models and parameters shall be validated by the competent authority providing for authorization to the CCP; A CCP shall call and collect margins on an intraday basis, at least when pre-defined thresholds are exceeded; A CCP shall call and collect margins that are adequate to cover the risk stemming from the positions registered in each account kept in accordance with the requirements for segregated accounts (as outlined in paragraph 10 of this Working Paper) with respect to specific financial instruments;

A CCP may calculate margins with respect to a portfolio of financial instruments provided that the methodology used is prudent and robust.

1.12.3

Default fund for CCPs

CCPs shall furthermore be require to maintain a default fund, in addition to the minimum capital requirement of 7.5 million euro and margin requirements as outlined in paragraph 11.2 of this Working Paper. The default fund is intended to cover for losses that exceed the losses covered by margin imposed and collected that arise from the default of one or more clearing members. Default is defined to include the opening of insolvency proceedings in respect of such clearing member. The default fund size is set by the CCP and the funds for this loss absorption buffer are raised with the clearing members. The size of the fund is determined by applying the following considerations: The CCP should be able to withstand (under extreme but plausible market conditions) the default of the largest clearing member; or The CCP should be able to withstand (under extreme but plausible market conditions) the default of the second and third largest clearing members if their aggregate positions exceed the positions of the largest clearing member; and

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CCP shall develop (stress testing) scenarios that are considered extreme but plausible with reference to (historical) most volatile periods that have been experienced by the markets for which the CCP offers its clearing services and taking into account also a number of hypothetical future (stressed) scenarios.

1.12.4

Other financial resources for CCPs

In addition to and separate form the margin and default fund requirements, CCPs shall hold (prefunded) additional financial resources to cover for potential shortfall if the margin and default fund buffers are not sufficient to cover for such losses. The additional (prefunded) financial resources should be sufficient for the CCP to withstand the default of two clearing members to which it has the largest exposures under extreme but plausible market conditions. 1.12.5 Liquidity risk controls for CCPs

CCP shall at all times have access to adequate liquidity to perform its services and activities. To that end, it shall obtain the necessary credit lines or similar arrangements to cover its liquidity needs in case the financial resources at its disposal are not immediately available. A clearing member, parent undertaking or subsidiary of that clearing member together shall not provide more than 25 % of the credit lines needed by the CCP. Liquidity needs shall be measured by the CCP on a daily basis. The liquidity requirements for the CCP shall be stress tested against the shortfall in liquidity caused by the default of two of its clearing members to which it has the largest exposures. 1.12.6 Default waterfall for CCPs

Detailed rules in EMIR concerning the distribution of proceeds in the even of a default of a clearing member, regulate that a CCP is required to first resolve the shortfall from the funds and resources contributions of the defaulting clearing member and the own resources of the CCP, before the funds and contributions made available by non-defaulting clearing members may be called. The margin contributed by non-defaulting clearing members may not be applied to resolve shortfall of funds as a result of the default of a clearing member. These waterfall provisions, if Dutch law would apply might be complex to implement under the current law provisions. A change of Dutch (bankruptcy) law would be needed to permit the implementation of the waterfall and the segregation provisions. 1.12.7 Collateral requirements for CCPs

The following is a, nearly literal, display of the collateral requirements imposed on CCPs pursuant to EMIR: 1. 2. A CCP shall accept highly liquid collateral with minimal credit and market risk to cover its initial and ongoing exposure to its clearing members. For non-financial counterparties, CCPs may accept bank guarantees taking into account such guarantees in exposure to a bank that is a clearing member.

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3.

It shall apply adequate haircuts to asset values that reflect the potential for their value to decline over the interval between their last revaluation and the time by which they can reasonably be assumed to be liquidated.

4.

It shall take into account the liquidity risk following the default of a market participant and the concentration risk on certain assets that may result in establishing the acceptable collateral and the relevant haircuts.

5.

A CCP may accept, where appropriate and sufficiently prudent, the underlying of the derivative contract or the financial instrument that originates the CCP exposure as collateral to cover its margin requirements.

REGULATORY TECHNICAL STANDARDS will be developed (ESMA to draft, after consulting EBA, ESRB and ESCB) for: 1. 2. 3. Type of collateral that could be considered as highly liquid (which shall in any event include cash, gold, government and high quality corporate bonds and covered bonds); Haircuts; Conditions under which commercial bank guarantees may be accepted as collateral.

1.12.8

Investment policy CCP

In the following matrix the requirements for investment by CCPs of its assets is displayed: Cash Highly liquid financial instruments (i) (ii) (iii) (iv) (v) Minimal market risk Minimal credit risk Rapid liquidation possibility Minimal adverse price effect when liquidating Highly secure arrangements with authorised financial institutions (where we interpreted this not as financial institutions as defined in EMIR) (vi) Standing deposit facilities of central banks or comparable means offered by central banks (vii) Identifiable CCP assets from those of third party depositary (differently titled accounts) (viii) No investment in own capital or that of parent or of subsidiaries Not applicable Required Required Required Eligible investment Not applicable Eligible investment Not applicable Required Required Required Required Required Required Required Required

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Cash

Highly liquid financial instruments

(ix)

Concentration risk measurement/overall credit risk exposures on single obligors

Required

Required

If the investment requirements are not met, the CCP may not comprise the relevant instruments or assets in the calculation of the capital adequacy requirements for CCPs (the capital adequacy requirements of article 16 (2) EMIR) and the dedicated own resources as defined in article 45(4) EMIR for the application of the Default Waterfall).

REGULATORY TECHNICAL STANDARDS will be developed (ESMA to draft after consulting EBA and ESCB) for: 1. 2. Financial instruments that can be considered highly liquid bearing minimal credit and market risk; Highly secure arrangements with authorised financial institutions (where EMIR uses the expression financial institutions in the relevant provision, we understand that is not referring to the defined concept of financial institution as this would mean that deposits could be maintained with nonregulated banks; 3. 1.12.9 Concentration (risk) limits. Default procedures -- portability

CCPs should have proper procedures in place for clearing members that are defaulting the participation requirements imposed by the CCPs on clearing members. Such default procedure should ultimately result in the winding down of the membership position of the defaulting clearing member and (accelerated) winding down of the assets and positions held by the clearing member for and on behalf of its clients. Such winding down of positions should (where this is feasible) effectively be organised through substitution of the defaulting clearing member by another non-defaulting clearing member. If it is not feasible to transfer the assets and positions to another clearing member, the CCP may liquidate the assets and positions held by the defaulting clearing member for the account of its clients. The CCP should, at default, apply contingency procedures to minimise losses and liquidity pressures and if defaulting clearing members positions are to be closed out, CCPs shall ensure that:

Operations are not disrupted; No exposures occur for non-defaulting clearing members to losses that they cannot anticipate or control; Collateral posted by clients and distinguished in either omnibus client segregation accounts or individual client segregation accounts will be used exclusively to cover the positions held for their account. This requirement suggests winding down of portfolios in isolated procedures preventing spill overs from one account held for clients to another account.

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Prior to declaring or triggering the default procedure for a clearing member that is (considered to be) defaulting and where the CCP is anticipating that the clearing member may not honour future obligations, the CCP should notify the competent authority (being the regulator supervising the CCP). The competent authority will then notify (i) ESMA, the (relevant members of the ESCB and (iii) the authority responsible for the supervision of the clearing member. Default procedures that aim at transferring assets and positions of clients form a defaulting clearing member to a non-defaulting clearing member (portability) require the cooperation and prior consent of clients and that of the non-defaulting clearing member assuming the responsibility for processing the assets and positions of such clients. The final EMIR text introduced elaborate language on the need to have transfer arrangements in place based on such pre-organised fall back scenario with the consents being in place prior to the trigger or declaration of default of the defaulting clearing member. A compulsory procedure (without such consents being organised) is considered not feasible and would have caused too much constraints in practice. 1.12.10 Review of models, stress testing and back testing

From the requirements imposed on CCPs to develop risk management models, to stress test these models and back test the reliability as set forth in EMIR the following main points may be quoted:

CCPs shall regularly review the models and parameters adopted to calculate their margin requirements, default fund contributions, collateral requirements and other risk control mechanisms;

CCPs shall subject the models to rigorous and frequent stress tests to assess their resilience in extreme but plausible market conditions and shall perform back tests to assess the reliability of the methodology adopted;

CCPs shall inform the competent authority and ESMA of the results of the tests performed and shall obtain their validation before adopting any change to the models and parameters; Significant model changes may not be introduced until the competent authority supervising the CCP has approved such change.

The default procedures are to be evaluated frequently and CCPs need to organise awareness with all of the clearing members of the functioning of these default procedures. CCPs are required to disclose key information on risk management models applied by them and the assumptions used for the stress testing of the models. REGULATORY TECHNICAL STANDARDS will be developed (ESMA to draft after consulting EBA, other relevant competent authorities and ESCB) for: (d) the type of tests to be undertaken for different classes of financial instruments and portfolios; (e) the involvement of clearing members or other parties in the tests; (f) the frequency of the tests; (g) the time horizons of the tests;

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(h) the key information as regards public disclosure of the risk management model and the assumptions for stress testing.. 1.12.11 Settlement

EMIR imposes a limited number of requirements as regards settlement of transactions. For cash settled transactions CCPs are required to the extent practical and available to have these transactions conducted through accounts held with one or more central banks. If such central bank payment facility is not available, other measures to reduce cash settlement risks must be taken. For the avoidance of doubt, it is not suggested that CCPs must secure the availability of credit lines with central banks for the purpose of reducing settlement risks. However, the fact that CCPs are likely to be regulated as a credit institution subject to the requirements of Directive 2006/48/EC (the Banking Consolidation Direective that soon will be replaced by the CRD IV Regulation and Directive), EMIRs recital text suggests: Access to adequate liquidity resources is essential for a CCP. It is possible for such liquidity to derive from access to central bank liquidity, creditworthy and reliable commercial bank liquidity, or a combination of both. Access to liquidity could result from an authorisation granted in accordance with Article 6 of Directive 2006/48/EC or other appropriate arrangements. In assessing the adequateness of liquidity resources, especially in stress situations, a CCP should take into consideration the risks of obtaining the liquidity by only relying on commercial banks credit lines. Where there is no concrete obligation pursuant to the rules regulating settlement for CCPs to address settlement risk when derivatives contracts need to be cash settled to have liquidity support provided by central banks, the suggestion comprised in the recital quoted here above may be seen as soft law position of the European regulator in respect of this subject matter. For physical deliveries, principal risk (the risk of the supplier of the (financial) instruments not delivering clean title to the relevant instruments), must be managed by applying payment against delivery mechanisms to the extent possible. 1.13 Interoperability arrangements relations with other CCPs

An important chapter of EMIR addresses the requirements for interoperability arrangements between two or more CCPs. Interoperability is defined in EMIR as an arrangement between two CCPs resulting into crossexecution of transactions. Such arrangements may for instance be relevant for clearing services offered by different CCPs located in different jurisdictions in respect of a same class of derivatives traded on a single trading venue. Interoperability arrangements are subject to prior approval of all the competent authorities supervising the relevant CCPs that wish to enter in an interoperability arrangement. The requirements imposed on the CCPs basically address the Siamese twin syndrome that could occur if two CCPs have entered into an interoperability arrangement. Spill over effects, concentration risks building up and systemic reactions as a

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result of a default of one CCP must be addressed to the largest extent. This effectively means that there are limitations on pooling financial assets and reduced possibilities to merge certain processes. Interdependencies and correlations must be monitored in a strict way and where this is necessary, back stop procedures should be triggered in case of distress of one of the co-operating CCPs. 1.14 Trade repositories

One of the key objectives of EMIR is to create as much as possible transparency of existing positions in the worldwide derivatives markets. The transparency objective is key for the measurement of the markets, the potential risks that may occur as a result of market volatility and, in situations of market constraint, the development of systemic risks. EMIR contains elaborate rules on the mandatory disclosure of derivatives positions in the form of post trade notifications by all the market parties involved. Notifications must be made for cleared transactions under the system of mandatory clearing for eligible (classes of) derivatives, as well as for cleared transactions outside the mandatory clearing obligations as well as over-the-counter transactions not subject to clearing. A key and central role in this system of disclosures will be played by the trade repositories. Trade repositories will itself be subject to authorisation requirements and are therefore subject to supervisory review. The competent authority coordinating authorisation is ESMA. Trade repositories that are (already) subject to supervision by national competent authorities will need to involve ESMA in any event and ESMA will further coordinate the relevant procedures to align national supervision into the coordinated scheme pursuant to EMIR. Trade repositories are, in their basic function, not subject to credit or counterparty risk or market risks. Therefore the supervision scheme applied for trade repositories focuses on operational risks, suitability of the management, adequate information processing and data protection. 1.15 Transitional provisions for pension scheme arrangements

Motivated by the fact that pension schemes arrangements, when forced to clear derivatives with CCPs would need to divest significant parts of their assets in order to free up the cash necessary for meeting margin obligations (awaiting technical solutions promoted by CCPs to post non-cash collateral to meet (variation) margin obligations), a specific exemption of mandatory clearing has been introduced after an accord reached late 2011 in the ECOFIN meeting on the subject matter of EMIR. The exempt status of pension schemes of the clearing obligation is not for an indefinite period and is intended to only last for a transitional period. This transitional period is as follows: 1. For three years after the entry into force of EMIR (therefore this period is likely to end on 31 December 2015) the clearing obligation shall not apply to OTC derivatives contracts that are objectively measurable as reducing investment risks directly relating to the financial solvency of pension scheme arrangements.

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2.

Derivatives contracts that (without the exemption) would otherwise be subject to the clearing obligation are subject to the obligation to establish risk mitigation techniques for OTC derivatives contracts not cleared by a CCP. This essentially may mean that the relevant contracts need to be collateralised in the bi-lateral relation between the pension scheme and the counterparty. In practice, this may mean that there is no significant change if parties already agreed to variation margin calculations and credit support.

Which schemes will be eligible to benefit from this exemption to clear derivatives with CCPs depends on as to whether or not the schemes fit into the elaborate definition given in EMIR so as to ensure that all schemes that aim at distributing lifelong or lump sum compensation at retirement fit into the group of exempt schemes. For the Netherlands all pension funds subject to the provisions of the Pensions Act (whether they act industry wide or company wide) qualify as institutions for occupational retirement provision as defined in Article 6(a) of Directive 2003/41/EC (IORP) as set forth in the first group of defined pension scheme arrangements of EMIR and are therefore undoubtedly profiting from the exemption regulation. Further interpretation shall, however, need to be given to parties fulfilling certain (investment management) roles for Dutch pension funds in view of the somewhat ambiguous language of the EMIR definitions addressing the role of such investment manager. This is also applicable to certain life insurance businesses providing occupational pension coverage as the definitions of EMIR are equally complex for these businesses as well. Although the relevant (significant) Dutch pension sector shall benefit from the exemptions for mandatory clearing, many other aspects concerning EMIR (or related to or impacted/caused by EMIR) shall require further compliance exercises in the near future. 1.16 Other transitional provisions

Other transitional provisions relate to the phased introduction of the regime of European Union CCPs already subject to supervision prior to the entry into force of EMIR or CCPs established in third countries that are being recognised by one or more competent authorities in the European Union. Similar provisions are given for already regulated trade repositories, whether established in the European Union or in a third party country.

ANNEX A: DERIVATIVES CONTRACTS WITHIN THE MEANING OF EMIR


1. 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; 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); 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 Multi Trading Facility; Options, futures, swaps, forwards and any other derivative contracts relating to commodities, that can be physically settled not otherwise mentioned in paragraph 3 and not being for commercial purposes, which have the characteristics of other derivative financial instruments1, having regard to whether, inter alia, they are cleared and settled through recognised clearing houses or are subject to regular margin calls;

2.

3. 4.

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5. 6.

7.

Derivative instruments for the transfer of credit risk; Financial contracts for differences. 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 Multi Trading Facility, are cleared and settled through recognised clearing houses or are subject to regular margin calls2.

Article 38 1. For the purposes of Section C(7) of Annex I to Directive 2004/39/EC, a contract which is not a spot contract within the meaning of paragraph 2 of this Article and which is not covered by paragraph 4 shall be considered as having the characteristics of other derivative financial instruments and not being for commercial purposes if it satisfies the following conditions: (a) it meets one of the following sets of criteria: (i) it is traded on a third country trading facility that performs a similar function to a regulated market or an MTF; (ii) it is expressly stated to be traded on, or is subject to the rules of, a regulated market, an MTF or such a third country trading facility; (iii) it is expressly stated to be equivalent to a contract traded on a regulated market, MTF or such a third country trading facility; (b) it is cleared by a clearing house or other entity carrying out the same functions as a central counterparty, or there are arrangements for the payment or provision of margin in relation to the contract; (c) it is standardised so that, in particular, the price, the lot, the delivery date or other terms are determined principally by reference to regularly published prices, standard lots or standard delivery dates. 2.A spot contract for the purposes of paragraph 1 means a contract for the sale of a commodity, asset or right, under the terms of which delivery is scheduled to be made within the longer of the following periods: (a) (b) two trading days; the period generally accepted in the market for that commodity, asset or right as the standard delivery period.

However, a contract is not a spot contract if, irrespective of its explicit terms, there is an understanding between the parties to the contract that delivery of the underlying is to be postponed and not to be performed within the period mentioned in the first subparagraph. 3. For the purposes of Section C(10) of Annex I to Directive 2004/39/EC, a derivative contract relating to an underlying referred to in that Section or in Article 39 shall be considered to have the characteristics of other derivative financial instruments if one of the following conditions is satisfied: (a) (b) (c) that contract is settled in cash or may be settled in cash at the option of one or more of the parties, otherwise than by reason of a default or other termination event; that contract is traded on a regulated market or an MTF; the conditions laid down in paragraph 1 are satisfied in relation to that contract.

4. A contract shall be considered to be for commercial purposes for the purposes of Section C(7) of Annex I to Directive 2004/39/EC, and as not having the characteristics of other derivative financial instruments for the purposes of Sections C(7) and (10) of that Annex, if it is entered into with or by an operator or administrator of an energy transmission grid, energy balancing mechanism or pipeline network, and it is necessary to keep in balance the supplies and uses of energy at a given time.
2

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Article 39 In addition to derivative contracts of a kind referred to in Section C(10) of Annex I to Directive 2004/39/EC, a derivative contract relating to any of the following shall fall within that Section if it meets the criteria set out in that Section and in Article 38(3): (a) (b) (c) (d) (e) (f) (g) telecommunications bandwidth; commodity storage capacity; transmission or transportation capacity relating to commodities, whether cable, pipeline or other means; an allowance, credit, permit, right or similar asset which is directly linked to the supply, distribution or consumption of energy derived from renewable resources; a geological, environmental or other physical variable; any other asset or right of a fungible nature, other than a right to receive a service, that is capable of being transferred; an index or measure related to the price or value of, or volume of transactions in any asset, right, service or obligation.

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Draft Technical Standards EMIR

In this Working Paper we have outline a significant number of topics that require further Regulatory Technical Standards (RTS) and in some instances also Implementing Technical Standards (ITS). In the below overview all of the standards that will need to be developed are summarised including a tracking of the status of development and the required involvement of the various authorities. Entries in the below matrix are made based on the text of EMIR in the version adopted by the European Parliament legislative decision of 29 March 2012. Based on this available draft, some of the references in this table are likely to be revised upon the final reviewed text of EMIR will be published and available. denotes involvement of the respective authority in the drafting of ITS/RTS and advisoryconsultation of these authorities, O denotes no required involvement.

Subject matter

RTS or ITS

ESMA

ESRB

EBA

Other authorities EU

Third country authorities

Discussion paper published Yes, 16 February 2012

Basis in EMIR, article 4.4

Deadline for submission to EC

1.

Contracts that are considered to have a direct, substantial and foreseeable effect within the Union or the cases where it is necessary or appropriate to prevent the evasion of any provision of EMIR

RTS

30-09-2012

2.

Types of indirect clearing arrangements

RTS

Yes, 16 February 2012

Unclear

Unclear

3.

Details to be included in the notifications of competent authority to ESMA that CCP is authorised to clear class of derivatives

RTS

Yes, 16 February 2012

5.1

30-09-2012

4.

(a) The class of OTC derivatives that should be subject to the clearing obligation

RTS

Yes, 16 February 2012

5.2

No deadline, dependency on action EU competent authority or third party country CCP notification that class is admitted for

(b)

The date or dates from which the clearing obligation takes effect, including any phase-in and the categories of counterparties to which the obligation applies; and

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Subject matter

RTS or ITS

ESMA

ESRB

EBA

Other authorities EU

Third country authorities

Discussion paper published

Basis in EMIR, article

Deadline for submission to EC

(c)

The minimum remaining maturity of the OTC derivative contracts (phasing in existing contracts to mandatory clearing)

clearing

5.

The classes of derivative contracts that should be included in its public register and that are subject to the clearing obligation but for which no CCP has yet received authorisation.

n/A

Yes, 16 February 2012

5.3

EMIR suggests 30 September 2012, but we note this is probably an erroneous note in the draft EMIR text

6.

Specify details to be included in ESMA public register

RTS

Yes, 16 February 2012

6.5

30-09-2012

7.

Specifying the notion of liquidity fragmentation of trades on different trading venues

RTS

Yes, 16 February 2012

8.5

30-09-2012

8.

Specifying the details and type of the reports for different classes of derivatives to be contributed to trade repositories

RTS

9.5

30-09-2012

9.

Determining (a) the format and frequency of the report for the different classes of derivatives to be notified to the trade repository and (b) the date by which derivative contracts shall be reported, including any phase in for contracts entered into before the entry into force of EMIR

ITS

Yes, 16 February 2012

9.6

30-09-2012

10. Setting (a) criteria for establishing which OTC derivatives contracts are objectively measurable as reducing risks relating to commercial activity or treasury financing activity (non-speculative nature of derivatives applied by nonfinancial counterparties) and (b) values of the clearing thresholds, which are determined taking into account the

RTS

, other relevant authorities

Yes, 16 February 2012

10.4

30-09-2012

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Subject matter

RTS or ITS

ESMA

ESRB

EBA

Other authorities EU

Third country authorities

Discussion paper published

Basis in EMIR, article

Deadline for submission to EC

systemic relevance of net positions and exposures by counterparty and per class of OTC derivatives 11. Specifying the various elements of the risk management techniques for non-CCP cleared OTC derivatives , all the European Supervisory Authorities 13. Specifying requirements regarding the capital, retained earnings and reserves of CCPs RTS O , EBA holds the pen, after consulting ESMA and with cooperation ESCB 14. Specifying the conditions under which European Union currencies are to be considered the most relevant for the determination of the composition of the college of supervisors authorised to supervise CCPs 15. Specifying the information that a third country CCP shall need to submit in its application for recognition RTS O O O O Yes, 16 February 2012 16. Specifying the minimum content of rules and governance arrangements of CCPs RTS O O O Yes, 16 February 2012 17. Details of the records and information to be retained by CCPs on executed derivatives transactions RTS O O O O Yes, 16 February 2012 29.4 30-09-2012 26.9 30-09-2012 25.8 30-09-2012 RTS O O O O No 18.6 30-09-2012 O No 16.3 30-09-2012 RTS O O O O Yes, 16 February 2012 12. Risk management procedures for non-CCP cleared OTC derivatives RTS O Yes, on 6 March 2012 11.15 30-09-2012 11.14 30-09-2012

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Subject matter

RTS or ITS

ESMA

ESRB

EBA

Other authorities EU

Third country authorities

Discussion paper published Yes, 16 February 2012

Basis in EMIR, article 29.5

Deadline for submission to EC

18. To determine the format of the records and information to be retained by CCPs

ITS

30-09-2012

19. Specifying the minimum content and requirements of the business continuity policy and of the disaster recovery plan of CCPs 20. Specifying the appropriate percentage and time horizons for the liquidation period and the calculation of historical volatility to set Margin requirements to be imposed, called and collected by CCPs for cleared transactions 21. Defining extreme but plausible market conditions under which a CCP should be able to withstand the default of its most significant clearing member(s) 22. Specifying the framework for managing the CCPs liquidity risk

RTS

, members of the ESCB

Yes, 16 February 2012

34.3

30-09-2012

RTS

, ESCB

Yes, 16 February 2012

41.5

30-09-2012

RTS

, ESCB

Yes, 16 February 2012

42.5

30-09-2012

RTS

, members of the ESCB

Yes, 16 February 2012

44.2

30-09-2012

23. Specifying the methodology for calculation and maintenance of the amount of the CCPs own resources to be used by the CCP before using the default fund contributions of non-defaulting clearing members 24. Specifying type of collateral that could be considered highly liquid and the haircuts and conditions under which commercial bank guarantees may be accepted as collateral by CCPs 25. Specifying the financial instruments that can be considered highly liquid, bearing minimal credit and market risk, the highly secured arrangements in respect of depositary

RTS

, members of ESCB

Yes, 16 February 2012

45.5

30-09-2012

RTS

, ESCB

Yes, 16 February 2012

46.3

30-09-2012

RTS

, ESCB

Yes, 16 February 2012

47.8

30-09-2012

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Subject matter

RTS or ITS

ESMA

ESRB

EBA

Other authorities EU

Third country authorities

Discussion paper published

Basis in EMIR, article

Deadline for submission to EC

financial institutions (we believe this is an erroneous use of the expression financial institutions for this purpose, FMLA) taking financial instruments as depositary in stead of securities settlement systems and concentration limits for exposures of CCPs in respect of their own investments 26. Specifying the elements of stress tests to be performed by CCPs RTS O , other relevant competent authorities and members of the ESCB 27. Specifying the details of the application for registration by Trade Repositories RTS O O O O Yes, 16 February 2012 28. Formal of application for authorisation by ESMA of Trade Repositories , members of the ESCB ITS O O O O Yes, 16 February 2012 29. Specifying the frequency and the details of the information to be published by Trade Repositories on aggregate positions by class of derivatives RTS O O Yes, 16 February 2012 81.5 30-09-2012 56.4 30-09-2012 56.3 30-09-2012 O Yes, 16 February 2012 49.4 30-09-2012

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