Shearman & Sterling LLP | Financial Regulatory Developments Focus | Proposed Exemption From the EU Clearing Obligation for OTC Derivatives Novated to EU Counterparties in Preparation For a "No Deal" Brexit
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  • Proposed Exemption From the EU Clearing Obligation for OTC Derivatives Novated to EU Counterparties in Preparation For a "No Deal" Brexit
    11/08/2018
    The European Securities and Markets Authority has proposed the introduction of a 12-month exemption from the clearing obligation to facilitate the novation of uncleared OTC derivative contracts to EU counterparties in the event of a "no deal" Brexit. The European Market Infrastructure Regulation imposes a clearing obligation on EU firms that are counterparties to certain OTC derivatives contracts. The clearing obligation applies to Interest Rate Swaps denominated in seven currencies (EUR, GBP, JPY, USD, NOK, PLN and SEK) and to two classes of credit default swap indices (iTraxx Europe Main and iTraxx Europe Crossover). The obligation to clear OTC IRS denominated in all seven currencies is in force for clearing members of EU CCPs as well as large financial counterparties and alternative investment funds. The IRS clearing obligation for IRS denominated in the G4 currencies will apply to small financial counterparties and AIFs from June 21, 2019 and to non-financial counterparties from December 21, 2018, and for IRS denominated in CZK, DKK, HUF, NOK, SEK and PLN, from August 9, 2018. The CDS clearing obligation is in force only for clearing members of EU CCPs. The CDS clearing obligation for large financial counterparties, AIFs and NFCs will apply from August 9, 2019. It will apply to small financial counterparties and AIFs from June 21, 2019.

    On Brexit, U.K. firms will lose the passports which enable them to provide certain services across the EU. If the EU and the U.K. fail to reach an agreement on the U.K.'s exit from the EU, U.K. firms may be unable to perform some of operations for their derivatives contracts with EU clients. In preparation for this eventuality, firms may want to novate these contracts to entities that are established and authorized in an EU27 member state. However, novation of an OTC derivatives contract may trigger the clearing obligation and result in unexpected taxes or costs to the firms (arising from an event over which they have no control). ESMA considers that this situation gives rise to a disincentive for firms to transfer contracts from U.K. firms to EU firms and would result in an unlevel playing field between EU firms.

    To address this, ESMA is proposing to amend the Regulatory Technical Standards made under EMIR that establish the clearing obligation to introduce a time-limited exemption from the clearing obligation. This would apply for bilateral OTC derivatives contracts that have either not yet become subject to the clearing obligation or have not been novated after a clearing obligation has arisen. The exemption would only apply to a novation to a new EU counterparty and would not apply to other life-cycle events performed by the parties to a derivatives contract. The exemption would be available for a period of 12 months following the U.K.'s exit from the EU. ESMA's view is that this should provide firms with sufficient time to negotiate any novation and for repapering that needs to be completed. ESMA encourages market participants to begin their preparations immediately. The exemption will not come into effect if the EU and U.K. agree the terms of the U.K.'s exit and the withdrawal agreement has entered into force and will not apply if the EU and the U.K. agree to extend the two-year negotiation period under the terms of the Treaty on European Union.

    ESMA has submitted to the European Commission proposed amendments to the following three RTS to give effect to the proposed exemption:
    • RTS on the clearing obligation for IRS denominated in G4 currencies (RTS 2015/2205);
    • RTS on the clearing obligation for CDS (RTS 2015/592); and
    • RTS on the clearing obligation for IRS denominated in certain other currencies (RTS 2016/1178).

    View ESMA's report.

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