On 8 November 2018, the European Securities and Markets Authority (ESMA) published a final report with draft regulatory technical standards (RTS) proposing to amend the three Commission Delegated Regulations on the clearing obligation under the European Market Infrastructure Regulation (EMIR). The draft RTS propose, in the context of the United Kingdom’s (UK) withdrawal from the European Union (EU), to introduce a limited exemption in order to facilitate the novation of certain non-centrally cleared OTC derivative contracts to EU counterparties during a specific time-window. The amendments would only apply if the UK leaves the EU without the conclusion of a withdrawal agreement – a no deal scenario.
In the context of the on-going withdrawal negotiations between the EU and the UK, and to address the situation where a UK counterparty may no longer be able to provide certain services across the EU, counterparties in the EU may want to novate their non-centrally cleared OTC derivative contracts by replacing the UK counterparty with an EU counterparty. However, by doing this, they may trigger the clearing obligation for these contracts, therefore facing costs that were not accounted for when the contract was originally entered into.
Limited exemption from the clearing obligation to facilitate novations
The draft RTS allows UK counterparties to be replaced with EU ones without triggering the clearing obligation. This limited exemption would ensure a level playing field between EU counterparties and the preservation of the regulatory and economic conditions under which the contracts where originally entered into.
The window for the novation of non-centrally cleared OTC derivative contracts which fall under the scope of this amending regulation would be open for twelve months following the withdrawal of the UK from the EU. Counterparties can however start repapering their contracts ahead of the application date, making the novation conditional upon a no-deal Brexit, given the conditional application date of this amending regulation.
Third country regimes
ESMA is aware of the varying third country regimes across Member States and the impact it has on the provisions of services related to OTC derivative life cycle events, and has already highlighted its concerns in this respect. Market participants will need to take these varying regimes into account in their no-deal contingency plans regarding non-centrally cleared OTC derivatives. Given the limited effectiveness of supervisory convergence in the absence of a common legal basis, ESMA is proposing to reduce legal uncertainty by acting in relation to the clearing obligation.
Next steps
The draft RTS have been submitted to the European Commission for endorsement, and they are subject to the scrutiny of the European Parliament and of the Council.
Further developments on risk-mitigation techniques
ESMA, together with the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA) is currently considering a similar approach to facilitate the novation of legacy contracts to EU counterparties considering that novation may also trigger the application of bilateral margin requirements.
As regards non-centrally cleared OTC derivative contracts, the above mentioned measures will be the only regulatory measures the ESAs intend to propose to help address the legal uncertainty raised by the withdrawal of the UK from the EU and to ensure a level-playing field between EU counterparties.