What is EMIR and why is the Commission proposing to amend it?
The European Market Infrastructure Regulation (EMIR) is a centrepiece of the legislation introduced in the wake of the financial crisis to make financial markets safer and more transparent. A key pillar of EMIR is the requirement for standardised OTC derivatives contracts to be cleared through a Central Counterparty (CCP), which entered into force in December 2015 (for more information see here). EMIR also introduced strict prudential, organisational and business conduct requirements for CCPs and established arrangements for their supervision to minimise any risk to users of a CCP and underpin the financial stability of the system (for technical terms, see glossary at the end of the MEMO).
The Commission has carried out an extensive assessment of EMIR to ensure that EU legislation is working effectively and efficiently. In addition to the 2015 public consultation on EMIR, this proposal relies on input received from stakeholders from the public consultations on the operations of the European Supervisory Authorities (ESAs) and on the Capital Markets Union (CMU) Mid-Term Review. It also considers feedback received following the publication of the Commission Communication responding to challenges for critical financial market infrastructures and further developing the CMU and the Staff Working Document (SWD) on EU equivalence decisions in financial services policy.
Based on this input, this proposal focuses on targeted amendments to the supervisory regime for EU and third country CCPs.
What has EMIR achieved so far in relation to CCPs?
Since the adoption of EMIR in 2012, the volume of CCP activity – both in the EU and globally – has grown rapidly in scale and scope. The share of OTC interest rate derivatives that are centrally cleared has risen from about 36% at the end of 2009 to 60% by the end of 2015 (for more information see here). The rapidly expanding role of CCPs in the global financial system reflects the introduction of central clearing obligations across different asset classes in the EU (since June 2016) and non-EU countries. Growing awareness of the benefits of central clearing among market participants has also increased voluntary use. The targeted amendments proposed in May 2017 to improve the effectiveness and proportionality of EMIR will reinforce this trend, by creating further incentives for CCPs to offer central clearing of derivatives to market participants.
At the same time, supervisory convergence in the EU has improved thanks to the establishment of so-called 'supervisory colleges' of the 17 central counterparties currently authorised under EMIR. In these colleges, all relevant competent authorities for the CCP (such as authorities responsible for the supervision of clearing members or authorities supervising trading venues serviced by the CCP or Central Securities Depositories to which the CCP is linked) participate in a voting capacity in the authorisation and – to a certain extent – in the supervisory process of the CCP. The European Securities and Markets Authority (ESMA) is represented in these colleges in a non-voting capacity and is provided with binding mediation powers whenever necessary. In addition, 28 CCPs outside the EU - or 'third-country CCPs' - have already been recognised by ESMA. These can now provide their services across the EU under EMIR's third-country regime. A further 12 CCPs from 10 non-EU countries have applied to date for recognition and are currently awaiting a decision of the Commission as regards the equivalence of their regulatory and supervisory regimes.
The growth of CCP activity – in the EU and globally – is likely to continue in the years to come with the introduction of further clearing obligations and growing incentives for voluntary clearing. Nevertheless, the market for central clearing remains concentrated with a few CCPs offering the bulk of clearing services, especially in certain asset classes. CCPs are also highly interconnected with other financial market participants. Although a CCP failure is an unlikely event, this would have major consequences for the stability of the financial system. The Commission's proposal for a Regulation on CCP Recovery and Resolution in November 2016 already introduced some requirements to make sure authorities have the appropriate arrangements in place to address such an occurrence, and mitigate potential costs for tax payers.
What led the Commission to make this proposal?
The Commission is making its proposal based on feedback that builds on an extensive assessment of EMIR and two public consultations: one on the operations of the European Supervisory Authorities (ESAs), another on the Capital Markets Union Mid-Term Review. We have also taken into account input received on our Communication responding to challenges for critical financial market infrastructures and to our Staff Working Document on equivalence.
On this basis, further amendments to the supervisory arrangements for EU and third-country CCPs under EMIR are required for two reasons:
- First, while supervisory colleges enable information sharing among different supervisors, under current supervisory arrangements for EU CCPsthe main decisions are ultimately taken by the national authorities in the Member States where the CCP is established. This is no longer adequate given the volume of cross-border activity by CCPs and the potential risks for the EU financial system as a whole. Furthermore, the important role of central banks needs to be better reflected in the decision-making process: central banks are responsible for payment systems used by CCPs and for monetary policy that can be impacted by CCP actions.
- Second, a significant volume of financial instruments denominated in the currencies of Member States are cleared by recognised CCPs in non-EU countries. This is possible thanks to the equivalence regime under EMIR, which envisages that authorisation and supervisory regimes in non-EU countries can be considered equivalent to the EU's rules. CCPs from those countries are allowed to operate in the EU, following a thorough appraisal of third country's rules by the Commission and of the CCP by ESMA. However, EMIR's current rules on equivalence and recognition have demonstrated certain shortcomings as regards ongoing supervision in third countries, meaning that EU authorities may not become aware of new or growing risks to the EU financial system. Furthermore, the actions of a third-country CCP can have an impact on the financial stability of the EU and its Member States and therefore raise significant concerns for EU central banks.
With the departure of the United Kingdom from the EU, these risks will be particularly exacerbated, as a substantial volume of derivatives transactions denominated in Euro or other EU Member States currencies are currently cleared via CCPs located in the UK.
In light of these considerations, the Commission already adopted a Communication on 4 May 2017 on responding to challenges for critical financial market infrastructures and further developing the Capital Markets Union. This proposal was pre-announced in that Communication.
Who will benefit from these changes?
The main beneficiaries of this proposal are citizens and the economy as a whole through a safer financial system where the probability of the failure of a CCP and the contagion to the broader financial system is further reduced. In addition, CCPs operating in the EU will benefit from a more streamlined European supervision process offering greater legal clarity and more efficient decision-making capacities.
What are the main proposed changes to EMIR for EU CCPs?
For CCPs established in the EU, national authorities will exercise supervision in agreement with the European Securities and Markets Authority (ESMA). For these purposes, it is proposed to set up a new CCP Executive Session within ESMA.
The existing colleges of national supervisors established under EMIR for each EU CCP will continue to act as bodies fostering cooperation and taking joint decisions, as they include all authorities who may be concerned by the activities of the CCP, for example the authorities responsible for trading venues and Central Securities Depositories. The Head of the new CCP Executive Session will chair the existing EMIR colleges in order to ensure consistency between the work of the Executive Session and that of the colleges.
How will the new CCP Executive Session in ESMA work?
The proposal would establish a new CCP Executive Session in the European Securities and Markets Authority (ESMA). This Executive Session will be responsible for all matters relating to CCPs within ESMA, including ESMA's new supervisory powers for EU CCPs and third-country CCPs. The CCP Executive Session will consist of several permanent newly- appointed independent members, along with the relevant national authorities responsible for the CCP concerned and with the relevant central bank(s) of issue and the Commission as non-voting members.
What are the main proposed changes to EMIR for third-country CCPs?
To better address the potential risks to the EU's financial stability, the framework for the recognition of third-country CCPs and their supervision will be significantly enhanced.
The proposal introduces a two tier system for third-country CCPs:
- Non-systemically important CCPs (so-called Tier 1 CCPs) will continue to be able to operate under the existing EMIR equivalence framework.
- Systemically important CCPs (so-called Tier 2 CCPs) will be subject to stricter requirements. A limited number of systemically important CCPs may be of such systemic importance, that the requirements are deemed insufficient to mitigate the potential risks (so called ‘substantially systemically important'). In such instances, a decision may be taken allowing a CCP to provide services in the Union if it is authorised under EMIR and establishes itself in the EU.
ESMA, in its new CCP Executive Session, will be responsible for monitoring and supervising all third-country CCPs by the Commission.
Who decides and how if a CCP is systemically important?
CCPs that are or may become of systemic significance for the financial stability of the EU or for one or more of its Member States will be considered 'systemically important'.
ESMA will decide if a third-country CCP is systemically important by assessing a number of aspects of the third-country CCP's business (e.g. its size and how much that CCP clears of each Union currency), its links to the EU (e.g. how many clearing members are EU entities and the links between that CCP and EU market infrastructures), as well as its potential impact on financial markets, financial institutions or financial stability if such a CCP were to fail. The Commission, in cooperation with ESMA and the European System of Central Banks (ESCB), will specify the exact criteria for assessing whether a third-country CCP is systemically important in a Delegated Act which is planned to be adopted within six months of the entry into force of this regulation.
Moreover, entities may be defined as ‘substantially systemically important CCPs' if they are deemed to be of such systemic importance for the EU or one or more of its Member States that the additional requirements for systemically-important CCPs are insufficient to mitigate potential risks.
ESMA, in agreement with the relevant central banks, will make a recommendation to the Commission whether or not a CCP is of substantial systemic importance. On that basis, the Commission may adopt an implementing act declaring that the CCP may only provide services in the Union if it is authorised in the EU. In this case, the CCP would have to establish itself in the EU and apply for authorisation to the competent authority of the Member State where it wishes to establish itself in accordance with the requirements laid out under EMIR.
What will the role of the European Central Bank be?
The role of the ECB is reinforced in the supervisory system through its permanent membership in the CCP Executive Session and in the supervisory colleges. For specific decisions directly related to their role and responsibilities, the ECB and the relevant central banks of issue will be given binding decision powers in the Executive Session.
Safe and efficient financial market infrastructures, in particular clearing systems, are essential for the transmission of monetary policy, a basic task to be carried out through the European System of Central Banks (ESCB) supporting the primary objective of maintaining price stability. The relevant members of the ESCB, as central banks of issue of the currencies of the financial instruments cleared by CCPs, should be involved in CCP supervision, due to the potential risks that the malfunctioning of a CCP could pose to the pursuit of those basic tasks and the primary objective, affecting the instruments and counterparties which are used to transmit monetary policy. As a result, the central banks of issue should be involved in the assessment of a CCP's risk management.
What additional requirements will systemically important CCPs be subject to?
Before being recognised by ESMA and being able to do business in the EU, a systemically important CCP will have to comply with several additional requirements. First, it should comply with the necessary prudential requirements for EU-CCPs (e.g. capital requirements, conduct of business rules, margin, etc.). Second, it should comply with any additional requirements set by the relevant EU-central banks (e.g. the availability or type of collateral held in a CCP, segregation requirements, liquidity arrangements, etc.). Third, it should give its agreement to provide ESMA with all relevant information and to enable on-site inspections, as well as a legal opinion confirming that such arrangements are valid in the third country. Fourth, CCPs should have all necessary measures and procedures in place to be able to comply with the first and third conditions.
In order to ensure proportionality in these requirements, a system of 'comparable compliance' similar to that in the US is introduced. This will enable CCPs to ask ESMA to compare EMIR's requirements with those of the third country. If the rules in a third country are deemed comparable to those in EMIR, ESMA may determine that the application of that country's rules is comparable to compliance with EMIR.
Will the cost of clearing rise for EU companies as a result?
This proposal will have costs and benefits.
The benefits arise for clearing members and their clients (clearing counterparties) who will benefit from safer CCPs. The impact of this initiative on the business conducted by clearing counterparties with CCPs established in the EU is expected to be minimal and certainly seamless from an operational standpoint.
On the cost side, CCPs will face supervisory fees which could be passed on to clearing members. This financial effect is, however, expected to be very limited compared to volume of financial instruments cleared and to be cleared. Depending on the intensity of supervision applied to third-country CCPs and should one or more third-country CCPs be required to establish itself in the EU, there could be higher financial costs and operational impacts on clearing counterparties. In cases where it is decided that a third-country CCP can only be authorised if established in the EU, this may lead to potential higher costs of trading due to market fragmentation and impacts on the liquidity of the instruments cleared and potential higher costs of clearing due to losses in margin efficiencies. In order to keep these costs to a minimum, however, the proposal introduces proportionate risk based requirements to protect the interests of clearing counterparties and their clients.
Will this result in market fragmentation?
The proposal features proportionate arrangements that strike the right balance between safeguarding financial stability and making sure the impact on markets is limited to the best extent possible.
The Commission remains committed to the system of equivalence. In order to avoid market fragmentation to the largest extent possible, specific arrangements based on objective criteria will be considered only for CCPs that play a key systemic role for EU financial markets and only where necessary.
The Commission expects supervisory authorities to remain vigilant as to the potential consequences for end users and the market in general, after the legislative proposal comes into force. We will strive to ensure that the implementation takes place as smoothly and seamlessly as possible.
What impact will existing equivalence decisions with non-EU jurisdictions have?
Regular reviews of all equivalence decisions have always been an integral part of the EU's equivalence framework all along. Unless there are regulatory or supervisory changes in the third-country or changed market circumstances, the proposal does not put into question the existing equivalence decisions adopted so far by the Commission.
In particular, the equivalence agreement with the US was hailed at its adoption as a major achievement in transatlantic cooperation and remains an important agreement in our bilateral cooperation. To date, the deal has proven fit for purpose, facilitating high-standard transatlantic OTC activities, while not putting financial stability at risk.
A derivative is a financial contract linked to the future value or status of the underlying to which it refers, for example the development of interest rates or of a currency value, or the possible bankruptcy of a debtor. Over-the-Counter (OTC) derivative contracts are not traded on an exchange but instead privately negotiated between two counterparties, for instance a bank and a manufacturer.
EMIR implements the 2009 G20 commitment to increase the stability of the OTC derivatives market in the EU. This commitment provides for all standardised OTC derivatives contracts to be cleared through central counterparties as well as OTC derivatives contracts to be reported to trade repositories.
EMIR establishes core requirements on OTC derivatives, central counterparties (CCP) and trade repositories (TR). These include:
Central counterparties (CCPs)
A CCP is an entity, which reduces systemic risk and enhances financial stability by standing between the two counterparties to a derivatives contract (i.e. acting as buyer to the seller and seller to the buyer of risk), thereby reducing the risk for both parties. A CCP's main purpose is to manage the risk that could arise if one of the counterparties is not able to make the required payments when they are due – i.e. defaults on the deal. CCPs are commercial firms. There are currently 17 European CCPs authorised and 28 third-country CCPs recognised under EMIR most of which clear various exchange traded or over-the-counter derivatives.