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December 10, 2019 |
Brexit – Reporting of Derivatives under EMIR

Click for PDF In the event of the United Kingdom leaving the European Union without an agreed deal on 31 January 2020, UK counterparties will need to make changes to their derivatives reporting arrangements in advance of that date to ensure that they comply with the UK’s European Market Infrastructure Regulation (“EMIR”) reporting requirements immediately post-Brexit. This briefing sets out what steps UK counterparties to derivatives transactions should take now in relation to their reporting arrangements to ensure a smooth transition on and after Brexit. EMIR and much of its secondary implementation legislation takes the form of a Regulation and is therefore (before exit) directly applicable in UK law. The European Union (Withdrawal) Act 2018 provides that EU legislation that is directly applicable, such as EU EMIR, will form part of UK law on exit day and gives power to the UK government to amend the legislation so that it operates effectively post-Brexit. Consequently, post-Brexit there will be two versions of EMIR: the original EU version which will continue to apply to EU counterparties to derivatives transactions, EU central counterparties (“CCPs”) and EU trade repositories (“TRs”) (“EU EMIR”); and the UK version incorporating amendments during the onshoring process to ensure the regime continues to operate effectively post-Brexit (“UK EMIR”). UK EMIR will operate parallel to EU EMIR. Both regimes aim to increase the resilience and stability of OTC derivative markets. UK EMIR sets out the regulatory regime relating to OTC derivatives transactions, CCPs and TRs in the UK. Like EU EMIR, UK EMIR imposes a number of requirements on derivatives market participants which include, among other things: The obligation to centrally clear certain standardised OTC derivative contracts; Requirements to reduce the risk arising from non-centrally cleared derivatives contracts through risk mitigation techniques; and The obligation to report derivatives transactions to a TR. From exit day onwards, UK counterparties to derivatives contracts will need to comply with UK EMIR rather than EU EMIR (assuming that the UK leaves the EU with no transitional arrangements in place), including in relation to the reporting of its derivatives transactions. The UK Financial Conduct Authority (“FCA”) released a statement to explain the changes that will be in store for TRs operating in the UK, UK counterparties and UK CCPs and what is expected with respect to compliance.[1] The UK government has confirmed that, as far as possible, the policy approach set out in the EMIR legislation will not change after the UK has left the EU. This is unsurprising given that much of EMIR derived from commitments made at international level at the G20 in 2009. What should UK counterparties be doing in advance of Brexit? Undertake an audit of the UK EMIR validation rules that will apply to reports submitted on or after Brexit to UK TRs. The UK EMIR validation rules diverge from the EU EMIR validation rules and therefore it is likely that operational changes will be necessary to ensure your UK EMIR reports are compliant post-Brexit. To the extent that a UK counterparty is currently reporting its trades to an EU TR, ensure that the necessary operational changes are made in advance of exit day to ensure that trades can be reported to a UK TR immediately post-Brexit. This may involve entering into new arrangements with a UK TR. For UK counterparties who have engaged a third party or their counterparty to perform their reporting for them (i.e., “delegated” reporting), engage with their third party service provider or counterparty to ensure that they are making any necessary changes to ensure compliance post-Brexit. Any UK counterparties who have accepted a delegation from clients and agreed to report on their behalf, where those clients are based in the EU, reporting will need to be provided to an EU TR post-Brexit and for UK clients, reporting will need to be made to a UK TR for those clients. Ensuring that the necessary operational changes are made will be critical for all firms providing delegated reporting services. As all outstanding derivatives contracts entered into by a UK counterparty on or after 16 August 2012 must be held in a UK TR (whether registered or recognised) on exit day, UK counterparties should engage with their TRs to ensure all relevant trades are identified and to understand the porting process to their UK TR of choice by the date of exit. What happens to outstanding trades post-Brexit? All outstanding derivative trades entered into by UK counterparties on or after 16 August 2012, must be held in a UK registered, or recognised, TR by 11:00 p.m. UK time on exit day. This will require derivatives transactions of UK counterparties that remain outstanding to be ported to a UK TR in time for exit day and will require the necessary steps to ensure that new derivatives transactions will be reported to a UK TR beginning on exit day. UK counterparties would be well-advised to engage with their TRs to ensure orderly porting to their UK TR of choice by exit day and to ensure that all their relevant trades have been identified. UK counterparties should note that any updates to these trades required after Brexit will need to be made to the UK TR and not to the original EU TR. ______________________    [1]   See FCA statement on the reporting of derivatives under the UK EMIR regime in a no-deal scenario, available at https://www.fca.org.uk/news/statements/fca-statement-reporting-derivatives-under-uk-emir-regime-no-deal-scenario (7 November 2019). Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions and Derivatives practice groups, or the authors: Michelle M. Kirschner – London (+44 20 7071 4212, mkirschner@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Please also feel free to contact any of the following practice leaders and members: Europe: Patrick Doris – London (+44 20 7071 4276, pdoris@gibsondunn.com) Amy Kennedy – London (+44 20 7071 4283, akennedy@gibsondunn.com) Michelle M. Kirschner – London (+44 20 7071 4212, mkirschner@gibsondunn.com) Lena Sandberg – Brussels (+32 2 554 72 60, lsandberg@gibsondunn.com) United States: Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Stephanie Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 9, 2019 |
Dodd-Frank 2.0: U.S. Agencies Revise the Volcker Rule on Proprietary Trading

Click for PDF Since it was enacted in July 2010, the Dodd-Frank Act’s Volcker Rule has challenged banks and their regulators alike.  This is particularly the case with respect to its restrictions on proprietary trading.  It has been one thing for former Federal Reserve Chairman Volcker to state that “you know it when you see it,” quite another to formulate a regulation that accurately defines proprietary trading and implements a broad statutory directive across complex business operations. On August 20, 2019, the Office of the Comptroller of the Currency and the Board of Directors of the Federal Deposit Insurance Corporation, Director Gruenberg dissenting, approved an expected rewrite of the regulation on proprietary trading, along with some minor amendments to the provisions governing private equity funds and hedge funds (Revised Rule).  The preamble stated that a new proposal to revise the funds’ provisions more broadly would be forthcoming.  The other Agencies charged with implementing the Volcker Rule are expected to follow. As with most of the revisions to Dodd-Frank since 2016, the revision – proposed in somewhat different form in June 2018 (2018 Proposal) – is a moderate approach that recalibrates the original regulation (Original Rule) and removes certain unworkable excesses.  This “Volcker 2.0” approach also focuses more intelligently on risk than the Original Rule and is more faithful to the statutory text.  At the same time, it still aligns with the most defensible reason for the Volcker Rule, maintaining the nature of banking institutions as customer-serving businesses.  The result is a pruning of some of the excesses of the Original Rule, while leaving the regulation targeted at banks with the largest trading operations. New Risk-Based Approach The Revised Rule, like the 2018 Proposed Rule, applies the statutory provisions differently depending on the size of a banking entity’s trading assets and liabilities.  It adopts a three-tiered approach, under which compliance obligations under the Rule’s market-making, underwriting, and risk-mitigating hedging exemptions, as well as overall compliance program requirements, differ based on the tier in which tier a banking entity finds itself. Tier Trading Assets/Liabilities[1] Significant $20 billion or more Moderate $1 billion to $20 billion Limited Less than $1 billion For non-U.S. banks, the final rule looks to the bank’s combined U.S. operations only, and not its worldwide operations, when determining in which tier to place the non-U.S. bank. The tiering revision alone is a substantial improvement.  The Original Rule deemed a banking entity worthy of heightened compliance obligations based on total asset size, and set that threshold at an irrationally low number – $50 billion.  Being based on amounts of trading assets and liabilities, the new tiers align more closely to the risks posed.  The Agencies raised the threshold of the “Significant” tier from $10 billion in the 2018 Proposal to $20 billion, but they declined to make changes to the other tiers. In addition, under the Economic Growth, Regulatory Relief and Consumer Protection Act of 2018, a banking entity is completely exempt from the proprietary trading restrictions if: It has, and is not controlled by a banking entity that has, total consolidated assets of $10 billion or less; and It has total trading assets and liabilities of 5% or less of total assets. New Definition of Proprietary Trading – Closer to the Statute The Dodd-Frank Act defined “proprietary trading,” as well as the associated term “trading account,” very obscurely: “[P]roprietary trading” . . . means engaging as principal for the trading account of the banking entity . . . in any transaction to purchase or sell, or otherwise acquire of dispose of, [Volcker covered financial instruments]. “[T]rading account” means any account used for acquiring or taking positions in [Volcker covered financial instruments] principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts [as determined by regulation].[2] The interpretive issue under these definitions is the concept of the “trading account.”  This is not a recognized term under prior banking law, nor do banking institutions organize their operations around such accounts.  For this reason, the Volcker Agencies originally took considerable leeway with the statutory text in expanding these definitions, with the result that most principal activity in covered financial instruments was brought within the trading prohibition, and then was required to find an exempted “permitted activity” like underwriting or market making to justify itself. Specifically, the Original Rule had three tests for determining what was proprietary trading, and one presumption that was rebuttable in theory, but not in fact: Purpose Test: a purchase and sale is principally for the purpose of short-term resale, benefiting from actual or expected short-term price movements, realizing short-term arbitrage profits, or hedging one or more such positions. Market-Risk Capital Test: the banking entity is subject to the market-risk capital rule and the financial instruments are both market-risk covered positions and trading positions (or hedges thereof). Status Test: the banking entity is licensed/registered as a dealer, swap dealer or security-based swap dealer, or the banking entity engages in any such business outside the U.S.; and the covered financial instrument is purchased and sold in connection with such activities. Rebuttable presumption that a short-term resale purpose exists if an instrument is held for fewer than 60 days, or its risk is substantially transferred within 60 days. The Revised Rule, by contrast, has two principal tests that will bind most institutions subject to the Revised Rule – the Market-Risk Capital Test and the Status Test.  The former has been slightly modified so as not to apply to a banking entity that is not consolidated with an affiliate that calculates risk-based capital ratios under the market risk capital rule for regulatory reporting purposes; the latter was substantively unchanged.  The Purpose Test is retained for those institutions that are not required to calculate market-risk capital, and do not elect to do so for Volcker purposes.  (Such an election must be for a banking entity and all its wholly-owned subsidiaries.)  The Revised Rule also reverses the Original Rule’s presumption so that, with respect to the Purpose Test, a position that is held for 60 days or more and where the risk is not substantially transferred within 60 days is presumed not to be proprietary trading. This simplification of the Original Rule is welcome and is a more reasonable construction of the statute.  First, the Purpose Test – which looked to a banking institution’s intent in purchasing and selling a Volcker instrument – is in many cases duplicative of the Market-Risk Capital Test.  It was also not unreasonably characterized by JPMorgan Chief Executive Officer Jamie Dimon as requiring “a lawyer and a psychiatrist” to analyze every trade.  Second, the Volcker Agencies never had enough staff to engage with banks on rebutting the 60-day presumption – this avenue of compliance was thus effectively read out of the Original Rule.  Finally, for reasons that were never persuasive, the Original Rule did not provide any indication of what period of time would suffice for a banking entity to have certainty that it was not proprietary trading. Expanded Exclusions from Proprietary Trading Certain purchase and sale transactions are wholly outside the Volcker Rule, some statutorily, some under the Original Rule.  The Revised Rule expands the number of regulatory exclusions to include: Purchases and sales of foreign exchange swaps and forwards, and cross-currency swaps (including nondeliverable cross-currency swaps), under the Liquidity Management Plan exclusion. Purchases and sales to correct bona fide trade errors; unlike the 2018 Proposal, there is no requirement that instruments bought or sold in such transactions be transferred to a special “trading error” account. For banking entities that are not dealers, swap dealers or security-based swap dealers, matched swap transactions entered into in connection with customer-driven swaps, such as a back-to-back swap entered into at the same time as a fixed-to-floating interest rate swap with a customer. Hedges of mortgage servicing rights or assets in connection with a documented hedging strategy. Purchases and sales of instruments that are not “trading assets” or “trading liabilities” under regulatory reporting forms. Revised Definition of “Trading Desk” For purposes of the conditions to the permitted activities of market-making and underwriting, the Original Rule included a definition of “trading desk,” the place where many of the conditions were measured.  In keeping with interpreting the statute’s restrictions broadly, the Original Rule defined the term as “the smallest discrete unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity or an affiliate thereof.”[3]  This definition did not align with the manner in which banking entities generally organized their businesses for operational, management or compliance purposes. The Revised Rule adopts a more flexible definition, which should align better with banks’ organizational structures and result in fewer compliance costs: “A unit of organization of a banking entity that purchases or sells financial instruments for the trading account of the banking entity or an affiliate thereof” that is either: Structured to implement a well-defined business strategy, organized to ensure appropriate setting, monitoring, and review of the desk’s limits, loss exposures and strategies, and characterized by a clearly defined unit that engages in coordinated trading activity with a unified approach to its key elements; operates subject to a common and calibrated set of risk metrics, risk levels and joint trading limits; submits compliance reports and other information as a unit for monitoring by management; and books its trades together; or For a banking entity that calculates risk-based capital ratios under the market risk capital rule, or a consolidated affiliate for regulatory reporting purposes of such a banking entity, established by the banking entity or its affiliate for purposes of market risk capital calculations under the market risk capital rule. Underwriting and Market-Making: RENTD Compliance Through Internal Limits The Volcker statute distinguishes permitted underwriting and market-making activities from impermissible proprietary trading in that the former are “designed not to exceed the reasonably expected near term demands of clients, customers, or counterparties” (RENTD).[4]  The Original Rule required “demonstrable analysis” of complex and opaque conditions as a means of satisfying the RENTD requirement, and in so doing, imposed considerable compliance obligations on banking entities.  In addition, studies since the enactment of the Volcker Rule found that liquidity in certain financial markets had been constrained[5] – itself a cause of supervisory concern. The Revised Rule seeks to reduce these obligations and increase market liquidity by permitting banking entities to make use of their own risk limits in showing compliance with the RENTD condition.  It therefore contains a rebuttable presumption of compliance with the Rule if a banking entity has established and implements, maintains, and enforces internal limits for the relevant trading desk designed to not to exceed RENTD.  The relevant supervisor may rebut the presumption of compliance if it believes that a banking entity’s trading desk is exceeding RENTD, after notice to the banking entity. With respect to underwriting, the internal limits must address, based on the nature and amount of the trading desk’s underwriting activities: the amount, types, and risk of its underwriting position; the level of exposures to relevant risk factors arising from its underwriting position; the period of time a security may be held; and the liquidity, maturity, and depth of the market for the relevant types of securities. With respect to market making, the internal limits must address: the amount, types, and risks of the trading desk’s market-maker positions; the amount, types, and risks of the products, instruments, and exposures the trading desk may use for risk management purposes; the level of exposures to relevant risk factors arising from its financial exposure; the period of time a financial instrument may be held; and the liquidity, maturity, and depth of the market for the relevant types of financial instruments. These limits are not required to be approved in advance, but they are subject to supervisory review and oversight on an ongoing basis.  Unlike the 2018 Proposal, the Revised Rule does not require banking entities to report limit breaches, but they must maintain and make available to their supervisors on request records regarding any limit that is exceeded and any temporary or permanent increase to a limit. If a banking entity breaches or increases a limit, the presumption of compliance will continue to be available only if the banking entity takes action as promptly as possible after a breach to bring the trading desk into compliance, and follows established written authorization procedures regarding the breach or increase, including demonstrable analysis of the basis for any temporary or permanent increase to a trading desk’s limit. In addition, the Revised Rule eliminates the specific compliance program requirements for the underwriting and market-making exemptions for banking entities that do not have significant trading assets and liabilities. Simplification of Hedging Permitted Activity; Risk-Tailored Compliance Like underwriting and market making, risk-mitgating hedging is an activity permitted by the statute even if it involves a purchase and sale of an instrument in the short term.  The Original Rule imposed substantial conditions on this activity, however, in an effort to guard against abuse.  These original conditions imposed a significant compliance burden and were not easily monitored in practice.  In particular, the requirements that the banking entity conduct a correlation analysis and continuously show that the hedge was demonstrably reducing or significantly mitigating identifiable risks was a significant challenge. The Revised Rule simplifies the conditions to risk-mitigating hedging and gives banking entities more flexibility in demonstrating compliance.  It removes the Original Rule’s requirements that a banking entity undertake a correlation analysis and show that the hedge was demonstrably reducing or significantly mitigating identifiable risks.  Instead, and more closely following the statute, the hedging must be “designed to reduce or otherwise significantly mitigate one or more specific, identifiable risks” being hedged and be “subject, as appropriate, to ongoing calibration” to ensure that the hedging does not become prohibited trading. In addition, for banking entities that have only moderate trading activities (greater than $1 billion in trading assets/liabilities but less than $20 billion), the Revised Rule reduces the scope of the required compliance program.  For such firms, the requirement for a separate internal compliance program for hedging has been eliminated, as well as certain specific requirements,[6] limits on compensation arrangements for persons performing risk-mitigating activities, and documentation requirements. For banking entities that have significant trading activities, the Revised Rule moderates the Original Rule’s requirement for maintaining additional documentation for hedges and hedging techniques not established by a trading desk’s policies and procedures.  The requirement does not apply to purchases and sales of financial instruments for hedging activities that are identified on a written list of financial instruments pre-approved by the banking entity that are commonly used by the trading desk for the specific types of hedging activity, if the banking entity complies with appropriate pre-approved limits for the trading desk when doing the hedging. Relaxation of Trading Outside the United States (TOTUS) Requirements Unlike many statutes, the Bank Holding Company Act of which the Volcker Rule is a part applies extraterritorially, subject to specific exemptions for non-U.S. banking organizations.  The Revised Rule relaxes the conditions that the Original Rule applied to the permitted activity of a non-U.S. bank trading “outside the United States,” the so-called TOTUS permitted activity.  In so doing, the Revised Rule focuses more clearly on potential risks to the United States caused by TOTUS activity. Under the new conditions, a trade qualifies for TOTUS if: the banking entity engaging as principal in the purchase or sale (including relevant personnel) is not located in the United States or organized under the laws of the United States or of any State; the banking entity (including relevant personnel) that makes the decision to purchase or sell as principal is not located in the United States or organized under the laws of the United States or of any State; and the purchase or sale, including any transaction arising from risk-mitigating hedging related to the instruments purchased or sold, is not accounted for as principal directly or on a consolidated basis by any branch or affiliate that is located in the United States or organized under the laws of the United States or of any State. Unlike the Original Rule, the trade can be with a U.S. counterparty and financing for the trade can be provided by the U.S. offices of the non-U.S. banking entity.  A non-U.S. banking entity may also use a non-affiliated U.S. investment adviser in the trade as long as the actions and decisions of the banking entity as principal occur outside of the United States. Modest Revisions to Covered Fund Provisions The Revised Rule makes only minor revisions to the Volcker funds restriction; the preamble states a new proposal on this subpart will be forthcoming.  In particular, the thorny question of whether a foreign excluded fund should be exempted from the definition of “banking entity” is left for another day, with some indication that the Agencies may still believe this is a question for Congress.[7]  The only amendments are the following: The Revised Rule removes the Original Rule’s requirement that banking entities include for purposes of the aggregate fund limit and capital deduction the value of any ownership interests of a third-party covered fund (i.e., covered funds that the banking entity does not advise or organize and offer) acquired or retained in accordance with the underwriting or market-making exemptions. The Revised Rule permits a banking entity to acquire or retain an ownership interest in a covered fund as a hedge when acting as intermediary on behalf of a customer that is not itself a banking entity to facilitate the exposure by the customer to the profits and losses of the covered fund (as in a fund-linked note). The Original Rule’s prohibition of such activities had no clear statutory basis. The Revised Rule removes the Original Rule’s condition to the SOTUS fund exemption that no financing be provided by U.S. offices. The Revised Rule codifies the Agency staff interpretation that the SOTUS marketing restriction applies only to funds sponsored by – and not to third-party funds invested in – by non-U.S. banking entities.[8] Tiered, Risk-Base Compliance Regime Consistent with its approach to risk, the Revised Rule substantially modifies the required compliance regime for banking entities with moderate and limited trading assets and liabilities.  Significantly, the CEO certification, which the Original Rule had required for banking entities with $50 billion or greater in total consolidated assets, is eliminated for all such banking entities.  This in itself is significant regulatory relief.  In addition, the six-pillar compliance regime of the Original Rule applies only to banking entities with significant trading assets and liabilities.  Banking entities with only moderate trading assets and liabilities may include in their existing compliance policies and procedures appropriate references to the Volcker Rule and its implementing regulation, with adjustments as appropriate given the activities, size, scope, and complexity of the banking entity.  Entities with limited trading assets and liabilities benefit from a rebuttable presumption of compliance with the Volcker Rule. Effective Date The Revised Rule will be effective on January 1, 2020.  In order to give banking entities a sufficient amount of time to comply with the changes adopted, banking entities will not be required to comply with the Revised Rule until January 1, 2021.  Because the Revised Rule relaxes the Original Rule’s requirements, the Agencies are permitting banking entities to comply voluntarily, in whole or in part, with the Revised Rule prior to January 1, 2021, subject to the Agencies’ completion of necessary technical changes, principally with respect to metrics reporting.[9] Conclusion Ultimately, the fundamental issue with the Volcker Rule is the statute Congress passed.  In an effort to cover every activity that could be proprietary trading, while at the same time using opaque and imprecise language, Congress ensured a “hard slog” for both banking entities and their supervisors.  The Original Rule compounded this problem by interpreting the statute to expand its reach in virtually all close cases.  The Revised Rule appropriately takes a different approach, focusing on what is the overall purpose of Dodd-Frank:  the reduction of risk to banking entities and the financial system more broadly.  By streamlining overall requirements, and focusing most stringently on the banking entities with the largest trading portfolios, “Volcker 2.0” provides better guidance to banking entities and will be easier for regulators to enforce. [1]   For purposes of these thresholds, the amount of trading assets and liabilities are calculated as the “average gross sum” of assets and liabilities on a trailing 4-quarter basis, and the following obligations are excluded:  U.S. government- and U.S. government agency-issued and -guaranteed securities, and securities issued or guaranteed by certain government-sponsored enterprises. [2]   12 U.S.C. §§ 1851(h)(4), (h)(6). [3]   12 C.F.R. § 248.3(e)(13). [4]   12 U.S.C. § 1851(d)(1)(B). [5]   See, e.g., J. Bao, M. O’Hara & A. Zhou, “The Volcker Rule and Market-Making in Times of Stress,” Finance and Economics Discussion Series 2016-102, Washington: Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2016.102, at 3 (“Our results show that bond liquidity deterioration around rating downgrades has worsened following the implementation of the Volcker Rule. We find such adverse effects whether we benchmark to the pre-crisis period or to the period just before the Volcker Rule was enacted, and we find that the relative deterioration in liquidity around these stress events is as high during the post-Volcker period as during the Financial Crisis. Given how badly liquidity deteriorated during the Financial Crisis, this finding suggests that the Volcker Rule may have serious consequences for corporate bond market functioning in stress times.”). [6]   These requirements include the requirements that at inception, the hedging position not give rise to significant new or additional risk that is not hedged contemporaneously and that hedging activity be subject to continuous review, monitoring and management. [7]   Stating that “[c]ertain concerns raised by commenters may need to be addressed through amendments to section 13 of the BHC Act,” the preamble notes how community banks were statutorily excluded from the definition of “banking entity” in 2018. [8]   The Revised Rule also clarifies that the SOTUS exemption does not preclude a non-U.S. banking entity from engaging a non-affiliated U.S. investment adviser as long as the actions and decisions of the banking entity to invest in a fund occur outside of the United States. [9]   In a formal acknowledgment of what Agency staff had previously unofficially stated, the Revised Rule relaxes the metrics that banking entities with significant trading assets and liabilities have to report. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or the following: Matthew L. Biben – New York (+1 212-351-6300, mbiben@gibsondunn.com) Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) James O. Springer – New York (+1 202-887-3516, jspringer@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

June 5, 2019 |
EMIR Refit Enters into Force on June 17, 2019 – Impacts and Action Items for End-Users

Click for PDF On May 28, 2019, final text was published in the Official Journal of the European Union (“OJEU”) for substantive amendments to the European Market Infrastructure Regulation (“EMIR”)[1] relating to the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for uncleared OTC derivatives contracts, the registration and supervision of trade repositories, and the requirements for trade repositories (“EMIR Refit”).[2]  EMIR Refit becomes effective on June 17, 2019 (20 days after publication in the OJEU)[3], and most of its provisions will begin applying on that date, while others will be phased in. Many of the changes of EMIR Refit aim to reduce compliance costs for end-user counterparties that are non-financial counterparties (“NFCs”) and smaller financial counterparties (“FCs”).  Some of these changes include (i) an exemption from the reporting of intragroup transactions; (ii) an exemption for small FCs from the clearing obligation, (iii) removal of the obligation and legal liability for reporting when an NFC transacts with an FC, and (iv) a determination of the NFC clearing obligation on an asset-class-by-asset-class basis.  While these amendments provide relief, end-users should be keenly aware of the nuances of the text of EMIR Refit, the extent to which relief applies, the timing and steps involved in these changes and any notifications which must be filed.  In particular, with the fast-approaching June 17, 2019 implementation date for EMIR Refit, end-users should take note of two immediate action items.  The first relates to an end-user’s requirement to perform a new calculation to determine whether or not it exceeds the clearing threshold, while the second requires an end-user to file a notification with the relevant national competent authorities (“NCAs”) in order to take advantage of an exemption for the reporting of intragroup transactions. In this alert, we outline some of the key impacts of EMIR Refit on end-users, including the changes to the clearing threshold calculations, the intragroup exemption from reporting and the relief provided to shift responsibility of the reporting obligation from NFCs below the clearing threshold to FCs, as well as the action items resulting from these changes.[4] I.  Changes to Clearing Threshold Calculation – Immediate Action Required EMIR Refit creates a new regime to determine when an NFC and an FC are subject to the clearing obligation.  These determinations will be based on whether the position of an NFC or an FC, as applicable, exceeds the requisite clearing thresholds.  In particular, the NFCs and FCs must determine whether their aggregate month-end average position for the previous 12 months across the entire group exceeds any of the thresholds for a particular asset class.  If an NFC or FC does not make this calculation by June 17, 2019, or if it exceeds the calculation, it must notify the European Securities and Markets Authority (“ESMA”) and the relevant NCA immediately and such NFC or FC will become subject to the clearing obligation beginning four months following such notifications.[5]  Further, NFCs and FCs that are currently subject to the clearing obligation and that remain subject to the clearing obligation under EMIR Refit must still provide notifications to ESMA and the relevant NCA. A.  Impacts on and Action Items for NFCs Under EMIR Refit, whether an NFC is subject to the clearing obligation is separately determined for each particular asset class for which the clearing threshold is exceeded.  Previously, EMIR required that if an NFC exceeded the clearing threshold in one asset class, then all of its OTC derivatives would be subject to the clearing obligation (to the extent the clearing obligation was applicable); however, EMIR Refit modifies this “all or nothing” requirement for NFCs.  Instead, the clearing obligation under EMIR Refit is determined on an asset-class-by-asset-class basis such that an NFC may exceed the clearing threshold for one asset class and be subject to the clearing obligation for that asset class, but may not be subject to the clearing obligation for other asset classes where the NFC does not exceed the clearing threshold.  If an NFC exceeds the clearing obligation in one asset class, it is nonetheless subject to margin requirements for all of its OTC derivatives transactions as the NFC exemption from margin for OTC derivatives remains an “all or nothing” determination.[6] EMIR Refit changes the way in which the entities calculate their positions by replacing Articles 10(1) and (2) of EMIR (which provided that NFCs are required to determine whether their rolling average position over 30 working days) with new provisions that provide that NFCs may calculate, every 12 months, their aggregate month-end average OTC derivatives positions for the previous 12 months across their entire worldwide group and for each asset class.[7]  NFCs would exclude from the calculation transactions that are “objectively measurable as reducing risks related to commercial activity or treasury financing activity” of the NFC or the NFC group (e.g., hedging transactions do not count towards the clearing threshold calculation) but would include intragroup transactions in the calculation.[8]  This average position in each asset class must then be compared against the following clearing thresholds[9]: Asset class Gross Notional Threshold Credit Derivatives €1 billion Equity Derivatives €1 billion Interest Rate Derivatives €3 billion Foreign Exchange Derivatives €3 billion Commodity and Other Derivatives €3 billion The first calculation must be performed by June 17, 2019 and once a year thereafter.  As mentioned above, if an NFC does not calculate its positions it will by default become subject to the clearing obligation in all asset classes.  We note that NFCs that make the calculation and determine that they fall below the clearing threshold in all asset classes, while not required to notify ESMA or their NCA, will nonetheless be required to notify their counterparties.  Indeed, ESMA recently updated its EMIR Q&A to explain that a “counterparty should obtain representations from its counterparties detailing their status” and noted that if a representation is not obtained from a counterparty it must be assumed that the counterparty is subject to the clearing obligation.[10] Four Key Action Items for NFCs Collect the necessary data and calculate OTC derivatives positions by asset class by June 17, 2019 and compare against the clearing thresholds (failure to do so will render the NFC subject to the clearing obligation and margin requirements).  NFCs should make such calculation in accordance with the requirements under EMIR Refit and should maintain appropriate documentation of such calculation for audit purposes. Notify ESMA and the relevant NCA (i) if the clearing threshold is breached in one or more asset classes or (ii) if no calculation is performed.  In the event the notifying NFC is subject to the clearing obligation, such NFC is required to establish clearing arrangements within four months of the notification. Notify counterparties of clearing status (i.e., whether above or below the threshold) and make any relevant changes to existing documentation. Ensure that reporting fields are consistent with any changes to the NFC’s clearing requirements. Impacts on and Action Items for Small FCs EMIR Refit enables certain FCs with limited OTC derivatives activities to be excluded from the clearing obligation.  Previously, EMIR required all FCs to comply with the relevant clearing requirements regardless of the amount of their activities such that every FC was subject to the clearing obligation.  By comparison, the exclusion for FCs is much more limited than the exclusion for NFCs; unlike NFCs, FCs are required to include all OTC derivatives activities in their clearing threshold calculation, including hedging transactions, and FCs maintain the “all or nothing” calculation and do not benefit from the more nuanced asset-class-by-asset-class determination.[11]  In all cases, FCs will remain subject to margin requirements on OTC derivatives.[12] Under EMIR Refit, FCs may calculate, every 12 months, their aggregate month-end average OTC derivatives positions for the previous 12 months across their entire worldwide group and for each asset class.  FCs would not exclude any OTC derivatives transactions from these calculations and would include hedging and intragroup transactions for other entities within the FC’s group.  This average position in each asset class must then be compared against the same clearing thresholds described above for NFCs. Just like NFCs, FCs must make their first calculation by June 17, 2019 and then each year thereafter.  Those FCs that do not make the calculation or that exceed the clearing threshold in one asset class would be subject to the clearing obligations in all asset classes and must notify ESMA and the relevant NCA immediately.  Further, even those FCs that fall below the clearing threshold will be required to notify by their counterparties of their status. Four Key Action Items for FCs Collect the necessary data and calculate OTC derivatives positions by asset class by June 17, 2019 and annually thereafter (failure to do so will render the FC subject to the clearing obligation).  FCs should make such calculation in accordance with the requirements under EMIR Refit and should maintain appropriate documentation of such calculation for audit purposes. Notify ESMA and relevant NCA (i) if the clearing threshold is breached in one or more asset classes or (ii) if no calculation is performed.  In the event the notifying FC is subject to the clearing obligation, such FC is required to establish clearing arrangements within four months of the notification. Notify counterparties of clearing status (i.e., whether above or below the threshold) and make any relevant changes to existing documentation. Ensure that reporting fields are consistent with any changes to the FC’s clearing requirements. II.  Exemption from Intragroup Transaction Reporting – Immediate Action Required Under the current reporting requirements in Article 9 of EMIR, all counterparties subject to EMIR are required to report their intragroup transactions (i.e., inter-affiliate transactions) to a trade repository.  However, effective June 17, 2019, EMIR Refit provides relief to NFCs from the requirement to report these intragroup transactions in certain circumstances.  Specifically, EMIR Refit provides an exemption from the reporting of derivatives contracts “within the same group where at least one of the counterparties is [an NFC] or would be qualified as [an NFC] if it were established in the [EU]” subject to the following criteria: Both counterparties are included in the same consolidation on a full basis; Both counterparties are subject to appropriate centralized risk evaluation, measurement and control procedures; and The parent undertaking is not an FC.[13] While this intragroup exemption from reporting is likely to provide significant relief to NFCs (particularly the global nature of the exemption), it is important to note that the exemption is not self-executing and that notification to the relevant NCA is required.  Specifically, the text requires counterparties wishing to take advantage of the exemption to “notify their competent authorities of their intention to apply the exemption.”[14]  The text further explains that “[t]he exemption shall be valid unless the notified competent authorities do not agree upon the fulfilment of the conditions [of such exemption] within three months of the date of notification.”[15] The language as drafted lacks some clarity as to how such notification to an NCA may be achieved in order to perfect this intragroup exemption.  For example, it is not clear what form the notification must take, whether it can cover multiple entities and whether a notification for one jurisdiction on behalf of the group may be recognized in another jurisdiction.  Further, while EMIR Refit creates a notification requirement and not an “approval” requirement, market participants must determine whether they seek to take advantage of the intragroup exemption upon notification to the NCA(s) or choose to wait until the three-month NCA response period lapses. NCAs may have different views and requirements with respect to what is required of this notification, but a multinational corporation with affiliates in multiple EU countries may be required to notify the NCA of each jurisdiction in which an affiliate seeking to rely on the intragroup exemption is located.  Accordingly, any counterparty seeking to take advantage of the intragroup exemption should review whether its NCA has provided guidance regarding the notification and/or reach out to its NCA to review with the applicable notification requirements for purposes of claiming the intragroup exemption.[16] Key Action Item for NFCs Those NFCs that wish to rely on the intragroup exemption from reporting must notify their relevant NCAs that they intend to rely on the exemption in order for such exemption to be available (following such notification(s), the intragroup exemption will apply unless the NCA responds three months to inform the NCA that it does not agree that the conditions for the intragroup exemption are met). III.  Changes to Reporting Obligation for NFCs Below the Clearing Threshold (“NFC-s”) Article 9 of EMIR currently provides a dual-sided reporting regime where all parties subject to EMIR must report the details of their OTC derivatives to a trade repository.  EMIR Refit seeks to ease these reporting burdens for NFC-s by providing that FCs will be “solely responsible and legally liable” for reporting contracts concluded with an NFC- on behalf of both counterparties, as well as for ensuring the accuracy of the details so reported.[17]  In other words, EMIR Refit does not create a single-sided reporting regime, but rather modifies its existing dual-sided reporting regime such that the FC will be responsible for reporting data for itself and for the NFC- where the NFC- retains no legal liability for the reporting of such data or the accuracy of the details of such data.[18]  NFC-s are responsible for providing the FC that is reporting the data with the details of the contracts that the FC “cannot be reasonably expected to possess” and the NFC- will remain responsible for the accuracy of that information.[19] EMIR Refit notably does not extend this reporting relief to OTC derivatives between an NFC- and a third-country counterparty that would be an FC if established in the EU (a “third-country FC”), unless the third-country reporting regime has been deemed equivalent and the third-country FC has reported the relevant transactions under such equivalent regime.  These restrictions on third-country FCs are particularly important given that the United States has not been deemed an equivalent regime and counterparties domiciled in the United Kingdom will become third-country FCs following the United Kingdom’s expected exit from the EU later this year.[20] Additionally, EMIR Refit provides NFC-s that have already invested in a reporting system with the option to opt out of this new regime and continue to report the details of their contracts that have been executed with FCs in the same manner as they report under EMIR, rather than having the FC counterparty report on behalf of the NFC-, by informing the FC that they would like to do so.[21] Unlike the intragroup exemption and the changes to the clearing obligation, these changes to the reporting obligation do not come into force until June 18, 2020. Three Key Action Items for NFC-s NFC-s should identify which of their counterparties are FCs in order to determine the counterparty relationships that will benefit from this relief and those where the NFC- will retain the reporting obligation (this will help to identify where delegated reporting agreements can be terminated and where they should remain in place). Provide information to FC counterparties that they cannot reasonably be expected to possess (FCs will likely reach out for this information (e.g., whether a transactions is a hedging transaction)). NFC-s that wish to opt out of the new reporting regime and continue to report the details of their OTC derivatives should notify their FC counterparties as soon as possible.    [1]   Regulation (EU) No 648/2012 of the European Parliament and Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories.    [2]   Regulation (EU) No 2019/834 of the European Parliament and Council of 20 May 2019 amending Regulation (EU) No 648/2012 as regards the clearing obligation, the suspension of the clearing obligation, the reporting requirements, the risk-mitigation techniques for OTC derivatives contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories.    [3]   In 2015, the European Commission conducted a comprehensive review of the EMIR to help to reduce disproportionate costs and burdens imposed by EMIR and simplify rules without putting financial stability at risk.  This review included, among other things, the European Commission’s Public Consultation on the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories and their broader Call for Evidence on the European Union (“EU”) regulatory framework for financial services.  See Public Consultation on Regulation (EU) No 648/2012 on OTC Derivatives, Central Counterparties and Trade Repositories; see also Call for Evidence, EU Regulatory Framework for Financial Services.  Following this review, on May 4, 2017, the European Commission proposed amendments to EMIR in the context of its Regulatory Fitness and Performance (Refit) program.  The EU Council published its compromise text on December 11, 2017 and ECON Committee report was adopted by EU Parliament on May 16, 2018.  The EU Council and EU Parliament reached political agreement on EMIR Refit on February 5, 2019.  Following that, Parliament’s ECON Committee approved the text, it was approved in plenary, adopted by EU Council and ultimately signed on May 20, 2019.    [4]   EMIR Refit also (i) extends the definition of “financial counterparties” to include EU alternative investment funds (AIFs) and their EU alternative investment fund managers (AIFMs); (ii) ends the frontloading requirement; (iii) ends the backloading requirement; (iv) provides power for ESMA and the European Commission to suspend the clearing and derivatives trading obligation; (v) extends the clearing exemption for risk-reducing transactions of pension schemes for two additional years with the ability to extend further; (vi) creates an obligation to provide clearing services on fair, reasonable, non-discriminatory and transparent terms (FRANDT); and (vii) requires regulators to validate risk management procedures for the exchange of collateral.    [5]   See ESMA Public Statement, Implementation of the new EMIR Refit regime for the clearing obligation for financial and non-financial counterparties, March 28, 2019, available at https://www.esma.europa.eu/sites/default/files/library/esma70-151-2181_public_statement_on_refit_implementation_of_co_regime_for_fcs_and_nfcs.pdf.    [6]   Recital (8) of EMIR Refit explains that “[NFCs] should nonetheless remain subject to the requirement to exchange collateral where any of the clearing thresholds is exceeded.”    [7]   Article 1(8)(a) of EMIR Refit.    [8]   Article 10(1) of Commission Delegated Regulation (EU) No 149/2013.    [9]   The clearing thresholds are defined under Article 11 of Commission Delegated Regulation (EU) No 149/2013. [10]   ESMA, Questions and Answers, Implementation of the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (EMIR), pp. 21-22 (May 28, 2019). [11]   Article 1(3) of EMIR Refit. [12]   Recital (7) of EMIR Refit explains that “small financial counterparties should be exempted from the clearing obligation, but they should remain subject to the requirement to exchange collateral to mitigate any systemic risk.” [13]   Article 1(7)(a) of EMIR Refit. [14]   Id. [15]   Id. [16]   We note that some NCAs have provided guidance or forms on how notification of the reliance on the intragroup exemption should be submitted while others have not.  See, e.g., EMIR: FCA Notification for an Intragroup Exemption from Reporting, available at https://www.fca.org.uk/publication/forms/emir-reporting-exemption-form.pdf. [17]   Article 1(7)(b) of EMIR Refit. [18]   While many NFC-s currently delegate the reporting responsibility to their counterparties, under EMIR delegated reporting the NFC-s retain the legal liability to report and for the accuracy of the data that is reported by the counterparties on the NFC-’s behalf. [19]   Id. [20]   For example, if an NFC- were to transact with an EU bank, the NFC- would no longer have a reporting obligation; however, if the NFC- were to transact with a US-based bank, the NFC- would retain the reporting obligation and delegated reporting would likely be desired. [21]   It should be noted that if an NFC- decides to opt-out of the new EMIR Refit reporting regime, it will retain the legal liability for reporting the OTC derivatives data as well as the liability for ensuring the accuracy of such data. The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner and Erica Cushing. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions and Derivatives practice groups, or any of the following: Europe: Patrick Doris – London (+44 20 7071 4276, pdoris@gibsondunn.com) Amy Kennedy – London (+44 20 7071 4283, akennedy@gibsondunn.com) Lena Sandberg – Brussels (+32 2 554 72 60, lsandberg@gibsondunn.com) United States: Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Erica N. Cushing – Denver (+1 303-298-5711, ecushing@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

May 16, 2019 |
Impact of CFTC’s Proposed Amendments to Swap Data Reporting Requirements on Reporting and Non-Reporting Counterparties

Click for PDF On May 13, 2019, the Commodity Futures Trading Commission (the “Commission” or the “CFTC”) published a notice of proposed rulemaking titled Proposed Amendments to the Commission’s Regulations Relating to Certain Swap Data Repository and Data Reporting Requirements (the “Proposal”).[1]  The Proposal seeks to modify existing swap data reporting requirements in Part 23 of the Commission’s regulations for swap dealers (“SDs”) and major swap participants (“MSPs”), Parts 43 and 45 of the Commission’s regulations for “reporting parties” and “reporting counterparties” (as such terms are defined in the Commission’s regulations),[2] and Part 49 of the Commission’s regulations for swap data repositories (“SDRs”).  The Proposal is the first rulemaking adopted by the CFTC following its Division of Market Oversight’s (the “Division”) July 2017 comprehensive analysis of the CFTC’s swap data reporting regulations, which was titled the Roadmap to Achieve High Quality Swaps Data (the “Roadmap”).[3]  In the Roadmap, the Division solicited public feedback on potential improvements to the CFTC’s swap data reporting regime in a manner that would achieve the CFTC’s regulatory goals of swap data transparency under the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”)[4] without imposing unnecessary burdens on market participants. Consistent with the Roadmap’s goals, the CFTC’s expressed objectives in adopting the Proposal are to “improve the accuracy of data reported to, and maintained by, SDRs,” “require reporting counterparties to verify the accuracy of swap data pursuant to […] SDR procedures,” and “provide enhanced and streamlined oversight over SDRs and data reporting generally.”[5]  The CFTC notes that the Proposal is the first of three planned rulemakings as described in the Roadmap.[6]  While most of the Proposal’s amendments are intended to modify Part 49 of the Commission’s regulations, which covers SDR registration requirements, SDR operational duties, and the CFTC’s oversight over SDRs generally, the Proposal also would make certain substantive amendments to the swap data reporting requirements for SDs and MSPs under Part 23 and reporting counterparties (and non-reporting counterparties) under Parts 43 and 45 (the “Counterparty Reporting Rules”).[7]  This Client Alert focuses on the Proposal’s modifications to the Counterparty Reporting Rules.  With respect to the Counterparty Reporting Rules, the Proposal notes that current swap data that is available to the CFTC lacks accuracy.  This view has been specifically echoed by CFTC Chairman J. Christopher Giancarlo and several other past and current CFTC Commissioners.[8] To address these concerns regarding accuracy and data quality, the Proposal includes specific amendments to the Counterparty Reporting Rules.  In particular, the Proposal, if adopted, would establish:  (1) new swap data accuracy verification requirements for reporting counterparties within certain timeframes depending on the type of reporting counterparty (i.e., different requirements for SDs/MSPs versus non-SDs/MSPs); (2) revisions to existing swap data error and omission rules for reporting counterparties; and (3) enhanced requirements for SDs and MSPs in terms of their written policies and procedures for swap data reporting under Parts 43 and 45 of the Commission’s regulations.  In the sections below, we have summarized each of these three proposed amendments to the Counterparty Reporting Rules and its impact on the reporting counterparties. The Proposal’s comment period deadline is July 29, 2019.  Since the Proposal and two anticipated proposed rulemakings that are expected to follow will address interconnected issues, the CFTC plans to re-open the comment period for the Proposal at the same time it issues each anticipated rulemaking so that commenters can provide comments on the three rulemakings altogether. Please contact a member of Gibson Dunn’s Derivatives Team if you have any questions regarding the Proposal. 1.    Swap Data Verification The Proposal, if adopted, would establish new swap data accuracy verification requirements for reporting counterparties within certain timeframes depending on the type of reporting counterparty.  The Proposal’s amendments relating to data verification fall under Part 45 of the Commission’s regulations, which generally focuses on the duties of reporting counterparties to report swap data to SDRs for regulatory purposes.  The current Counterparty Reporting Rules do not explicitly require reporting counterparties to verify the data reported with the relevant SDR.  However, the Proposal would create a mandate that all reporting counterparties must verify their swap data for accuracy and completeness with reports provided by the SDR.[9]  Effectively, the Proposal would require a reporting counterparty to reconcile their internal books and records for each open swap against any and all open swaps reflected in an open swap report received from an SDR.[10]  Further, reporting counterparties would be required to conform to any swap data verification policies and procedures enacted by an SDR.[11] The Proposal includes specific timing requirements for reporting counterparty data verification as well as the timing of the frequency of the open swaps reports to be distributed by the SDR.  The open swaps reports must be distributed by the SDR to SD, MSP and DCO reporting counterparties on a weekly basis and to non-SD and non-MSP reporting counterparties on a monthly basis.[12]  Upon receipt and review of the open swaps report, reporting counterparties must submit either a (i) verification of data accuracy[13] or (ii) notice of discrepancy in response to every open swaps report received from an SDR within the following timeframes:  (a) 48 hours of the SDR’s providing the open swaps report if the reporting counterparty is a SD or MSP; or (b) 96 hours of the SDR’s providing the open swaps report for non-SD/MSP reporting counterparties.[14]  In the event that the reporting counterparty finds no discrepancies between its books and records and the data in the SDR’s open swap report, the reporting counterparty must nonetheless submit a verification of data accuracy indicating that the swap data is complete and accurate to the SDR in accordance with the aforementioned timing requirements.[15]  If, however, the reporting counterparty finds a discrepancy in the swap data (i.e., over-reporting or under-reporting), the reporting counterparty must submit a notice of discrepancy to the SDR in accordance with the timing outlined above.[16] The Commission explains that the Proposal’s swap data verification rules aim to improve swap data quality by facilitating the swift resolution of any discrepancies between the swap data maintained by an SDR and the information on record with a reporting counterparty.  However, the data verification requirements of the Proposal would impose new and notable obligations on all reporting counterparties (including smaller, non-SD/non-MSP reporting counterparties) that are not in existence under today’s reporting rules.  In particular, the Proposal would require reporting counterparties to review the SDR’s policies and procedures around the verification process, to build comprehensive systems to verify the swap data reported to the SDR by comparing its internal records against open swaps reports received from the SDR, and to send verification or discrepancy notices to the SDR within relatively short timeframes.  As reporting counterparties already report information to SDRs under the Counterparty Reporting Rules, the Commission expressed its belief that SDRs and reporting counterparties would coordinate with one another to implement a system which is efficient and convenient for both parties, with particular attention to not be unnecessarily burdensome to non-SD/MSP and non-derivatives clearing organization reporting counterparties.[17]  Further, many reporting counterparties report swap data to more than one SDR and given that each SDR will have its own unique policies and procedures, the verification process will differ between SDRs. 2.    Changes to Errors and Omissions Reporting If adopted, the Proposal would also revise the swap data error and omission correction requirements for reporting counterparties.[18]  Currently, the error and omission correction requirements under Part 43 and those under Part 45 have substantive differences from one another.  For example, Part 43 requires a reporting counterparty that “becomes aware of an error or omission in the swap transaction and pricing data” to “promptly notify the other party of the error and/or correction” while Part 45 does not have a similar notification requirement for the reporting counterparty to provide such notice.[19]  The Proposal would seek to fix the gaps between the two rules and would require reporting counterparties to correct any errors and omissions to which they may be aware, including, but not limited to, errors or omissions present in the swap data in the open swaps reports provided as part of the verification process specific in the Proposal.  For example, Proposed regulations 43.3(e)(1) and 45.14(b)(1) provide that to the extent that a reporting counterparty becomes aware of any error or omission in swap data previously reported to an SDR, the reporting counterparty must submit corrected swap data to the SDR.[20]  The error and omissions correction requirements would apply regardless of the state of the swap.  In other words, it would include the correction of live swaps and swaps that are no longer active (i.e., which are commonly referred to as “dead trades”). In addition, the Proposal would establish specific error and correction procedures for reporting counterparties.  In particular, the Proposal would retain the current error and correction procedure in the Counterparty Reporting Rules that requires reporting counterparties to correct swap data “as soon as technologically practicable” following discovery of the errors or omissions.[21]  The Proposal would modify the “as soon as technologically practicable” timing requirement by creating a backstop of three business days after the discovery of the error or omission.[22]  In the event that the reporting counterparty is unable to correct errors or omissions within three business days of discovery, the Proposal would require the reporting counterparty to immediately inform the Director of DMO, or such other CFTC employees whom the Director of DMO may designate, in writing, of the errors or omissions and provide an initial assessment of the scope of the errors or omissions and an initial remediation plan for correcting the errors or omissions.[23]  Proposed regulations 43.3(e)(1)(iii) and 45.14(b)(1)(iii) would require that a reporting counterparty conform to the SDR’s policies and procedures for correction of errors and omissions that the SDRs would be required to create under the Proposal.[24] The Proposal would also establish new requirements for non-reporting counterparties.  Proposed regulations 43.3(e)(2) and 45.14(b)(2) would require a non-reporting counterparty that “by any means becomes aware” of an error or omission in swap data previously reported to an SDR, or the omission of swap data for a swap that was not previously reported to an SDR as required, to notify its counterparty to the swap (i.e., the reporting counterparty) as soon as technologically practicable following discovery of the errors or omissions, but no later than three business days following the discovery of the errors or omissions.[25]  This section of the Proposal also specifies that a non-reporting counterparty that does not know the identity of the reporting counterparty for a swap must notify the SEF or DCM where the swap was executed of the errors or omissions as soon as technologically practicable following discovery of the errors or omissions, but no later than three business days after the discovery.[26]  In the Proposal, the Commission expressed its hope that the requirement to correct all swap data, regardless of status, would ensure that reporting counterparties establish and maintain properly functioning reporting systems to prevent the reporting of errors or omissions. The Proposal’s modifications to the errors and omissions correction requirements would notably make Parts 43 and 45 of the Commission’s regulations consistent in this regard.  In particular, the Proposal would remove the counterparty notification requirement set forth in current CFTC regulation 43.3(e)(1)(i).  However, the Proposal would create a more definitive timeframes in which reporting counterparties are required to correct errors and omissions and in which non-reporting counterparties are required to notify their counterparties of any such errors or omissions.  With respect to non-reporting counterparties, the current rules require that when a non-reporting counterparty “discovers” an error or omission it must “promptly notify” the reporting counterparty of such error or omission.  The Proposal would create more stringent requirements in this regard such that non-reporting counterparties that merely become “aware” of an error or omission by “any means” must notify the reporting counterparty “as soon as technologically practicable” but no later than three business days.  Further the Proposal clarifies that the non-reporting counterparty’s notification obligation with respect to omissions extends to data that was not reported to an SDR (but that presumably should have been reported). 3.    SD and MSP Requirements The Proposal would also establish enhanced requirements for SDs and MSPs with respect their written policies and procedures for swap data reporting under parts 23, 43, and 45 of the Commission’s regulations.  Under the current regime, SDs and MSPs are required to report all information and swap data required for swap transactions when they are reporting counterparties for purposes of regulatory and real-time public reporting.[27]  SDs and MSPs are also required to implement electronic systems and procedures necessary to transmit electronically all information and swap data required to be reported in accordance with Part 43 and Part 45.[28]  The Proposal would require each SD and MSP to establish, maintain and enforce written policies and procedures that are reasonably designed to ensure that the SD and MSP comply with all obligations to report swap data to an SDR, which would include any requirements under Part 43 and Part 45, as well as any rules established by the SDR.[29]  The preamble to the Proposal sets forth specific content that would be expected to be included in the SD or MSP’s policies and procedures.[30] The Proposal also would require SDs and MSPs to review their policies and procedures on an annual basis and to update them as needed to reflect the requirements in Part 43 and Part 45.[31]  The Commission believes that the annual review requirement in the Proposal would ensure that SDs’ and MSPs’ policies and procedures remain current and effective over time.  SDs and MSPs are currently expected to establish policies and procedures related to all of their swap market activities, including their swap data reporting obligations.[32]  The Proposal’s amendments to Part 23 would make the expectations around these policies and procedures explicit by creating new obligations and setting forth guidance around content regarding reporting policies and procedures, rather than merely cross-referencing Parts 43 and 45 as we see under the current regulations. [1]      Certain Swap Data Repository and Data Reporting Requirements, 84 Fed. Reg. 21044 (May 13, 2019). [2]      See 17 C.F.R. § 43.3(a)(3) (sets forth the determination of which counterparty to a swap transaction is the “reporting party” and has the obligation to report swap data to an SDR for purposes of real-time public reporting); 17 C.F.R. § 45.8 (sets forth the determination of which counterparty to a swap transaction is the “reporting counterparty” and has the obligation to report swap data to an SDR for purposes of regulatory reporting).  For purposes of this Client Alert, the term “reporting counterparty” will refer to both a “reporting party” under Part 43 and a “reporting counterparty” under Part 45. [3]      Division of Market Oversight, Roadmap to Achieve High Quality Swaps Data, U.S. Commodity Futures Trading Commission, July 10, 2017, available at http://www.cftc.gov/idc/groups/public /@newsroom/documents/file/dmo_swapdataplan071017.pdf. [4]      Dodd-Frank Wall Street Reform and Consumer Protection Act, 124 Stat. 1376, Pub. Law 111-203 (July 21, 2010), as amended. [5]      Proposal at 21044. [6]      Proposal at 21045. [7]      The Proposal also includes proposed amendments to the reporting requirements for derivatives clearing organizations (“DCOs”), swap execution facilities (“SEFs”), and designated contract markets (“DCMs”) to the extent that these entities are also reporting counterparties.  This Client Alert is focused on the Proposal’s specific impact on the Counterparties and, for that reason, does not discuss the proposed amendments impacting DCOs, SEFs, and DCMs. [8]      Speech by Commissioner J. Christopher Giancarlo, Making Market Reform Work for America (Jan. 18, 2017), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-19 (“The CFTC has faced many challenges in optimizing swap data ranging from data field standardization and data validation to analysis automation and cross-border data aggregation and sharing.  Market participants vary significantly in how they report the same data field to SDRs.  Those same SDRs vary in how they report the data to the CFTC”). Statement by Commissioner Scott D. O’Malia, SIFMA Compliance and Legal Society Annual Seminar (Mar. 19, 2013), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opaomalia-22 (“In a rush to promulgate the reporting rules, the Commission failed to specify the data format reporting parties must use when sending their swaps to SDRs.  In other words, the Commission told the industry what information to report, but didn’t specify which language to use.  This has become a serious problem. . . .  The end result is that even when market participants submit the correct data to SDRs, the language received from each reporting party is different.  In addition, data is being recorded inconsistently from one dealer to another.”). Speech by Commissioner Dan M. Berkovitz, Proposed Amendments to the Commission’s Regulations Relating to Certain Swap Data Repository and Data Reporting Requirements (Apr. 25, 2019), available at https://www.cftc.gov/PressRoom/SpeechesTestimony/berkovitzstatement042519 (“Accurate, complete, and timely information is therefore vital to any successful swap data reporting regime.  These objectives were central to post-crisis reform efforts, and they must remain the primary considerations as the Commission moves to enhance its reporting rules”). [9]    Proposal at 21098.  Proposed § 45.14(a) addresses the verification of swap data accuracy against the SDR’s open swaps report. [10]   Proposal at 21098.  Proposed § 45.14(a)(1) addresses a reporting counterparty’s requirement to verify the accuracy and completeness against the open swap reports from the SDR. [11]   Proposal at 21103.  Proposed § 49.11 would set forth rules around such SDR policies and procedures relating to verification of swap data accuracy and would require the SDR to verify the accuracy of the data with reporting counterparties. [12]   Proposal at 21103.  Proposed §§ 49.11(b)(2) and (3) address the timing obligations for SDRs to distribute open swaps reports to reporting counterparties. [13]   For purposes of clarification, examples of unsatisfactory verification may include:  (i) failure to perform the verification in a timely manner and (ii) providing a verification of data accuracy indicating that the swap data was complete and accurate for swap that was not correct when verified. [14]   Proposal at 21098.  Proposed § 45.14(a)(2) addresses the timing in which such verification against the open swap reports from the SDR must occur.  This proposed requirement would also treat DCO reporting counterparties in the same way it does SD and MSP reporting counterparties. [15]   Proposal at 21098.  Proposed § 45.14(a)(3) addresses the requirement to submit a verification of data accuracy regardless of whether there are discrepancies identified.  Such verification would be required to be submitted in the form and manner required by the SDR’s swap data verification policies and procedures. [16]   Proposal at 21098.  Proposed § 45.14(a)(4) addresses the requirement to submit a notice of discrepancy in the event of any inconsistencies.  Such notice of discrepancy would need to be submitted in the form and manner required by the SDR’s swap data verification policies and procedures. [17]   Proposal at 21068. [18]   Proposal at 21097-21099.  Proposed §§ 43.3(e) and 45.14(b) address the error and omission correction requirements for Parts 43 and 45 of the CFTC’s regulations. [19]   17 C.F.R. § 43.3(e)(1)(i). [20]   Proposal at 21098-21099. [21]   17 C.F.R. §§ 43.3(e)(3), 43.3(e)(4), 45.14(a). [22]   Proposal at 21098-21099.  Proposed §§ 43.3(e)(1)(i) and 45.14(b)(1)(i) address the timing for errors and corrections. [23]   Proposal at 21098-21099.  Proposed §§ 43.3(e)(1)(ii) and 45.14(b)(1)(ii) address the requirement to notify the Director of the Division of Market Oversight if the error correction timing cannot be met. [24]   Proposal at 21098-21099. [25]   Proposal at 21098-21099.  The Proposal makes clear that the non-reporting counterparty is not only responsible for notifying the reporting counterparty of errors or omissions in the data that is reported, but also to notify the reporting counterparty of data that was not reported to an SDR. [26]   Proposal at 21099-21099.  Proposed §§ 43.3(e)(2) and 45.14(b)(2) would also require that if the reporting counterparty, SEF or DCM, as applicable, and the non-reporting counterparty agree that the swap data for a swap is incorrect or incomplete, the reporting counterparty, SEF or DCM, as applicable, must correct the swap data in accordance with proposed § 43.3(e)(1) or § 45.14(b)(1), as applicable. [27]   See 17 C.F.R. §§ 23.204(a), 23.205(a). [28]   See 17 C.F.R. §§ 23.204(b), 23.205(b). [29]   Proposal at 21097. [30]   With respect to Part 45, the Proposal explains that such policies and procedures would include, but not be limited to: (i) the reporting process and designation of responsibility for reporting swap data, (ii) reporting system outages or malfunctions (including the use of back-up systems), (iii) verification of all swap data reported to an SDR, (iv) training programs for employees responsible for reporting under Part 45, (v) control procedures relating to reporting under Part 45 and designation of personnel responsible for testing and verifying such policies and procedures; and (vi) reviewing and assessing the performance and operational capability of any third party that carries out any duty required by Part 45 on behalf of the SD or MSP as well as any rules established by the SDR.  With respect to Part 43, the Proposal explains that such policies and procedures would include, but not be limited to:  (i) the reporting process and designation of responsibility for reporting swap transaction and pricing data, (ii) reporting system outages or malfunctions (including use of back-up systems), (iii) training programs for employees responsible for reporting under Part 43, (iv) control procedures relating to reporting under Part 43 and designation of personnel responsible for testing and verifying such policies and procedures, (v) reviewing and assessing the performance and operational capability of any third party that carries out any duty required by Part 43 on behalf of the SD or MSP; and (vi) the determination of whether a new swap transaction or amendment, cancelation, novation, termination, or other lifecycle event of an existing swap, is subject to the real-time reporting requirements under Part 43.  Proposal at 21073. [31]   Proposal at 21097. [32]   See, e.g., 17 C.F.R. § 3.3(d)(1) (requiring a chief compliance officer to administer each of the registrant’s policies and procedures relating to its business as an SD/MSP that are required to be establish pursuant to the Act and the Commission’s regulations); 17 CFR § 3.2(c)(3)(ii) (requiring the National Futures Association to assess whether an entity’s SD/MSP documentation demonstrates compliance with the Section 4s Implementing Regulation to which it pertains which includes § 23.204 and § 23.205). The following Gibson Dunn lawyers assisted in preparing this client update: Jeffrey Steiner, Carl Kennedy and Erica Cushing. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions and Derivatives practice groups, or any of the following: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) Erica N. Cushing – Denver (+1 303-298-5711, ecushing@gibsondunn.com) © 2019 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

December 7, 2018 |
Derivatives End-User’s Guide to the QFC Resolution Stay Requirements

Click for PDF Last year, the Board of Governors of the Federal Reserve System[1], the Federal Deposit Insurance Corporation (“FDIC“)[2], and the Office of the Comptroller of the Currency[3] issued final rules (collectively, the “U.S. Rules“) requiring globally systematic banking organizations (“G-SIBs“) in the United States and their subsidiaries, as well as all U.S. operations of non-U.S. G-SIBs (each, a “Covered Entity“)[4]  to include in their qualified financial contracts (“QFCs“)[5] language that provides for contractual stays on early termination rights.  By now, most buy-side counterparties to QFCs, including corporates and other non-financial end-users (collectively, “End-User Counterparties“) have been contacted by their Covered Entity counterparties with a request to amend their QFCs by January 1, 2019 to include contractual language so that the Covered Entities can comply with the U.S. Rules. This Alert provides a brief background on the U.S. Rules from an End-User Counterparty’s perspective, reviews the impacts of the U.S. Rules on End-User Counterparties and highlights practical considerations for End-User Counterparties. If you have any questions regarding this Gibson Dunn Alert, please contact a member of the Derivatives Team.[6]         I.   Background The economic dislocation in 2008, and in particular the Lehman Brothers failure, highlighted the interconnectedness of the world’s financial systems.  As a result, the Financial Stability Board and home country regulators focused on ways to minimize the impact of a G-SIB failure on the global financial system.  Regulators in the world’s financial centers urged G-SIBs to adopt modifications to their existing and future derivatives (and similar) contracts that would limit End-User Counterparty termination rights (e.g., cross-default and direct default rights) in the event of a resolution or bankruptcy of the G-SIB or one of its affiliates.  Regulators believe that unfettered early termination rights make it more difficult for a G-SIB to pass through a bankruptcy or resolution proceeding, as a rush to terminate in the event of failure has significant knock-on complications. Titles I and II of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act“)[7] provided U.S. regulators with new tools to effect the orderly resolution of G-SIBs.  One of those tools requires each G-SIB to prepare and submit to U.S. regulators a resolution plan commonly referred to as a “living will” that outlines the steps it would take for a rapid and orderly resolution of the G-SIB under the U.S. Bankruptcy Code in the event of material financial distress or failure.  Title II of the Dodd-Frank Act enacted a special resolution regime, known as the Orderly Liquidation Authority (“OLA“), which authorizes the appointment of the FDIC as a receiver to carry out the liquidation of large and complex financial institutions should an orderly resolution under the U.S. Bankruptcy Code not be feasible (the “U.S. Special Resolution Regime“). For more than 25 years, market participants have used ISDA Master Agreements to memorialize and govern the rights and responsibilities for their over-the-counter derivatives transactions.  Under these standardized agreements, non-defaulting parties have generally had a right to designate an “Early Termination Date” in respect of an “Event of Default” by the other party or by other “Specified Entities,”[8] which typically includes affiliates who may or may not be “Credit Enhancement Providers.”[9]  An Event of Default thus includes a bankruptcy or resolution of the direct counterparty (i.e., a direct default) and also the bankruptcy or resolution of any of the “Specified Entities” or “Affiliates” (i.e., a cross-default).[10] Such early termination rights generally provide the non-defaulting party with the ability to close out its relationship with the defaulting counterparty as well as its relationship with any affiliates of the defaulting counterparty.  Following an Event of Default, and the occurrence of an Early Termination Date, either automatically or by designation by the non-defaulting party, the obligation to make further payments or deliveries in respect to the transactions governed by the ISDA Master Agreement will end.  Instead, there will be an obligation to pay a close-out amount, calculated as provided in the ISDA Master Agreement. A filing under the U.S. Bankruptcy Code generally does not impact the ability to exercise early termination and close-out rights.  The U.S. Bankruptcy Code generally exempts QFCs (which term includes ISDA Master Agreements) from application of the automatic stay; this means that non-defaulting parties can, notwithstanding the filing of a case under the U.S. Bankruptcy Code by the defaulting counterparty or one of its Specified Affiliates, enforce an Event of Default and exercise close-out rights without the requirement to obtain any approval from the bankruptcy court. By contrast, the U.S. Special Resolution Regime does not incorporate such provisions—non-defaulting counterparties are subject to a stay period before enforcing termination rights, or exercising close-out rights, arising from the insolvency of a Covered Entity or a specified affiliate and, if certain conditions are satisfied, they may be permanently prevented from exercising such rights. a.   The U.S. Rules The primary objectives of the U.S. Rules are to address the threat to financial stability posed by existing default rights under QFCs and to enable the resolution of G-SIBs in a controlled manner.  The U.S. Rules seek to accomplish these objectives by requiring two amendments (discussed below) to the QFCs between a Covered Entity or any of a Covered Entity’s affiliates that are also Covered Entities (collectively, a “Covered Entity Group“) and an End-User Counterparty or any of the End-User Counterparty’s consolidated affiliates (collectively, an “End-User Group“).  Under the U.S. Rules, a Covered Entity will no longer be able to execute a QFC with an End-User Counterparty without violating those rules unless all QFCs between each entity in the Covered Entity Group and all relevant entities in the End-User Group are amended. The first required amendment under the U.S. Rules addresses the uniformity of treatment between parties that opt-in to the relevant provisions of a resolution regime and parties that are subject to the law of the jurisdiction of the resolution regime because it is the governing law of the contract.  To reduce the risks that courts in foreign jurisdictions would disregard the U.S. Special Resolution Regime provisions that stay an End-User Counterparty’s rights under QFCs with Covered Entities due to a foreign governing law provision, the amendment effectively requires the End-User Counterparty to opt in to the U.S. Special Resolution Regime. The opt-in mechanic of this first amendment is similar to what is required under the resolution stay rules that were passed in other jurisdictions (e.g., UK, Switzerland, Japan, Germany, etc.). The second amendment under the U.S. Rules is unique to the United States in that it restricts the ability of End-User Counterparties to exercise certain cross-default rights under QFCs.  Specifically, this amendment subjects an End-User Counterparty’s cross-default rights to a mandatory stay where a parent or affiliate acting as Credit Enhancement Provider to a Covered Entity counterparty’s obligations under a QFC goes into insolvency proceedings (i.e., under the U.S. Bankruptcy Code), notwithstanding that the Covered Entity counterparty may still able to make payments and perform under the QFC, (i.e., the Covered Entity is not itself insolvent).  Additionally, the second amendment requires an End-User Counterparty to agree that if a Covered Entity affiliate that is not a Credit Enhancement Provider goes into an insolvency, such End-User Counterparty’s cross-default rights resulting from that Covered Entity affiliate’s insolvency are permanently stayed with respect to the QFC with the direct Covered Entity counterparty.  Effectively, this provides for a full override of the “Specified Entity” defaults in the ISDA Master Agreement.  The goal of this second amendment is to facilitate “the resolution of a large financial entity under the U.S. Bankruptcy Code and other resolution frameworks by ensuring that the counterparties of solvent affiliates of the failed entity cannot unravel their contracts with the solvent affiliate based solely on the failed entity’s resolution.”[11] b.   Amending QFCs – Timing The U.S. Rules mandate that if a Covered Entity enters into a QFC with an End-User Counterparty on or after January 1, 2019 (the “Trigger Date“), then all of the QFCs between the Covered Entity Group and the End-User Group must incorporate the required amendments effective as of the relevant “compliance date.”  The U.S. Rules provide staggered compliance dates that determine when the U.S. Rules actually become effective for different types of counterparties as follows:  (a)  for QFCs between Covered Entities – January 1, 2019; (b) for QFCs between Covered Entities and “financial counterparties” – July 1, 2019; and (c) for QFCs between Covered Entities and any other type of counterparty – January 1, 2020.  This means that if an End-User Counterparty’s QFCs are fully performed, terminated or otherwise unwound prior to the relevant compliance date for such End-User Counterparty, those QFCs would not be subject to the U.S. Rules and would not need to be amended.  Further, to the extent End-User Counterparties adhere to the ISDA Protocol (discussed below) or agree to a bilateral amendment in advance of the appropriate compliance date, such amendment would likely not become effective until the appropriate compliance date.  Therefore, End-User Counterparties could retain their current default rights under the ISDA Master Agreement until their respective required compliance dates regardless of when such counterparties actually amend their QFCs. From a practical perspective, however, the staggered compliance dates are unlikely to deter Covered Entities from requiring that all relevant amendments to QFCs be put in place between the End-User Group and the Covered Entity Group by no later than January 1, 2019 or the first date thereafter on which the relevant Covered Entity enters into a new QFC with any member of the End-User Group.  In other words, Covered Entities are incentivized to amend all of their QFCs irrespective of the compliance dates because entering into a new QFC after January 1, 2019 without all of the required amendments in place could potentially expose the Covered Entity Group to regulatory and business risks (e.g., the risk that an End-User Counterparty that triggers the U.S. Rules’ requirements will not agree to amend its QFCs by the relevant compliance date).  To remove such risks, Covered Entities have been seeking to have all amendments to QFCs in place prior to January 1, 2019, regardless of a particular counterparty’s compliance date. c.   Amending QFCs – Protocol Adherence or Bilateral Amendment? There are two ways that an End-User Counterparty can amend its QFCs with Covered Entities.  End-User Counterparties can either adhere to the ISDA 2018 U.S. Resolution Stay Protocol as published by the International Swaps and Derivatives Association Inc. (the “ISDA Protocol“)[12] or bilaterally amend its QFCs to comply with the U.S. Rules’ contractual requirements and restrictions (ISDA has also published forms of bilateral amendments).[13]  The ISDA Protocol is an “all to all” method whereby all of an entity’s QFCs with all Covered Entities that have adhered to the ISDA Protocol are amended.  In the case of End-User Counterparties, the ISDA Protocol is essentially a global amendment to the terms of all QFCs between the End-User Counterparty and every Covered Entity that also adheres to the ISDA Protocol.  The ISDA Protocol would require an adhering party to “opt in” to the special resolution regimes of France, Germany, Japan, Switzerland and the United Kingdom (which have all finalized their resolution stay rules) in addition to the U.S. Special Resolution Regime.  Accordingly, the process would make the amendment process easy by allowing the End-User Counterparty to adhere to the ISDA Protocol one time in order to address all requests from all Covered Entities for the End-User Counterparty to amend its QFCs in accordance with the U.S. Rules. In contrast, under a bilateral amendment process, the counterparties can agree (on a group-by-group basis) to amend their QFCs that are affected by the U.S. Rules.  A bilateral amendment would not require  an “opt in” to the special resolution regimes of France, Germany, Japan, Switzerland and the United Kingdom, although counterparties in those jurisdictions will likely request this nonetheless.  Further, under a bilateral amendment, the parties can agree not to amend QFCs that do not need to be amended to be brought into compliance. It is important to note that the ISDA Protocol and the bilateral amendments would only amend QFCs and would only be applicable to the End-User Counterparty that is the adhering party. All affiliates that have entered into QFCs with Covered Entities would each need to separately amend those QFCs.  Further, the ISDA Protocol only becomes effective upon the appropriate compliance date for the adhering party (notwithstanding when the entity actually adheres to the ISDA Protocol).  Bilateral amendments would need to be reviewed and negotiated to ensure the scope and timing of compliance are appropriate. Although the ISDA Protocol generally tracks the requirements of the U.S. Rules, there are a few differences relating to creditor enhancement provisions and certain default rights in the ISDA Protocol as compared to a bilateral amendment that would track the U.S. Rules directly.  The ISDA Protocol tracks the terms of the ISDA 2015 Universal Stay Protocol (which was published before the U.S. Rules) and provides a safe harbor from certain of the U.S. Rules.  This variation both aligns with the preference of prudential banking regulators for ISDA Protocol adherence and incentivizes End-User Counterparties to adhere.  In particular, under the ISDA Protocol provides that an End-User Counterparty only waives its rights to exercise remedies under a QFC due to an affiliate of its direct Covered Entity counterparty entering insolvency proceedings under Chapter 7 or 11 of the U.S. Bankruptcy Code or proceedings under the Securities Investor Protection Act, as amended, or Federal Deposit Insurance Act.  However, a bilateral agreement has a much broader scope, because an End-User Counterparty would have to waive such rights if the affiliate of its direct Covered Entity counterparty enters into any insolvency proceeding (including non-U.S. insolvency proceedings). Additionally, under the U.S. Rules and a bilateral amendment approach, if an End-User Counterparty seeks to exercise a default right in respect of a QFC with a Covered Entity counterparty, it must demonstrate by “clear and convincing evidence” or a similar or higher burden of proof that the right to exercise such default right is permitted under the U.S. Rules.  Meeting such a standard could be difficult to prove depending on the facts and circumstances.  The ISDA Protocol similarly requires the stayed party to have the burden of proof to establish by clear and convincing evidence that a default right may be exercised with respect to the QFC; however, the ISDA Protocol, unlike a bilateral amendment, makes clear that default rights related to performance defaults may be exercised without meeting such burden of proof.  For example, under the ISDA Protocol a stayed party could exercise its default rights in the event that its direct counterparty fails to perform (i.e., make payments) at any time; however, under a bilateral amendment, a stayed party would need to establish by clear and convincing evidence that the performance default is not related to an affiliate of the direct party becoming a party to U.S. proceedings, etc.  Accordingly, under the bilateral amendment, there is a broader scope of scenarios where this heightened burden of proof may be applicable compared to the ISDA Protocol.      II.   Impact on End-User Counterparties Below are two examples to illustrate the practical implications of the U.S. Rules for End-User Counterparties. EXAMPLE 1: Bank X (which is a Covered Entity) enters into a QFC with Company A on January 2, 2019.  Entering into this QFC on or after January 1, 2019 triggers the requirements of the U.S. Rules.  As a result, the following QFCs between Bank X and Company A would need to be amended: i.   the January 2, 2019 QFC between Company A and Bank X; ii.   all existing and future QFCs between Company A and Bank X; iii.   all existing and future QFCs between Company A and any Bank X affiliate that is a Covered Entity; and iv.   all existing and future QFCs entered into by any consolidated affiliate of Company A and Bank X or any Bank X affiliate that is a Covered Entity. This means that in order to enter into this new QFC with Bank X, Company A and all of Company A’s affiliates on the same consolidated financial statements must either: i.   adhere to the ISDA Protocol; or ii.   bilaterally amend all QFCs with Bank X and all of Bank X’s affiliates (since all the Bank X affiliates are Covered Entities).[14] EXAMPLE 2: Company A enters into a 10-year interest rate swap with Bank X (a U.S. bank) on December 20, 2018.  On January 2, 2019, Company A’s affiliate Company B enters into a 5-year interest rate swap with Bank X’s affiliate, Broker Dealer Y (a U.S. broker dealer). Company A’s entry into the 10-year interest rate swap with Bank X does not trigger the U.S. Rules because it is entered into before January 1, 2019.   If neither Company A nor its affiliates entered into any QFCs with Bank X or its affiliates after January 1, 2019, Company A would, under the U.S. Rules, retain its existing early termination and cross-default rights with respect to the 10-year interest rate swap. However, Company B’s entry into the interest rate swap with Broker Dealer Y after January 1, 2019 would trigger the U.S. Rules for all of Company B’s consolidated affiliates, including Company A, with respect to all existing and future QFCs with any consolidated Broker Dealer Y affiliate, including Bank X.  Accordingly, it would: (i) Require Company B either to enter into the ISDA Protocol or enter into a bilateral amendment for all QFCs with Bank X, Broker Dealer Y and all of their consolidated affiliates.  This would subject the Company B interest rate swap and all other QFCs with Broker Dealer Y’s affiliates to the contractual stay provisions beginning on July 1, 2019 or January 1, 2020, as appropriate. (ii) Require Company A and all other consolidated affiliates to enter into the ISDA Protocol or enter into a bilateral amendment for all QFCs with Bank X, Broker Dealer Y and all of their consolidated affiliates.  This would subject the Company A 10-year interest rate swap and all other QFCs with Bank X and its affiliates to the contractual stay provisions beginning on July 1, 2019 or January 1, 2020, as appropriate.   III.   Conclusions and Considerations Although the U.S. Rules do not impose direct obligations on End-User Counterparties to QFCs with Covered Entities, those End-User Counterparties that seek to continue to trade QFCs with Covered Entities will face certain indirect requirements and effects.  Specifically, End-User Counterparties must amend their QFCs with Covered Entities by either (i) adhering to the ISDA Protocol or (ii) negotiating bilateral amendments with their Covered Entity counterparties.  Once effective, these amendments will limit an End-User Counterparty’s existing cross-default rights under an ISDA Master Agreement (and other types of QFCs) with Covered Entities. At this time, the consequences of the U.S. Rules on the marketplace are unclear as there is little precedent to assist in interpretation and negotiation.  There appear to be divergent views in the marketplace. While it is true that an End-User Counterparty’s cross-default rights are limited under the U.S. Rules, some argue that such limitations on early termination rights will likely protect End-User Counterparties by decreasing the chances of a systemic failure and, given the creditor safeguards, decrease the likelihood that an End-User Counterparty would suffer an unanticipated loss due to the failure of a Covered Entity.  On the other hand, others have argued that the U.S. Rules could cause market participants to shy away from a vulnerable entity thereby further increasing the likelihood of failure of that entity and End-User Counterparties could face potential exposure during the stay period in the event the resolution proceedings do not work out as planned.  In any event, credit, pricing and risk determinations will continue to evolve as the market adapts to the U.S. Rules and a “new normal” will result. In the meantime, End-User Counterparties should be sure to coordinate an approach for amending their QFCs (particularly if the affiliates are controlled by different treasury centers or boards).  Additionally, because adherence to the ISDA Protocol is a universal amendment, End-User Counterparties will want to identify each outstanding QFC to which it is a party with a Covered Entity in order to evaluate the extent to which their default rights may be restricted under those QFCs.    [1]   12 C.F.R. §§ 252.2, 252.81-88; see also, Restrictions on Qualified Contracts of Systemically Important U.S. Banking Organizations and the U.S. Operations of Systemically Important Foreign Banking Organizations; Revisions to the Definition of Qualifying Master Netting Agreement and Related Definitions, 82 Fed. Reg. 42,882 (Sept. 12, 2017).    [2]   12 C.F.R. §§ 382.1-7.    [3]   12 C.F.R. § 47.1-8.    [4]   The following U.S. banking institutions have been identified as G-SIBs: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JP Morgan Chase, Morgan Stanley, State Street, and Wells Fargo. The following foreign banking institutions have been identified as G-SIBs: Agricultural Bank of China, Bank of China, Barclays, BNP Paribas, China Construction Bank, Credit Suisse, Deutsche Bank, Groupe BPCE, Groupe Crédit Agricole, Industrial and Commercial Bank of China Limited, HSBC, ING Bank, Mitsubishi UFJ FG, Mizuho FG, Nordea, Royal Bank of Canada, Santander, Société Générale, Standard Chartered, Sumitomo Mitsui FG, UBS, and Unicredit Group.    [5]   The definition of QFC is expansive and includes a broad range of transactions including, but not limited to, derivatives, repurchase, reverse repurchase and securities lending transactions.  See 12 U.S.. § 5390(c)(8)(D).    [6]   https://www.gibsondunn.com/practice/derivatives/    [7]   See Dodd-Frank Wall Street Reform and Consumer Protection Act, Public Law 111–203, 124 Stat. 1376 (2010).    [8]   The standard terms of Section 6(a) of the 1992 and 2002 ISDA Master Agreement (some of which are capitalized in this alert) provide parties to a derivatives transaction the right to terminate following an “Event of Default” (as such term is defined in the ISDA Master Agreement).  Specifically, this provision notes that if “Automatic Early Termination” has been selected in the ISDA Schedule, then upon the occurrence of certain defaults, including bankruptcy-related events, an “Early Termination Date” is deemed to have automatically occurred immediately before such event.  In other circumstances, an Event of Default gives the non-defaulting party the right to terminate the agreement and trigger the close-out, netting and setoff provisions therein by designating an Early Termination Date.    [9]   A Credit Enhancement Provider is a party that provides credit enhancement or support in respect of an ISDA Master Agreement entered into by another party.  Credit enhancement or support can take the form, among others, of a guarantee, pledge of collateral, letter of credit, transfer of margin or any similar arrangement, in each case only to the extent such credit enhancement relates to the ISDA Master Agreement.  The definition of “Credit Enhancement Provider” is found in the ISDA Protocol (as defined below). [10]   See Section 5(a)(vii) of the 1992 or 2002 ISDA Master Agreement. [11]   82 Fed. Reg. at 42,883. [12]   The text of the ISDA Protocol is available at https://www.isda.org/a/CIjEE/3431552_40ISDA-2018-U.S.-Protocol-Final.pdf. [13]   Each affiliate that is a separate legal entity that has QFCs with a covered entity will need to separately adhere to the ISDA Protocol or enter into a bilateral amendment. ISDA has published four different form of bilateral amendments as well as model language that an entity can use to amend its QFCs with respect to a particular covered entity and its affiliates.  The form of bilateral amendments are available at https://www.isda.org/a/vrCEE/US-Stay-Regulations-Bilateral-Amendments.pdf. [14]   There is no requirement that all of Company X’s affiliates amend their QFCs in the same way; however, if some affiliates choose a bilateral amendment while others choose the ISDA Protocol, they could have different rights and be in a different position with respect to their rights against a QFC with the same party. The following Gibson Dunn lawyers assisted in preparing this client update: Arthur Long, Jeffrey Steiner, Carl Kennedy and Erica Cushing. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact the Gibson Dunn lawyer with whom you usually work in the firm’s Derivatives or Business Restructuring and Reorganization practice groups, or the following: Derivatives Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) James O. Springer – Washington, D.C. (+1 202-887-3516, jspringer@gibsondunn.com) Erica N. Cushing – Denver (+1 303-298-5711, ecushing@gibsondunn.com) Business Restructuring and Reorganization Group: Michael A. Rosenthal – New York (+1 212-351-3969, mrosenthal@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

October 11, 2018 |
Financing Arrangements and Documentation: Considerations Ahead of Brexit

Click for PDF Since the result of the Brexit referendum was announced in June 2016, there has been significant commentary regarding the potential effects of the UK’s withdrawal from the EU on the financial services industry. As long as the UK is negotiating its exit terms, a number of conceptual questions facing the sector still remain, such as market regulation and bank passporting. Many commentators have speculated from a ‘big picture’ perspective what the consequences will be if / when exit terms are agreed.  From a contractual perspective, the situation is nuanced. This article will consider certain areas within English law financing documentation which may or may not need to be addressed. Bank passporting The EU “passporting” regime has been the subject of much commentary since the result of the Brexit referendum.  In short, in some EU member states, lenders are required under domestic legislation to have licences to lend.  Many UK lenders have relied on EU passporting (currently provided for in MiFID II), which allows them to lend into EU member states simply by virtue of being regulated in the UK (and vice versa). The importance for the economy of the passporting regime is clear. Unless appropriate transitional arrangements are put in place to ensure that the underlying principle survives, however, there is a risk that following Brexit passporting could be lost.  Recent materials produced by the UK Government suggest that the loss of passporting may be postponed from March 2019 until the end of 2020, although financial institutions must still consider what will happen after 2020 if no replacement regime is agreed.  The UK Government has committed to legislate (if required) to put in place a temporary recognition regime to allow EU member states to continue their financial services in the UK for a limited time (assuming there is a “no deal” scenario and no agreed transition period). However, there has not to date been a commitment from the EU to agree to a mirror regime. Depending on the outcome of negotiations on passporting, financial institutions will need to consider the regulatory position in relation to the performance of their underlying financial service, whether that is: lending, issuance of letters of credit / guarantees, provision of bank accounts or other financial products, or performing agency / security agency roles. Financial institutions may need to look to transfer their participations to an appropriately licensed affiliate (if possible) or third party, change the branch through which it acts, resign from agency or account bank functions, and/or exit the underlying transaction using the illegality protections (although, determining what is “unlawful” for these purposes in terms of a lender being able to fund or maintain a loan will be a complex legal and factual analysis).  More generally, we expect these provisions to be the subject of increasing scrutiny, although there seems to be limited scope for lenders to move illegality provisions in their favour and away from an actual, objective illegality requirement, owing to long-standing commercial convention. From a documentary perspective, it will be necessary to analyse loan agreements individually to determine whether any provisions are invoked and/or breached, and/or any amendments are required.  For on-going structuring, it may be appropriate for facilities to be tranched – such tranches (to the extent the drawing requirements of international obligor group can be accurately determined ahead of time) being “ring-fenced”, with proportions of a facility made available to different members of the borrower group and to be participated in by different lenders – or otherwise structured in an alternative, inventive manner – for example, by “fronting” the facility with a single, adequately regulated lender with back-to-back lending mechanics (e.g. sub-participation) standing behind.  In the same way, we also expect that lenders will exert greater control – for example by requiring all lender consent in all instances – on the accession of additional members of the borrowing group to existing lending arrangements in an attempt to diversify the lending jurisdictions.  Derivatives If passporting rights are lost and transitional relief is not in place, this could have a significant impact on the derivatives markets.  Indeed, without specific transitional or equivalence agreements in place between the EU and the UK, market participants may not be able to use UK clearing houses to clear derivatives subject to mandatory clearing under EMIR.  Additionally, derivatives executed on UK exchanges could be viewed as “OTC derivatives” under EMIR and would therefore be counted towards the clearing thresholds under EMIR.  Further, derivatives lifecycle events (such as novations, amendments and portfolio compressions) could be viewed as regulated activities thereby raising questions about enforceability and additional regulatory restrictions and requirements. In addition to issues arising between EU and UK counterparties, equivalence agreements in the derivatives space between the EU and other jurisdictions, such as the United States, would not carry over to the UK.  Accordingly, the UK must put in place similar equivalence agreements with such jurisdictions or market participants trading with UK firms could be at a disadvantage compared to those trading with EU firms. As a result of the uncertainty around Brexit and the risk that passporting rights are likely to be lost, certain counterparties are considering whether to novate their outstanding derivatives with UK derivatives entities to EU derivatives entities ahead of the exit date.  Novating derivatives portfolios from a UK to an EU counterparty is a significant undertaking involving re-documentation, obtaining consents, reviewing existing documentation, identifying appropriate counterparties, etc. EU legislation and case law Loan agreements often contain references to EU legislation or case law and, therefore, it is necessary to consider whether amendments are required. One particular area to be considered within financing documentation is the inclusion of Article 55 Bail-In language[1].  In the last few years, Bail-In clauses have become common place in financing documentation, although they are only required for documents which are governed by the laws of a non-EEA country and where there is potential liability under that document for an EEA-incorporated credit institution or investment firm and their relevant affiliates, respectively.  Following withdrawal from the EU, the United Kingdom will (subject to any transitional or other agreed arrangements) cease to be a member of the EEA and therefore English law governed contracts containing in-scope liabilities of EU financial institutions may become subject to the requirements of Article 55.  Depending on the status of withdrawal negotiations as we head closer to March 2019, it may be appropriate as a precautionary measure to include Bail-In clauses ahead of time – however, this analysis is very fact specific, and will need to be carefully considered on a case-by-case basis. Governing law and jurisdiction Although EU law is now pervasive throughout the English legal system, English commercial contract law is, for the most part, untouched by EU law and therefore withdrawal from the EU is expected to have little or no impact.  Further, given that EU member states are required to give effect to the parties’ choice of law (regardless of whether that law is the law of an EU member state or another state)[2], the courts of EU member states will continue to give effect to English law in the same way they do currently.  Many loan agreements customarily include ‘one-way’ jurisdiction clauses which limit borrowers/obligors to bringing proceedings in the English courts (rather than having the flexibility to bring proceedings in any court of competent jurisdiction). This allows lenders to benefit from the perceived competency and commerciality of the English courts as regards disputes in the financial sector. Regardless of the outcome of the Brexit negotiations, such clauses  are likely to remain unchanged due to the experience of English judges in handling such disputes and the certainty of the common law system. It is possible that the UK’s withdrawal will impact the extent to which a judgement of the English courts will be enforceable in other EU member states.  Currently, an English judgement is enforceable in all other EU member states pursuant to EU legislation[3].  However, depending on the withdrawal terms agreed with the EU, the heart of this regulation may or may not be preserved. In other words, English judgements could be in the same position to that of, for example, judgements of the New York courts, where enforceability is dependent upon the underlying law of the relevant EU member state; or, an agreement could be reached for automatic recognition of English judgements across EU member states.  In the same vein, the UK’s withdrawal could also impact the enforcement in the UK of judgements of the courts of the remaining EU member states. Conclusion Just six months ahead of the UK’s 29 March 2019 exit date, there remains no agreed legal position as regards the terms of the UK’s withdrawal from the EU. It is clear that, for so long as such impasse remains, the contractual ramifications will continue to be fluid and the subject of discussion.  However, what is apparent is that the financial services sector, and financing arrangements more generally, are heavily impacted and it will be incumbent upon contracting parties, and their lawyers, to consider the relevant terms, consequences and solutions at the appropriate time. [1]   Article 55 of the Bank Resolution and Recovery Directive [2]   Rome I Regulation [3]   Brussels I regulation. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Global Finance practice group, or the authors: Amy Kennedy – London (+44 (0)20 7071 4283, akennedy@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Alex Hillback – Dubai (+971 (0)4 318 4626, ahillback@gibsondunn.com) Please also feel free to contact the following leaders and members of the Global Finance and Financial Institutions practice groups: Global Finance Group: Thomas M. Budd – London (+44 (0)20 7071 4234, tbudd@gibsondunn.com) Gregory A. Campbell – London (+44 (0)20 7071 4236, gcampbell@gibsondunn.com) Richard Ernest – Dubai (+971 (0)4 318 4639, rernest@gibsondunn.com) Jamie Thomas – Singapore (+65 6507 3609, jthomas@gibsondunn.com) Michael Nicklin – Hong Kong (+852 2214 3809, mnicklin@gibsondunn.com) Linda L. Curtis – Los Angeles (+1 213 229 7582, lcurtis@gibsondunn.com) Aaron F. Adams – New York (+1 212 351 2494, afadams@gibsondunn.com) Financial Institutions Group: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

September 27, 2018 |
New York Office of the Attorney General Publishes Report on Virtual Currency Platforms and Their Potential Risks

Click for PDF This Alert reviews the New York State Office of the Attorney General’s (the “OAG”) Virtual Markets Integrity Initiative Report (the “Report”), which was published on September 18, 2018.[1]  The publication of the OAG’s 42-page Report brings to a close its six-month fact-finding inquiry of several virtual currency platforms.[2]  The OAG sent out detailed letters and questionnaires to a number of virtual currency platforms seeking information from the platforms across a wide-range of issues, including trading operations, fees charged to customers, the existence of robust policies and procedures, and the use of risk controls. The OAG’s purpose in conducting this inquiry was to inform investors and consumers of the risks they face when considering whether to trade on virtual currency platforms.  The OAG is charged with enforcing laws that protect investors and consumers from unfair and deceptive practices and that safeguard the integrity of financial markets.  To that end, the OAG “compil[ed] and analyz[ed] the responses, compar[ed] [those responses] to the platforms’ publicly available disclosures,” and gave the platforms opportunities to confirm the OAG’s analysis in advance of the Report’s publication.[3] The Report focuses on three main concerns.  First, the OAG highlighted that virtual currency platforms may not sufficiently disclose or take measures to mitigate potential conflicts of interest.  Second, the OAG opined that virtual currency platforms currently do not take sufficient efforts to impede market manipulation and protect market integrity.  And third, the OAG expressed its view that virtual currency platforms may not have adequate safeguards for the protection of customer funds. We believe that the virtual currency industry (i.e., investors, consumers, platforms and other stakeholders) should view the Report as a best practices or best standards document, upon which virtual currency platforms may be measured in terms of their riskiness and viability. Please contact Gibson Dunn’s Digital Currencies and Blockchain Technology Team if you have any questions regarding the Report or any of the information discussed in this Alert. I.   The Virtual Currency Markets and New York’s Oversight Authority In order to have a better understanding of the potential impact of the Report, a primer on virtual currency markets generally and the State of New York’s oversight of virtual currency platforms is appropriate.             a.   Primer on Virtual Currency Markets The virtual currency markets have only been in existence for roughly ten years.  While these virtual or digital units of currency have no intrinsic value and are generally traded outside of the purview of direct government controls, the market’s popularity and trading volumes have catapulted it to a total market capitalization of approximately USD 218 billion as of September 27, 2018.[4]  One market analyst has estimated the existence of approximately 2,001 different virtual currencies, which are traded on platforms or “exchanges” around the globe.[5] The most popular virtual currency, Bitcoin, currently has a market capitalization of approximately USD 113 billion and a price of USD 6,523.[6]  There are several other virtual currencies—including ether, XRP, EOS, litecoin, and bitcoin cash—that are also widely traded. Investors and consumers generally access the virtual currency markets through trading platforms, most of which are unregistered and/or not subject to comprehensive governmental oversight in a manner similar to registered exchanges in other financial markets such as securities, commodities, and derivatives markets.  There are approximately 100 different virtual currency trading platforms in the world; not all are open to U.S. persons.[7] In the United States, government supervision over virtual currency markets continues to evolve at both the federal and state levels.  At the federal level, several federal regulators—including the Commodity Futures Trading Commission (“CFTC”) and the Securities and Exchange Commission (“SEC”)—have all begun to bring virtual currency trading more squarely under governmental supervision and control, either through defining their authority in federal court cases,[8] issuing regulatory guidance or consumer advisories,[9] or bringing enforcement actions against fraudsters and market participants and trading platforms, which violate existing laws.[10] In addition, states have enacted legislation or adopted regulations requiring virtual currency platforms to become licensed before offering trading access to their residents.  Some of these states, including New York, have also taken a more aggressive posture in warning consumers about fraudsters and platform operators that prey on their investor and consumer residents.[11]             b.   The State of New York’s Oversight of Virtual Currency Platforms New York has been a leader in establishing regulatory oversight over virtual currency markets in two important respects.  First, in 2014, New York—through its Department of Financial Services (“NYDFS”)—issued a comprehensive regulatory framework requiring virtual currency platforms and operators to secure a special business license called a “BitLicense” when engaging in virtual currency activities, and for those platforms and operators to establish consumer protections, anti-money laundering compliance, and cybersecurity guidelines.[12]  NYDFS has also granted limited purpose trust charters under New York banking law to virtual currency companies and has issued specific virtual currency product approvals.[13]  NYDFS has awarded eight BitLicenses, and it has granted two virtual currency limited-purpose trust company charters.[14] Second, New York has issued detailed guidance focusing on fraud detection and prevention.[15]  NYDFS’s guidance mandates that virtual currency licensees and chartered entities implement measures designed to effectively detect, prevent, and respond to fraud, attempted fraud, and similar wrongdoing in the trading of virtual currencies.  Many industry observers have viewed this guidance as amplifying and strengthening the monitoring requirements that already exist in New York’s regulations applying to BitLicensees. The OAG’s recent inquiry and its publication of the Report thus build on a developed framework of state regulation. II.   The Report and Its Three Key Areas of Concern The Report covers the following broad topics: (a) The jurisdiction in which virtual currency platforms operate; (b) The platforms’ acceptance of currencies (i.e., fiat and/or virtual); (c) Fees charged and disclosures of fee structures to customers; (d) The robustness of a platform’s trading policies and procedures; (e) How the platforms manage various types of conflicts of interest; (f) How the platforms safeguard customer funds through the establishment of security processes and procedures, the role of insurance, and the use of independent audits; and (g) The platforms’ processes around providing access to customers’ funds, as well as how the platforms handle trading suspensions and outages. We have produced the following chart that summarizes the OAG’s assessment of, and key findings from analyzing, the questionnaire responses received with respect to each of the topics above.  The Report also offered recommendations to assist virtual currency investors and consumers (i.e., platform customers) in making educated choices when deciding whether to invest or trade on a particular virtual currency platform. Topical Area Assessment Recommendations Jurisdiction Knowing where a platform is incorporated and headquartered is important because the platform’s domicile impacts which laws apply to any rights and remedies an investor or consumer may have in the event of a dispute, loss, theft or insolvency. Participating platforms claimed to limit trading access to authorized customers from particular locations; however, many of these platforms do not have effective know-your-customer (“KYC”) programs or actively monitor customers’ IP addresses in order ensure the identity and location of particular customers. Customers should know the jurisdictions from which their virtual currency trading platforms are located and headquartered. Platforms need to significantly enhance and improve their KYC programs and to develop effective IP monitoring systems in order to properly monitor and limit the platforms’ trading systems to authorized customers.   Acceptance of Currency To obtain virtual currency initially, customers must find a platform that accepts fiat currency (i.e., government-backed currency). It is important to know which trading platforms accept fiat currency; the acceptance of fiat currency demonstrates that the platform has a relationship with a regulated bank. Customers should be mindful of whether a virtual currency platform has a formal banking relationship in place.  The existence of such a relationship may offer customers a useful indicator for evaluating that a particular platform is a legitimate business concern. Fees and Fee Disclosures Most virtual currency trading platforms charge fees per transaction.  However, many virtual currency platforms’ fees may differ based on the price of the virtual asset that is bought or sold, the volume of trades executed by the customer, the order type chosen, or the timing of an order submission. Some platforms offer significant discounts to high-volume trading customers.  This discounting is known as a “maker-taker” fee model. Additionally, some platforms charge fees for withdrawals and deposits of customer fiat and virtual currencies. Customers should understand which actions will trigger fees, the size of those fees, and whether the platform will charge hidden fees.  To that end, the OAG recommends that customers should review and understand a platform’s complete fee schedule before the customer begins trading. Fee transparency is absolutely essential and customers should understand when a particular platform offers high-volume customer discounts. Trading Policies The Report drew several comparisons between virtual currency markets and the policies and market structure seen in securities trading. The OAG observed that, similar to securities platforms, the virtual currency platforms that participated in the inquiry do provide special features to professional traders. The OAG also noted that these platforms allow automated and algorithmic trading but few if any have robust policies in place to address such trading. The OAG noted that, while all of the participating platforms expressed a commitment to stamp out abusive trading practices, few had actual policies in place to define, detect, prevent, or penalize suspicious trading or market manipulation. The OAG noted that only a couple of platforms that responded to the questionnaire allow margin trading, whereby customers were allowed to borrow funds to trade a virtual asset. Since monitoring trading activity on a platform is critical to the integrity of the entire market, the OAG recommended that virtual currency platforms develop robust policies around automated and algorithmic trading, provide more transparency around the special trading features and order types offered to professional traders, improve customer onboarding procedures and implement serious market surveillance capabilities akin to those in securities trading venues  in order to detect and punish suspicious trading activity.   Conflicts of Interest The OAG noted that virtual currency platforms may have conflicts in terms of: (1) the standards applied when considering whether to list virtual assets; (2) compensation that they receive for listing particularly virtual assets; (3) the lack of consistent industry policies and procedures regarding platform employee trading; and (4) the ability of a platform to trade on its venue in a proprietary capacity. The OAG recommended that virtual currency platforms disclose payments and other compensation that they receive for listing a particular virtual currency. The OAG noted that, while the measures taken to monitor or prevent employee trading on platforms differed, virtual currency platforms should generally make their policies around employee trading more transparent to customers. Although proprietary trading certainly occurs in other markets, the OAG cautioned that customers should be aware that: (1) a platform could be trading on its own account on its own venue on an undisclosed basis; (2) high levels of proprietary trading may raise serious questions about the true available liquidity on a platform; and (3) the platforms may be trading with informational advantages. Safeguarding Customer Funds The OAG noted that, although safeguarding customer funds is of paramount importance, the virtual currency platforms that submitted responses did not consistently employ measures to ensure the security of those funds in the platforms’ custody The OAG also noted that industry standards have not yet developed around insurance for virtual currency platforms (i.e., what assets should be insured, against what risks, and at what price). The OAG noted that, although a number of the platforms reported that they have retained outside firms to conduct independent audits, the industry lacked common auditing standards. The OAG recommended that virtual currency platforms require two-factor identification by default to ensure that customer’s data is secure.  The OAG also recommended that platforms make better use of “cold storage” (i.e., a security practice wherein private keys to virtual currency are kept off of the internet).  Finally, the OAG recommended that platforms regularly conduct “penetration testing” in order to identify security holes in a platform’s information technology and data security infrastructure. The OAG recommended that customers should demand more information from trading platforms about how those platforms insure risks related to the virtual or fiat currency held within their custody. The OAG recommended that the industry come together to develop common auditing standards for virtual currency platforms. Access to Customer Funds During Suspensions/Outages The OAG noted that platforms often fail to detail their procedures for transferring virtual currency from customer accounts to private wallets, or for processing fiat currency withdrawals both under normal market conditions and during a suspension or outage.  The platforms that participated in the inquiry had differing policies. The OAG further noted that platforms do not have adequate policies or procedures for suspending trading or delaying pending trades, and the handling of open orders during and immediately following suspension and/or platform outage. The OAG recommended that customers should familiarize themselves with how pending trades and currency withdrawals are treated under normal market conditions and during a trading suspension or outage. Disclosure of Historical Outages The OAG noted that while most platforms notify customers of any trading suspensions or outages, few of the platforms provide full disclosure of past outages or suspensions, and the reasons for those events. The OAG suggested that customers examine whether a platform provides a history of prior outages and trading interruptions because by doing so it helps customers evaluate historical stability, reliability, and transparency of a venue. After conducting the general assessment described above, the OAG highlighted its three principal areas of concern: Virtual Currency Platforms Do Not Disclose or Take Measures to Mitigate Potential Conflicts of Interest.  Virtual currency platforms may operate with several conflicts of interest, including:  (1) operating several lines of business that would be restricted or carefully regulated if those platforms were exchanges in traditionally regulated markets; (2) receiving fees and other incentives to list particular virtual currencies; (3) having insufficient policies and procedures for limiting access to platforms employees to trade alongside of customers; and (4) engaging in proprietary trading alongside customers when platforms have access to nonpublic information. Virtual Currency Platforms Do Not Take Serious Efforts to Impede Market Manipulation and Protect Market Integrity.  The Report opined that many virtual currency platforms are susceptible to manipulative and fraudulent trading activity.  Such platforms lack robust real-time and historical market surveillance capabilities like those found in the securities and commodities and derivatives markets. Customer Fund Safeguards on Platforms are Limited and Often Illusory.  The Report also flagged that virtual currency markets may lack consistent and transparent approaches to ensure the protection of customer funds.  While many virtual currency platforms use independent auditors to conduct reviews of the platforms’ holdings, and some platforms have insurance, the scope and sufficiency of the audits and insurance do not provide adequate protections to customers for losses of their virtual or fiat currency. The OAG reiterated that New York’s virtual currency regulations address many of these concerns and the topics identified in its assessment.  The OAG reminded BitLicense registrants that they should be adhering to these requirements already. III.   Conclusion Although the Report was directed at New York investors and consumers, its assessment principles and recommendations may also establish more generally applicable industry standards.  Indeed, platforms operating outside of New York can use the OAG’s assessment and recommendations to enhance and improve their existing operations. The Report noted that the OAG has made referrals to NYDFS to initiate investigatory proceedings against three platforms that appear to engage in a virtual currency business in New York.  The Report may also influence other states and the federal government to consider developing regulations or guidance based on the OAG’s assessment and recommendations.    [1]   See Office of the New York State Attorney General, Virtual Markets Integrity Initiative Report, Sept. 18, 2018, available at https://ag.ny.gov/sites/default/files/vmii_report.pdf.    [2]   See Office of the New York State Attorney General, Press Release, A.G. Schneiderman Launches Inquiry Into Cryptocurrency “Exchanges”, Apr. 17, 2018, available at https://ag.ny.gov/press-release/ag-schneiderman-launches-inquiry-cryptocurrency-exchanges.    [3]   Report, p.2.    [4]   See CoinMarketCap, Sept 27, 2018, available at https://coinmarketcap.com/all/views/all/.    [5]   See Report p.2 (“there are more than 1,800 different virtual currencies. . . .”); see also CoinMarketCap, Sept. 27, 2018, available at https://coinmarketcap.com/all/views/all/.    [6]   See CoinMarketCap, Sept. 27, 2018, available at https://coinmarketcap.com/all/views/all/.    [7]   The website CoinMarketCap estimates that there are 14,252 different “markets” for trading cryptocurrencies.  See id.  The definition of “markets” also includes offline commercial areas or arenas for trading.    [8]   Through administrative decisions issued in 2015, the CFTC set forth its interpretation that virtual currencies (which include cryptocurrencies like Bitcoin) are commodities under the Commodity Exchange Act.  See In the Matter of: Coinflip, Inc., d/b/a Derivabit, and Francisco Riordan, CFTC Docket No. 15-29, available here.    [9]   See, e.g., CFTC Advisory, Customer Advisory: Use Caution When Buying Digital Coins or Tokens, July 16, 2018, available at https://www.cftc.gov/sites/default/files/2018-07/customeradvisory_tokens0718.pdf. [10]   See, e.g., CFTC v. Kantor et al., Civ. Act. No. CV182247, Apr. 17, 2018, available at https://www.cftc. gov/sites/default/files/2018-04/enfbluebitbancorder041718.pdf. [11]   Georgia, Illinois, Kansas, Massachusetts, Tennessee, Texas and Washington have established streamlined application processes for financial technology firm applicants to obtain money transmitter licenses. [12]   See 23 NYCRR Part 200 (Virtual currencies) (2018). [13]   See https://www.dfs.ny.gov/banking/virtualcurrency.htm. [14]   See id. [15]   See NYSDFS, Guidance on Prevention of Market Manipulation and Other Wrongful Activity, Feb. 7, 2018, available at https://www.dfs.ny.gov/legal/industry/il180207.pdf. Gibson Dunn’s lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or the authors: Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) © 2018 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

November 14, 2017 |
U.S. Treasury’s Capital Markets Report Gives Market Regulators Green Light to Streamline Derivatives Regulations

This alert examines the derivatives policy recommendations set forth in the U.S. Department of Treasury’s (“Treasury”) report titled A Financial System That Creates Economic Opportunities: Capital Markets[1] (the “Report” or the “Capital Markets Report”), which Treasury released on October 6, 2017.  The Capital Markets Report is the second in a series of reports that Treasury has released or is expected to release in accordance with President Trump’s February 3, 2017, Executive Order on Core Principles for Regulating the United States Financial System[2] (the “Order”). The Report is particularly relevant to derivatives market participants because it reflects the Trump Administration’s policies on Federal regulation and oversight of derivatives-related activities, bank capital standards, the regulation and supervision of financial market utilities, international aspects of the capital markets’ regulations, and various administrative matters relating to agency rulemaking processes.  Although Treasury’s policy recommendations will not result in wholesale reforms in the immediate term, the Report urges Congress to consider certain legislative proposals and empowers financial regulators to begin the rulemaking process to amend existing regulations with the goal of reducing burdensome compliance obligations. Section I of this alert provides background on the Capital Markets Report.  Section II discusses key takeaways from the Report that we believe are most pertinent to our clients.  Section III reviews the Report’s policy recommendations related to derivatives markets.  The alert concludes with Section IV, reiterating themes and takeaways from the Report’s recommendations.  Although the Report also includes several other capital markets recommendations that focus on regulatory issues beyond derivatives reform, those recommendations are outside the scope of this alert. I.     Background Under the Order, the Secretary of the Treasury is directed to consult with member agencies of the Financial Stability Oversight Council and to report on how existing laws, regulations, and other Government policies promote, support, or inhibit the seven core principles outlined in the Order.[3]  The Order has signaled to financial regulators that the Trump Administration wants a reappraisal of a number of Obama-era regulations imposed on financial institutions and derivatives end users. To meet its directive under the Order, Treasury has organized its recommendations into a series of reports.  The first report, on banks and credit unions, was released on June 12, 2017.  The second report, and the focus of this alert, was released on October 6, 2017.  Treasury released a report on asset management and insurance companies on October 26, 2017.  Treasury is expected to release a fourth report on non-banks, financial technology, and cybersecurity in financial markets sometime in the first quarter of 2018. The Capital Markets Report serves as an agenda for many of the issues that the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”, together with the SEC, the “Commissions”) are expected to address in the coming years.  The content of the Report, the range of topics discussed, and the level of detail in the Report’s recommendations demonstrate Treasury’s close collaboration with the Commissions and engagement with industry stakeholders.[4]  Indeed, the Chairmen of both Commissions indicated that staff from their respective agencies engaged with Treasury in preparing the Report.  SEC Chairman Jay Clayton expressed appreciation for “Treasury’s willingness to seek the SEC’s input during the drafting process[,]” and that the Report “will be of immediate and lasting value.”[5]  Similarly, CFTC Chairman J. Christopher Giancarlo indicated that the CFTC “was actively engaged with Treasury in the preparation of this [R]eport,” and that the CFTC was “pleased to see our perspective incorporated in the final product.”[6]  He further stated that “if implemented, the recommendations provided within this [R]eport will help foster financially sound markets in a way that encourages broad-based economic growth and American prosperity and respects the American taxpayer.”[7] II.     Key Takeaways We believe that there are four key takeaways from the Capital Markets Report of which derivatives market participants should be cognizant.  First, the Capital Markets Report outlines an ambitious agenda for the Commissions with a focus on streamlining and harmonizing regulations to lower costs for market participants, promoting capital formation, keeping U.S. markets competitive, and fostering economic growth.  In the near term, we anticipate that the CFTC may quickly propose rulemakings in the spirit of the Report’s recommendations.  In fact, there has already been momentum in that regard.  The CFTC has taken steps towards modernizing existing rules, regulations, and practices through soliciting comments as part of Project KISS,[8] and improving reporting rules for products and swap data responsibilities through its reform efforts.[9]  These proposals and efforts to modernize existing rules, regulations, and practices, however, will take some time to be finalized and implemented by the industry.  In contrast, the SEC has not been as focused on Title VII reforms given the volume of additional non-derivatives related recommendations for the SEC to consider.  It is unclear therefore how quickly the SEC will focus on derivatives reforms. Second, we anticipate that the Commissions will begin more fully addressing some of the rulemaking procedural criticisms raised in the Report, such as the recommendation that the Commissions perform more robust cost-benefit and economic analyses for their rulemakings and the recommendation to rely less heavily on staff action.  With respect to cost-benefit and economic analyses, we have observed that the CFTC has recently taken steps to address this criticism.  The CFTC’s Chief Economist, Bruce Tuckman—who was appointed to the position last August—stated that he looked forward to working with Chairman Giancarlo on “increasingly guiding CFTC rule-making and risk monitoring with cutting-edge economic analysis and empirical work.”[10]  Chairman Giancarlo has spoken publicly about the need for the CFTC to apply “rigorous cost benefit analysis” in its rulemaking,[11] and recently requested additional funds from Congress for fiscal year 2018 so the Commission can “enhance economic cost benefit analysis capabilities.”[12]  With respect to the Commissions’ reliance on staff action, the Chairmen of the Commissions have made public statements to the effect that the agencies will work more collaboratively with the industry during the rulemaking consultation process and rely less heavily on the issuance of staff no-action letters and interpretations.  Indeed, Chairman Giancarlo has emphasized the need to ensure that market participants and affected parties do not experience significant implementation issues when complying with the CFTC’s rulemakings.[13] Third, market participants should expect the Commissions to engage in efforts to harmonize their derivatives regulations and to cooperate with international regulators.  With respect to the rulesets of the two agencies, the Report clearly favors domestic harmonization over merging the Commissions.  With respect to international cooperation, the Commissions already have engaged in two examples following the issuance of the Report.  The first example is the SEC’s adoption of measures to facilitate the cross-border implementation of the European Union’s Markets in Financial Instruments Directive II (“MiFID II”) research provisions.[14]  The second example, discussed below in Section III(2) of this alert, is the CFTC’s two recent actions on harmonization with the European Commission (“EC”).[15] Fourth and finally, market participants should expect Congress to consider legislative proposals that would, if adopted, result in targeted amendments to Title VII of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) in order to address some of its more over-bearing provisions.  While most of Treasury’s recommendations call for regulatory action, there are certain areas in the Report where Treasury acknowledges the need for Congress to take action, in particular with respect to the definition of “financial entity” as well as harmonizing rulemaking among agencies.  Because Congress currently is focused on legislative matters such as tax reform, health care, and infrastructure, the timing and vehicles for implementing the Report’s legislative recommendations remain unclear. III.     Capital Markets Report Derivatives-Related Recommendations The Capital Markets Report makes ninety-one recommendations in nine topic areas.[16]  The derivatives-related topic areas include: (1) derivatives legislative recommendations; (2) derivatives regulatory recommendations; (3) bank capital and margin; (4) financial market utilities; and (5) administrative matters (i.e., regulatory structure and process).  Across those topic areas, we discuss below the most important recommendations to derivatives market participants and derivatives market reform. (1)  Legislative Recommendations In its preparation of the Capital Markets Report, Treasury generally expressed widespread support for the broad derivatives regulatory changes enacted under Title VII of Dodd-Frank.  The Report recommends, however, three legislative amendments relating to the derivatives title of Dodd-Frank. Definition of “Financial Entity.”  The Report recommends a legislative amendment to finally address the numerous proposals since Dodd-Frank’s passage to modify the definition of “financial entity” and clarify the scope of the exception for nonfinancial end users’ affiliates.  It recommends that Congress amend the Commodity Exchange Act (“CEA”) Section 2(h)(7) to provide the CFTC with rulemaking authority to modify and clarify the scope of the financial entity definition and the treatment of affiliates, and provide the SEC analogous rulemaking authority under the Securities Exchange Act of 1934 (“Exchange Act”) Section 3C(g) for security-based swaps. Harmonization.  The Report focuses heavily on the harmonization of existing and forthcoming rules among the agencies and recommends that Congress consider further action to aid in this goal, particularly in relation to the regulation of swaps and security-based swaps. Streamline and Formalize Rulemakings.  The Report recommends that the Commissions streamline regulation by avoiding imposing substantive new requirements by interpretation or other guidance.  However, it suggests that Congress restore the Commissions’ authority to provide exemptions to requirements when necessary to facilitate market innovation.  The Report says that regulators should also conduct reviews of existing agency rules in order to decrease regulatory burdens and ensure relevance, and should fully solicit comments and input from the public. (2)  Significant Regulatory Recommendations Most of Treasury’s recommendations are regulatory in nature and come under the rulemaking authority of the Commissions.  Following Treasury’s release of the Report, the CFTC issued a comprehensive statement explaining what it views as the Report’s key recommendations on derivatives.[17]  The CFTC’s statement emphasizes recommendations on capital treatment in support of central clearing; swap execution facilities; the SEC-CFTC merger debate; SEC-CFTC harmonization; cross-border issues; economic analysis; swap data reporting; and central counterparties’ (“CCPs”) “skin in the game.”  We highlight seven of the most significant regulatory recommendations on derivatives below. Swap Dealer De Minimis Threshold.  The Report recommends that CFTC maintain the swap dealer de minimis threshold calculation at $8 billion and establish that any future changes to the threshold will be subject to a formal rulemaking.  The Report found that lowering the threshold to a $3 billion level would result in a tremendous increase in the number of regulated entities but would only capture less than 1 percent of notional activity.  The Report indicates that market participants strongly support maintaining the $8 billion level and that clarification on the topic will reassure markets.On October 26, the CFTC voted to extend the sunset date  of the exception threshold by one year, ensuring that the threshold will stay at $8 billion until December 31, 2019, instead of decreasing to $3 billion on December 31, 2018.[18]  This action was the CFTC’s second order providing such relief.  The CFTC explained in the current order that it needed additional time to complete its analysis of swap data and consider appropriate further action, including potential amendments to the de minimis exception.  It further noted that any such amendments, if implemented, would not become effective until some point in 2018 because the CFTC would have to follow its normal rulemaking process under the Administrative Procedure Act. Formalize Staff Guidance.  In relation to the implementation of the swaps regulatory framework under Title VII of Dodd-Frank, the Report recommends that regulators rely less on no-action letters and take steps to simplify and formalize staff guidance where necessary.  The CFTC has already begun its efforts in this regard by soliciting comments from the public on Project KISS and CFTC staff’s Roadmap to Achieve High Quality Swaps Data (the “Roadmap”), which is discussed below. Finalize Position Limits.  The Report notes that progress on establishing position limits has been a challenge.  The CFTC finalized a position limits rule in November 2011, which was vacated in September 2012 by the U.S. District Court for the District of Columbia after a legal challenge.  The Commission has since had multiple re-proposals of the position limits rules but has not taken final action.  The Report urges the CFTC to finalize its position limits rulemaking as contemplated by the statutory mandate, taking into account, among other things, the appropriate availability of bona fide hedging exemptions for end-users, and finally bring clarity to this important issue.  We anticipate that yet another position limits re-proposal is forthcoming from the CFTC. Swap Data Reporting Reform. The Report supports the CFTC’s Roadmap efforts to standardize and harmonize reporting rules for products and swap data repositories.  The Roadmap effort is directed by the CFTC’s Division of Market Oversight and lays out the tranches of changes to the CFTC’s swap data reporting rules.  The Report recommends the CFTC commit adequate resources to the Roadmap effort, amend its rules through a formal rulemaking process, and implement the new standards within the timeframe outlined in the Roadmap. Cross-Border Jurisdiction. On cross-border issues, the Report highlights the need for U.S. regulators to continue to engage and cooperate with international counterparts and seek notice and comment for rulemakings in an effort to avoid market fragmentation, redundancies, undue complexity, and conflicts of law.  Treasury recommends that the Commissions:  (1) make their swaps and security-based swaps rules compatible with non-U.S. jurisdictions; (2) adopt outcomes-based substituted compliance regimes that minimize redundancies and conflicts by considering the rules of other jurisdictions; and (3) reconsider their approaches to transactions that are arranged, negotiated, or executed by personnel in the United States for applying transaction-level swap requirements.  The CFTC indicated preliminary steps to comply with these recommendations through its October 13, 2017 joint announcement with the EC on harmonizing two key derivatives regulatory requirements.[19] Harmonize Margin Requirements for Uncleared Swaps. The Report recommends that the CFTC and U.S. banking regulators harmonize margin requirements for uncleared swaps domestically and cooperate with non-U.S. jurisdictions so that U.S. bank swap dealers and U.S. firms are not at a disadvantage to domestic and international competitors.  The Report recommends that regulators consider amendments to their rules to allow for more realistic time frames for collecting and posting margin on uncleared swaps; reconsider treating end users all the same for the purposes of margin on uncleared swaps; and that the SEC re-propose its proposed margin rule for uncleared security-based swaps in a manner that is aligned with the margin rules of the CFTC and U.S. prudential regulators.The CFTC and the EC announced on October 13, 2017 that they had adopted substituted compliance uncleared margin determinations for each other’s uncleared margin requirements.[20]  As a result, swap dealers subject to both CFTC’s and European’s uncleared margin rules now have more certainty that they will not have to establish duplicative compliance programs.[21] SEF Execution Methods and MAT Process.  Due to market participants’ concerns that the CFTC’s current mandatory trading protocols (i.e., order book and “RFQ-to-3” requirements) are overly restrictive—a concern also expressed by CFTC Chairman Giancarlo—the Report recommends that the CFTC:  (1) consider rule changes to permit swap execution facilities (“SEFs”) to use any means of interstate commerce to execute swaps subject to trade execution mandates; (2) reevaluate the made available to trade (“MAT”) determination process to ensure liquidity; and (3) consider clarifying or eliminating footnote 88 of the June 2013 CFTC SEF final rules that triggered the exclusion of U.S. participants by most non-U.S. trading platforms and that ultimately has led to a bifurcation of the global interest rate swaps market.[22]One recent step that the CFTC has taken to ameliorate the effects of footnote 88 is the agency’s October 13 joint announcement with the EC regarding an agreement to recognize each other’s authorized trading venues.  Once the terms of their agreement is finalized, European firms operating in the United States will be able to trade derivatives on authorized U.S. trading venues while still complying with EU law in advance of the trading obligation go-live date of Markets in Financial Instruments Directive II.[23]  The agreement, once finalized, also will allow U.S. firms to comply with the CFTC’s trade execution requirement by executing swaps on EU-authorized trading venues.  Since the announcement sets forth only a common plan, both regulators must take additional steps to effectuate recognition of each other’s trading venues.  The timing of the EC’s and the CFTC’s actions to finalize their agreement is uncertain. (3)  Bank Capital and Margin Recommendations U.S. banking agencies and the CFTC finalized their respective margin rules for the uncleared swaps and bank-affiliated swap dealers in November 2015 and nonbank swap dealers in January 2016.  The Report recommends that U.S. regulators take steps to harmonize their margin requirements for uncleared swaps domestically and cooperate with non-U.S. jurisdictions to promote a level playing field for U.S. firms. Treasury’s recommendations of particular importance to derivatives market participants are highlighted below. Capital Treatment in Support of Central Clearing.  Treasury reiterates its recommendation in the Banking Report that initial margin for centrally-cleared derivatives should be deducted from the supplementary leverage ratio denominator, thereby reducing the cost for banks to provide clearing services and ending the penalization of entities for clearing their swaps.  Additionally, the Report recommends a risk-adjusted approach for valuing options under capital rules, and that banking regulators conduct regular assessments on how capital and liquidity rules impact the incentives to centrally clear derivatives. Exemption from Initial Margin Requirements.  The Report notes that market participants hold the view that U.S. regulators have taken a stricter approach than non-U.S. jurisdictions with respect to many of the particular requirements of the uncleared margin rules.  Accordingly, the Report recommends that U.S. prudential regulators consider providing an exemption to initial margin requirements for derivatives trades between affiliates of the same bank (i.e., inter-affiliate transactions), harmonizing the requirements with those of the CFTC and corresponding non-U.S. requirements, and promoting a level playing field for U.S. firms. (4)  Financial Market Utilities Recommendations CCPs, trade repositories, and exchanges are an essential part of the Dodd-Frank derivatives market infrastructure.  The Report states these financial market utilities (“FMUs”) are critical financial infrastructures that are also highly interconnected with other U.S. financial institutions and, therefore, pose a threat of systemic risk. Strengthen Oversight.  To address concerns regarding systemic risk, Treasury recommends additional oversight of FMUs and finalizing strong resolution regimens for these entities in order to limit potential taxpayer-funded bailouts and moral hazard, especially important because FMUs may have access to the Federal Reserve System’s (“Federal Reserve”) discount window. Increase Resources for Regulators.  The Report further recommends that more resources be devoted to the regulators that supervise systemically-important FMUs, in particular for the CFTC to enhance supervision of CCPs, and for the Federal Reserve to review risks related to  account access, strengthen stress testing exercises, and coordinate and complete the development of resolution plans for FMUs. CCP “Skin in the Game.”  The Report also recommends that CCPs and their members work together to strike an appropriate balance between the CCPs’ resources and mutualized resources of clearing members. (5)  Administrative Recommendations The Report makes a number of recommendations that are focused on the administrative procedures followed by the Commissions rather than on specific substantive requirements.  Each of the key recommendations in this regard are discussed below. SEC-CFTC Merger Debate.  The Report highlights the need for harmony and cooperation between regulators.  However, Treasury stops short of recommending a merger between the SEC and CFTC, citing the key differences in their underlying regulatory purposes—capital formation and investment versus hedging and risk transfer—and insignificant cost savings of five percent.  Instead, the Report recommends that the Commissions better harmonize rules to avoid increased compliance cost and complexity for market participants.  Specifically, the Report notes that where the CFTC has finalized most of the rulemakings required under Dodd-Frank, there are several “critical rulemakings” that the SEC has not yet finalized or implemented.  Treasury recommends that the Commissions harmonize Title VII of Dodd-Frank reform rules with an eye towards reducing burdens on market participants. Enhance Cost Benefit Analyses.  The Report stresses that the Commissions continue to perform more, and heightened, economic analysis of costs and benefits in rulemaking, including an updated consideration of the effects on small entities, and that the Commissions publish this information where appropriate. Comprehensive Reviews of Self-Regulatory Organizations.  The Report finds that, while self-regulatory organizations (“SROs”) offer many benefits to the capital market, over time they have grown larger, their members have less control, and many have become for-profit publicly traded companies.  As a result, some constituencies told Treasury that SROs have become less transparent while their rules and costs continue to increase, and have created a potential for regulatory duplication with Commissions or other SROs.  Thus, Treasury recommends the Commissions conduct comprehensive reviews of the SROs and make recommendations for operational, structural, and governance improvements of the SRO framework to include, among other things, controlling for conflicts of interest; transparency regarding fee structures; and limitations on regulatory, surveillance, and enforcement responsibilities.  If enhanced oversight of SROs is required, the regulators should take action in this regard. Definition of “Small Entity.”  Under the Regulatory Flexibility Act (“RFA”), Federal agencies are required to consider the impact of rulemaking on small entities.  Rules regarding which entities are considered a “small entity” by the Commissions, however, can be overbroad in some instances and too narrow in others.  The Report recommends that the Commissions review and update these definitions so that the RFA analysis appropriately considers the impact on persons who should be considered small entities. IV.     Conclusion  Each of the derivatives-related recommendations in the Capital Markets Report conform with the Order’s seven core principles, which essentially seek to foster U.S. economic growth through right-sizing regulatory obligations.  To reach this goal, Treasury urges regulatory agencies and Congress to focus on streamlining and harmonizing regulations, something we anticipate the Commissions—whose input was incorporated into the Report—will address by making procedural changes to rulemaking and working more closely with each other and international regulators.  Legislative amendments to some provisions of Title VII of Dodd-Frank should also be expected.  Ultimately,  Treasury’s proposed agenda will take a significant amount of time to develop and implement, so the impact of these recommendations likely will not be felt by market participants in the near term.    [1]   U.S. Dep’t of the Treas., A Financial System That Creates Economic Opportunities: Capital Markets (2017), available at https://www.treasury.gov/press-center/press-releases/Documents/A-Financial-System-Capital-Markets-FINAL-FINAL.pdf.    [2]   Exec. Order No. 13,772, 82 Fed. Reg. 9965 (Feb. 8, 2017).    [3]   The seven core principles in the Order are: (a) empower Americans to make independent financial decisions and informed choices in the marketplace, save for retirement, and build individual wealth; (b) prevent taxpayer-funded bailouts; (c) foster economic growth and vibrant financial markets through more rigorous regulatory impact analysis that addresses systemic risk and market failures, such as moral hazard and information asymmetry; (d) enable American companies to be competitive with foreign firms in domestic and foreign markets; (e) advance American interests in international financial regulatory negotiations and meetings; (f) make regulation efficient, effective, and appropriately tailored; and (g) restore public accountability within Federal financial regulatory agencies and rationalize the Federal financial regulatory framework. For further information, see our Client Alert, President Trump Issues Executive Order on Financial Regulation, and Memorandum on Department of Labor Fiduciary Rule (Feb. 6, 2017), available at http://www.gibsondunn.‌com‌‌‌‌/publications/Pages/President-Trump-Issues-Executive-Order-on-Financial%20Regulation–DOL-Fiduciary-Rule.aspx.    [4]   In addition to collaborating with the Commissions, Appendix A to the Report contains a list of market participants, think tanks, trade groups, regulators, consumer advocates, and academics that engaged with Treasury in preparing the recommendations in the Report.    [5]   Statement attributed to Chairman Jay Clayton (Oct. 6, 2017) (on file with U.S. Sec. & Exch. Comm’n).    [6]   U.S. Commodity Futures Trading Comm’n, Statement of Chairman Giancarlo on Treasury Report on Capital Markets (Oct. 6, 2017), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/‌giancarlostatement100617.    [7]   Id.    [8]   Project KISS is the CFTC’s initiative to seek public input on simplifying and modifying the CFTC’s rules.  In particular, the CFTC requested comments on five key initiatives:  (1) Registration; (2) Reporting; (3) Clearing; (4) Executing; and (5) Miscellaneous.  The comment period for providing comments on these initiatives closed on September 30, 2017.  See U.S. Commodity Futures Trading Comm’n, CFTC Requests Public Input on Simplifying Rules (May 3, 2017), available at http://www.cftc.gov/PressRoom/PressReleases/pr7555-17.    [9]   See Section III(2) Swap Data Reporting Reform. [10]   U.S. Commodity Futures Trading Comm’n, Chairman Giancarlo Appoints Bruce Tuckman CFTC’s Chief Economist (Aug. 21, 2017), available at http://www.cftc.gov/PressRoom/PressReleases/pr7604-17. [11]   See, e.g., U.S. Commodity Futures Trading Comm’n, Remarks of CFTC Commissioner J. Christopher Giancarlo before the U.S. Chamber of Commerce (Nov. 20, 2014), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlos-2.   [12]   U.S. Commodity Futures Trading Comm’n, Testimony of J. Christopher Giancarlo, Acting Chairman, Commodity Futures Trading Commission, before the U.S. Senate Committee on Appropriations Subcommittee on Financial Services and General Government (June 27, 2017), available at http://www.cftc.gov/PressRoom/SpeechesTestimony/opagiancarlo-26. [13]   U.S. Commodity Futures Trading Comm’n, Testimony of J. Christopher Giancarlo, Chairman, Commodity Futures Trading Commission, before the U.S. House Committee on Agriculture (Oct. 11, 2017), available at https://agriculture.house.gov/uploadedfiles/testimony_for_j._chris_giancarlo_before_house_ag__10.11.17.pdf. [14]   U.S. Securities and Exchange Comm’n, SEC Announces Measures to Facilitate Cross-Border Implementation of the European Union’s MiFID II’s Research Provisions (Oct. 26, 2017), available at https://www.sec.gov/news/press-release/2017-200-0. [15]   For further information, see our Client Alert, Ready? Set? Harmonize: The CFTC and EC Announce Two Actions to Harmonize Their Derivatives Regulations ( Oct. 27, 2017), available at http://gibsondunn.com/publications/Pages/CFTC-and-EC-Announce-Two-Actions-to-Harmonize-Their-Derivatives-Regulations.aspx. [16]   Appendix B of the Report contains a table of recommendations outlining in detail each recommendation, the branch or regulator responsible for the related policy, and the core principle that applies. [17]   U.S. Commodity Futures Trading Comm’n, CFTC Backgrounder on the Department of Treasury’s Report on Capital Markets, available at http://www.cftc.gov/idc/groups/public/@newsroom/documents/file/ treasuryreport100617.pdf. [18]     U.S. Commodity Futures Trading Comm’n, CFTC Issues Order Extending Current Swap Dealer De Minimis Threshold to December 2019 (Oct. 26, 2017), available at http://www.cftc.gov/PressRoom/PressReleases/pr7632-17. [19]   For further information, see our Client Alert, Ready? Set? Harmonize: The CFTC and EC Announce Two Actions to Harmonize Their Derivatives Regulations ( Oct. 27, 2017), available at http://gibsondunn.com/publications/Pages/CFTC-and-EC-Announce-Two-Actions-to-Harmonize-Their-Derivatives-Regulations.aspx. [20]   Id. [21]   Swap dealers that are subject to the U.S. prudential regulators’ uncleared margin rules, however, are not covered by the Uncleared Margin Determinations and, as a result, are unable to rely on this substituted compliance relief. [22]   See CFTC, Final Rule, Core Principles and Other Requirements for Swap Execution Facilities, 78 Fed. Reg. 33476 (June 4, 2013). [23]   For further information, see our Client Alert, Ready? Set? Harmonize: The CFTC and EC Announce Two Actions to Harmonize Their Derivatives Regulations (Oct. 27, 2017), available at http://gibsondunn.com/publications/Pages/CFTC-and-EC-Announce-Two-Actions-to-Harmonize-Their-Derivatives-Regulations.aspx Gibson Dunn’s lawyers  are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work in the firm’s Financial Institutions practice group, or the following: Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com) Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com) Stephanie L. Brooker – Washington, D.C. (+1 202-887-3502, sbrooker@gibsondunn.com) Amy Kennedy – London (+44 (0)20 7071 4283, akennedy@gibsondunn.com) Carl E. Kennedy – New York (+1 212-351-3951, ckennedy@gibsondunn.com) Jeffrey L. Steiner – Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) © 2017 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

June 29, 2016 |
BREXIT Update – Finance and Derivatives Markets Focus

As you will all be aware, the UK electorate voted last week to leave the European Union.  The Referendum does not itself trigger any immediate legal consequences and the actual timing for a UK exit from the EU (if at all) is uncertain.  However, the vote to leave had an immediate and direct effect on the global finance markets, with Sterling falling to a 30-year low against the Dollar, and the ratings agencies announcing a UK ratings downgrade reflective of weakening investor confidence.  UK equities are volatile, with many UK listed banks and corporates suffering heavy sell-offs, and the European bond market has recorded significant outflows.    There are mixed views as to the medium to long-term effects of recent events, but it seems likely that continuing political uncertainty will result in a gradual slowdown in the European finance markets for at least the summer months.  As a result, focus has turned to the consequences for key players within the European loan, high yield and derivatives space – whether they be investors pulling monies, credits seeking alternative types and means of financings, or hedge counterparties raising risk profiles.   This Client Alert considers a number of factors, following the vote to leave, which have an impact on the European finance and derivatives space. European loan market Consequences for open commitments and deals in syndication In the immediate aftermath of the vote to leave, a number of investors and credits have looked to question the viability of open commitments across both loan and high yield documentation.  As bitter memories of the 2008 financial crisis bring out fears of hung bridges and drawdowns under interim facilities agreements, lawyers have been asked to consider whether there are immediate "vote to leave" or "BREXIT" loopholes and/or trigger points within underlying documentation.  Each set of papers must be considered on its merits.  Unless there are specific "Brexit" or "Flexit"[1] clauses, tight "certain funds-style" conditionality which is now typically included within European commitment papers and/or loan documentation means that it is unlikely that the vote to leave will permit a bank or other investor legitimately to pull a commitment, at least in the short term.  Further, and as we noted in our previous Client Alert[2], it is thought unlikely that the vote to leave, or an eventual BREXIT, will itself lead a lender to call a material adverse change provision.  However, there may of course be certain consequential effects e.g. prejudicial hedging exposures, negative trading positions etc., which could collectively make it more likely that a lender will formulate a case for invoking such a provision.  Even if open commitments are initially unaffected, to the extent that there are active deals in primary syndication, it is highly likely that lenders will continue to carefully scrutinize syndication and market flex provisions to see when and how they can be invoked, particularly in light of a general softening in the secondary markets, and going forward an expected rise in the cost of borrowing and the desire for tighter covenant and/or other documentation terms. Scrutiny and reprofiling of existing transactions Looking forward, the continuing volatility in the European loan and high yield markets referred to above may have an adverse impact on the availability and/or cost of some types of finance.  Coupled with this, it is assumed that M&A and private equity activity will also decrease, and consequently the volume of pipeline deals and new money issuance will fall.  For credits already laden with significant debt, we expect that there will be a resurgence of the types of debt reprofiling experienced after the 2008 financial crisis – for example, covenant resets and maturity extensions (i.e. "amend and extend" transactions).  Borrowers will also need to ensure that any existing structures work notwithstanding any transitional arrangements put in place following the vote to leave but prior to BREXIT, particularly in relation to debt service and withholding tax exemptions.    As a result, we expect that both investors and borrowers will be spending significant time reviewing existing loan and high yield documentation to assess where there are inherent risks and/or flexibilities.  In particular, we expect investors and borrowers will be considering the extent to which underlying documentation permits the disposing of, hiving out or acquiring of assets, extracting cash out of a distressed group by way of dividend or other cash leakage, or the incurrence of additional debt. Tapping uncommitted facilities Of direct relevance to this analysis will be the significant number of recent European loan documents – across the mid-market and "top-tier" space – that include sophisticated uncommitted incremental or additional facilities, with broad (if any) purpose clauses and minimal conditions for exercise, often tied only to compliance with a pro-forma leverage test.  The flexibility within these incremental (or so-called "accordion") facilities will provide borrowers with a readily available hook to raise additional financing, and we expect that some borrowers will look to tap existing incremental structures rather than seek full refinancings.  Of course, borrowers will still need to find lenders who are prepared to fund these additional facilities.  However, notwithstanding market volatility, investors will still have capital that they need to deploy, and we expect that the number and dynamic of players in the market will increase.  From a legal perspective, the advent of borrowers tapping incremental facilities will be likely to lead to interesting intercreditor discussions.  Very few incremental facilities have actually been used to date, and, therefore, the mechanics remain largely untested, particularly within intercreditor agreements where so-called "hollow tranches" have been drafted blind to provide for future incremental debt issuance.  Consequences for distressed transactions Inevitably, both investors and borrowers will seek more creative solutions to overcome immediate liquidity issues, and if the above reprofiling alternatives are unavailable, then credits will move into the distressed refinancing or restructuring space.  As with the post-2008 world, this will necessarily lead to the increased scrutiny of pan-European insolvency regimes (in the absence of a holistic, Chapter 11-style approach).  Unless alternative arrangements are agreed post-BREXIT, EU insolvency proceedings would no longer benefit from automatic recognition in the UK, and UK insolvency proceedings would no longer benefit from such recognition in the EU.  The UK would have to rely on the cross-border insolvency rules of the member states.  That said, many restructurings are concluded outside formal insolvency proceedings, and these arrangements will be largely unaffected by BREXIT. Yankee loans As borrowers within the European loan market face challenges with new money financings, we expect to see a resurgence in so-called "Yankee loans", i.e., an increase in the number of European borrowers looking to access the US markets for loan financings.  This may come hand in hand with increased cross-border investment in the UK, forecast by some commentators to increase as a result of a weaker Pound.  Only time will tell whether or not this plays out, but in the meantime borrowers will be wise to explore financing opportunities in the US markets.  Many of the key features of Yankee loans that were initially attractive to borrowers will continue to be so, notably:  lower margins, incurrence based covenants and overall greater documentation flexibility.  If a credit can manage any exchange rate costs associated with borrowing in Dollars, the US loan market is likely to be a viable alternative. The European high yield market The European high yield market is also expected to be light on new-money issuance for the short-term, and it would not be a surprise if the market is quiet for longer than usual over the summer months.  High yield issuance has suffered in any event through 2016, and inflows and new issuance levels have remained low compared to comparable periods for previous years. However, in this respect, the European high yield market may be more prepared and resilient for any fall-out from the vote to leave, particularly as issuers have already begun to explore taps to existing bond documentation, covenant flexibility and alternative capital structures, for example, the addition of holdco PIKs or other layers of subordinated debt within pre-existing structures.  Market conditions through the year have resulted in a dominance of refinancings, and there is potentially significantly more to be achieved in this space.  In addition, investors, issuers and lawyers alike have already been faced with a number of restructuring scenarios involving high yield bonds and therefore are already beginning to test cross-jurisdictional issues and intercreditor challenges, including voting rights and enforcement regimes. Market participants As borrowers look for more creative solutions in both the European loan and high yield markets, they are also likely to look towards less traditional debt providers, including alternative capital providers and direct lending funds.  Banks are likely to be most affected by any transitional arrangements following the vote to leave; particularly in terms of a changing regulatory landscape, including as regards regulatory capital rules and their application, and passporting within the EU.  We have seen these non-bank players become increasingly active in recent years and there are several larger direct lending funds capable of offering a wide variety of alternative capital solutions with big ticket sizes.  In part due to pre-existing concerns regarding regulatory enforcement, banks are showing a diminishing appetite for what are perceived to be higher risk credits, whether for sector, leverage or other reasons, and therefore, by contrast, direct lending funds who offer more flexibility in this area, become a viable option for borrowers.  In this respect, we expect that the European market may move even closer to the US market, where alternative capital providers have a more significant role.  Non-bank lenders are also likely to be capable of offering much of the structural flexibility and creativity required for the expected wave of reprofiling and refinancing transactions noted above, including second lien and PIK debt, as well innovative equity injections.  Derivatives and hedging Given London’s position as one of the leading markets for global foreign exchange and over-the-counter derivatives activity, the impact of the vote to leave, on-going transitional arrangements and then eventual BREXIT on the global derivatives markets has the potential to be significant for all derivatives market participants.  It is a good time for market participants to take stock of their existing derivatives contracts and understand their potential risks and exposures as a result of BREXIT.  The full impact of the vote to leave on the derivatives markets is uncertain and will remain uncertain until the transitional arrangements and post-BREXIT negotiations are finalized and fully realized.  However, market participants should be alive to the following potential future effects. Increased Collateral Calls Now that credit rating agencies have downgraded UK sovereign ratings, counterparties with exposure to the UK may see their own creditworthiness impacted.  As a result, the cost of credit could become more expensive, leading to increased collateral requirements.  General volatility in the markets could also increase margin requirements and additional margin obligations could be triggered by exposure to collateral such as Sterling or gilts.  These additional margin calls could lead to potential issues with respect to the movement of collateral among counterparties in addition to the costs of collateral. Derivatives Documentation While there do not appear to be any immediate impacts of the standard termination events and events of default under the International Swaps and Derivatives Association (ISDA) Master Agreement, the extent to which derivatives documentation is affected will depend on the specific negotiated terms of the agreements, as well as the specific terms of the transitional arrangements and the agreed position post-BREXIT.  For example, downgrades that result from exposures to the UK may trigger certain negotiated provisions such as Additional Termination Events, Material Adverse Change clauses or Additional Events of Default.  Additionally, as financial institutions and other entities begin to reorganize and move positions as a result of the vote to leave, market participants should take note of any modifications to the Transfer provisions under the ISDA Master Agreement, as well as other provisions, such as Credit Event Upon Merger and Force Majeure.  Further, tax provisions, provisions regarding governing law, as well as any references to the European Market Infrastructure Regulation (EMIR) and other EU regulations could be affected.  Finally, many ISDA Agreements and other derivatives documentation are governed by English law and require submission to the jurisdiction of the English courts.  BREXIT is unlikely to affect the validity of these choices.[3] Regulatory and effects on Central Counterparties and Trade Repositories The vote to leave and the subsequent transitional arrangements create significant uncertainty around how existing EU derivatives regulation and directives such as EMIR, the Markets in Financial Instruments Regulation (MiFIR) and the Markets in Financial Instruments Directive II (MiFID 2), will apply in the UK.  The UK will need to determine how regulations applicable to the EU, such as EMIR and MiFIR, will apply going forward.  Similarly, the UK will need to determine whether to retain directives that have been implemented and whether amendments should be made.  Additionally, it is possible that the UK could decide to implement its own parallel regulatory regime for derivatives to complement EMIR, MiFIR, MiFID 2, and similar regulation.  Market participants subject to UK law and trading with UK counterparties, including UK affiliates or UK branches of non-UK counterparties, should continue to track these regulatory developments.  Further, if the UK is not a member of the EU or EEA, English law contracts may need to address the contractual bail-in provisions under Article 55 of the Bank Recovery and Resolution Directive[4]. Additionally, the UK is home to some of the largest Central Counterparty Clearing Houses (CCPs) and trade repositories.  As a result of BREXIT, those entities may be viewed as "third country" CCPs or trade repositories under EMIR.  This would require an equivalence determination or other arrangement for the UK-based CCPs and trade repositories to continue to be able to offer services to market participants subject to EMIR.  Conclusions Although not without immediate challenges for those looking to either raise capital or lend new money across the European loan and high yield markets, the vote to leave will also provide opportunities for participants across the financing space.  It is a good opportunity for market participants to assess existing debt and investments, and to review existing derivatives contracts and understand potential risks and exposures.  It is clear that the transitional arrangements will play a large role in shaping the European finance world for the medium to long term, and it will be key for all to continue to monitor changing regulatory invention to assess the impact for on-going finance needs, evolving structures and market dynamics. [1]      Certain investors introduced clauses into documentation allowing them to increase margin / interest rates in the event of a vote to leave / BREXIT taking place.            [2]      http://www.gibsondunn.com/publications/Pages/What-Happens-If-the-United-Kingdom-Votes-to-Leave-the-European-Union.aspx  [3]      http://www.gibsondunn.com/publications/Pages/What-Happens-If-the-United-Kingdom-Votes-to-Leave-the-European-Union.aspx [4]      http://www.gibsondunn.com/publications/Pages/EU-Bail-in–Bad-News-for-Banks-but-Not-for-Direct-Lenders.aspx  This client alert was prepared by London partner Stephen Gillespie and London Senior Associate Amy Kennedy, with assistance from New York Partner Arthur Long and Washington, D.C. Counsel Jeff Steiner (both focusing on derivatives), and London Of Counsel Anne MacPherson.  We have a working group in London (led by Stephen Gillespie, Nicholas Aleksander, Patrick Doris, Charlie Geffen, Ali Nikpay and Selina Sagayam) that has been considering these issues for many months.  Please feel free to contact any member of the working group or any of the other lawyers mentioned below. Ali Nikpay – AntitrustANikpay@gibsondunn.comTel: 020 7071 4273 Charlie Geffen – CorporateCGeffen@gibsondunn.comTel: 020 7071 4225 Stephen Gillespie – FinanceSGillespie@gibsondunn.com Tel: 020 7071 4230 Philip Rocher – LitigationPRocher@gibsondunn.com Tel: 020 7071 4202 Jeffrey M. Trinklein – TaxJTrinklein@gibsondunn.com Tel: 020 7071 4224 Nicholas Aleksander – TaxNAleksander@gibsondunn.com Tel: 020 7071 4232 Alan Samson – Real EstateASamson@gibsondunn.comTel:  020 7071 4222 Patrick Doris – LitigationPDoris@gibsondunn.comTel:  020 7071 4276 Penny Madden QC – ArbitrationPMadden@gibsondunn.comTel:  020 7071 4226 Selina Sagayam – Corporate SSagayam@gibsondunn.comTel:  020 7071 4263 Steve Thierbach – Capital Markets SThierbach@gibsondunn.comTel:  020 071 4235 Amy Kennedy – Finance AKennedy@gibsondunn.com Tel:  020 7071 4283  Arthur S. Long – DerivativesALong@gibsondunn.com Tel:  212-351-2426  (New York) Michael D. Bopp  – DerivativesMBopp@gibsondunn.com Tel:  202-955-8256(Washington, D.C.) Jeffrey L. Steiner – Derivatives JSteiner@gibsondunn.comTel:  202-887-3632  (Washington, D.C.)   © 2016 Gibson, Dunn & Crutcher LLP Attorney Advertising:  The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.

August 19, 2015 |
Mandatory Clearing Makes Its Way to Europe: European Commission Adopts New Rules Requiring Clearing for OTC Interest Rate Derivatives

​On August 6, 2015, the European Commission issued a Delegated Regulation (the "Delegated Regulation") that requires all financial counterparties ("FCs") and non-financial counterparties ("NFCs") that exceed specified thresholds to clear certain interest rate swaps denominated in euro ("EUR"), pounds sterling ("GBP"), Japanese yen ("JPY") or US dollars ("USD") through central clearing counterparties ("CCPs").[1]  Further, the Delegated Regulation addresses the so-called "frontloading" requirement that would require over-the-counter ("OTC") derivatives contracts subject to the mandatory clearing obligation and executed between the first authorization of a CCP under European rules (which was March 18, 2014) and the date on which the clearing obligation takes place, to be cleared, unless the contracts have a remaining maturity shorter than certain minimums.  These mandatory clearing obligations for certain interest rate derivatives contracts will become effective after review by the European Parliament and Council of the European Union ("EU") and publication in the Official Journal of the European Union and will then be phased in over a three-year period, as specified in the Delegated Regulation, to allow smaller market participants additional time to comply.  All market participants that have entities located in Europe that use derivatives, including intragroup transactions, as well as all entities that trade with a European counterparty, should pay attention to these developments, as the clearing obligations under Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories ("EMIR")[2] are calculated based on a broad group of derivatives transactions and on a group-wide basis, without regard to jurisdiction.  This is significantly different from the entity-based determinations under Title VII of the Dodd-Frank Act and the regulations of the Commodity Futures Trading Commission ("CFTC"), which are based on whether or not an entity is a "financial entity," as defined in the Commodity Exchange Act, and qualifies for an exception.[3] The issuance of the Delegated Regulation came just before the closing of the comment period for the European Commission’s public consultation on the review of EMIR.[4]  This is a noteworthy development, as the European Commission has asked for comment in their review of EMIR on matters relating to the clearing obligation, including on the calculation of the clearing thresholds, CCPs and other related issues.  Accordingly, given the timing, it seems a difficult scenario that changes to EMIR could be made prior to the initial compliance dates for the clearing obligation. This client alert summarizes the Delegated Regulation and highlights areas that all market participants should evaluate to ensure compliance.  Background On August 16, 2012, EMIR came into force with immediate consequences for entities engaged in derivatives affecting the European Economic Area ("EEA").[5]  Among other things, EMIR requires the mandatory clearing of certain OTC derivatives transactions and requires that the European Securities Markets Authority ("ESMA") propose classes of OTC derivatives that should be subject to clearing, as well as the appropriate phase-in for compliance.  In this regard, on July 11, 2014, ESMA published a consultation paper that proposed mandatory clearing for certain interest rate swaps and draft regulatory technical standards ("RTS") specifying, among other things, which interest rate swaps would be subject to clearing, the phase-in period for compliance and minimum maturities for frontloading.[6]  Following the consultation, ESMA submitted a final report to the European Commission on October 1, 2014 on the clearing obligation for interest rate swaps, which included amendments to the draft RTS based on comments received.[7] According to Article 5 of EMIR, the European Commission, on the basis of a proposal from ESMA, should determine the types of OTC derivatives contracts that should be made subject to mandatory clearing by a CCP.[8]  Accordingly, the European Commission informed ESMA in December 2014 of its intention to adopt the draft RTS with certain amendments, which were sent back to ESMA.[9]  ESMA adopted a formal opinion on these amendments on January 29, 2015, and made certain additional changes to its approach based on the amendments.[10]  ESMA then adopted a revised opinion on March 6, 2015.[11] The European Commission has now issued the Delegated Regulation in line with the formal opinion adopted by ESMA, which will now need to be reviewed by the European Parliament and the Council of the EU.   Which entities are subject to the clearing obligation? EMIR identifies that a clearing obligation applies to FCs[12] and NFCs that exceed the clearing thresholds set forth in in Article 11 of the Commission Delegated Regulation (EU) No 149/2013 ("NFC+s").[13]  The mandatory clearing requirements do not apply to those non-financial counterparties that do not exceed the clearing threshold ("NFC-s").  The clearing thresholds are as follows (in gross notional value, by asset class): EUR 1 billion — Credit derivative contracts EUR 1 billion — Equity derivative contracts EUR 3 billion — Interest rate derivative contracts EUR 3 billion — Foreign exchange derivative contracts EUR 3 billion — Commodity derivative contracts and other derivatives For an EU NFC entity to determine whether or not it exceeds the clearing threshold, it must calculate all of the non-hedging transactions, which are defined under Article 10 of EMIR to mean those transactions that are not "objectively measurable as reducing risks related to commercial activity or treasury financing activity of the non-financial counterparty or of that group [of NFC affiliates],"[14] across its entire worldwide corporate group.[15]  Such a corporate group calculation would include not only the non-hedging transactions of those NFC affiliates that are organized in the EU, but also those non-financial affiliates organized outside the EU, including those that do not have a direct, substantial and foreseeable effect within the EU.[16]  Additionally, exchange-traded derivatives contracts executed on non-EU exchanges that are not recognized as equivalent would be counted as OTC derivatives and, if not hedging, must nonetheless be counted towards the notional amount for determining the clearing thresholds.  Accordingly, non-hedging futures contracts that are executed on US futures exchanges would need to be included in the corporate group calculation.  Furthermore, non-hedging intragroup transactions must be included in the calculation, resulting in double-counting of such internal transactions, as the thresholds are based on gross notional amount. If the aggregate notional value of this entire worldwide NFC group exceeds the relevant clearing threshold in one asset class, then every NFC within the entire corporate group that is subject to EMIR would become an NFC over the clearing threshold (i.e., an "NFC+") and therefore subject to the mandatory clearing requirements for all asset classes.  Accordingly, NFC- entities that are using derivatives in the EU solely to hedge or mitigate commercial risks could nonetheless become NFC+ entities subject to the mandatory clearing requirements based on the activities of one or more NFC affiliates.  For example, an NFC entity may have affiliates located in the EU that use swaps solely to hedge their commercial risks; however, the NFC corporate group may include one or more affiliates within the corporate group that are located outside the EU that enter into derivatives for purposes other than hedging (e.g., to make markets in certain commodities).  If the non-hedging activities of those non-EU affiliates exceed the clearing thresholds for any one asset class, all NFCs within the corporate group that are subject to EMIR become subject to the clearing mandate for all swaps that are required to be cleared, regardless of asset class and regardless of whether a particular NFC entity is itself engaging in non-hedging activities. What contracts must be cleared? The Delegated Regulation would require the clearing of the following interest rate swap categories, which are detailed in Annex 1 to the Delegated Regulation: Fixed-to-Float (i.e., plain vanilla) interest rate swaps that: Reference the Euro Interbank Offered Rate ("EURIBOR") or the London Interbank Offered Rate ("LIBOR") Have a maturity of 28 days to 50 years Settled in one of the following currencies: EUR, GPB, USD or JPY Basis (i.e., Float-to-Float) interest rate swaps that: Reference EURIBOR or LIBOR Have a maturity of 28 days to 50 years Settled in one of the following currencies: EUR, GPB, USD or JPY Forward Rate Agreements ("FRAs") that: Reference EURIBOR or LIBOR Have a maturity of three days to three years Settled in one of the following currencies: EUR, GPB or USD Overnight Index Swaps ("OIS") that: Reference Euro OverNight Index Average, FedFunds or the Sterling OverNight Index Average Have a maturity of seven days to three years Settled in one of the following currencies: EUR, GPB or USD However, contracts with covered bond issuers or with cover pools for covered bonds would be exempt from the clearing obligation so long as certain criteria are met.[17] When must entities comply with the mandatory clearing obligation? Articles 2 and 3 of the Delegated Regulation set forth four categories of entities and phases in compliance with the clearing obligation based on these categories, with certain exceptions.  The categories are defined as follows: Category Description Compliance Date 1 Clearing members 6 months after the date the Delegated Regulation enters into force 2 FCs and alternative investment funds that are NFCs with an aggregate month-end average outstanding gross notional amount of non-centrally cleared derivatives exceeding EUR 8 billion[18] 12 month after the date the Delegated Regulation enters into force 3 FCs and alternative investment funds that are NFCs with aggregate month-end average of outstanding gross notional amount of non-centrally cleared derivatives below EUR 8 billion 18 months after the date the Delegated Regulation enters into force 4 NFCs that are not in Categories 1, 2 or 3 3 years after the date the Delegated Regulation enters into force For situations where a swap is concluded between counterparties in different categories, the compliance date would be the later date.  For example, if a clearing member enters into a transaction with an NFC that is not in Categories 1, 2 or 3, the compliance date would be three years after the regulation enters into force. For swaps entered into between a counterparty established in the EU and another established in a third country[19] that are part of the same group (i.e., an intragroup transaction), the Delegated Regulation provides a longer compliance timeframe to allow for equivalence determinations with third countries.  Specifically, the Delegated Regulation explains that compliance will be required three years after the date the regulation enters into force if there has been no equivalence decision adopted pursuant to Article 4 of EMIR or, if an equivalence decision has been adopted, the later of the following dates:  60 days after the date of entry into force of the decision adopted pursuant to Article 13(2) of EMIR for the purposes of Article 4 of EMIR, or the date when clearing takes effect pursuant to the phase-in compliance timeframes specified above.  This alternative compliance timeline would apply so long as certain conditions are met with respect to the intragroup transaction. How is frontloading addressed? Article 4(1)(b) of EMIR requires that OTC derivatives contracts (that have become subject to the clearing obligation) that are entered into or novated either on or after the date from which the clearing obligation takes effect or during the frontloading period, under certain conditions, must be cleared.  Article 4(1)(b)(ii) of EMIR explains the frontloading period to include derivatives contracts concluded after the notification that the first CCP is authorized to clear a certain class of derivatives (which was March 18, 2014 for interest rate derivatives), but before the date that the clearing obligation becomes effective, provided that the remaining maturity on such derivatives contracts justifies frontloading.  Article 4 of the Delegated Regulation sets forth these minimum remaining maturities which can be used to determine whether or not frontloading is necessary for a given transaction.     Specifically, the remaining maturities are split up based on the categories of interest rate swaps that are required to be cleared (e.g., fixed-to-float, basis (float-to-float), forward rate agreements and overnight index swaps) and Categories 1, 2 and 3.  The minimum remaining maturities range from six months to 50 years and frontloading is required either two months or five months after the Delegated Regulation enters into force.  Below is a summary of the minimum remaining maturities ranges. Minimum Remaining Maturities: Basis (i.e., Float-to-Float) and Fixed-to-FloatAs described in Table 1 and Table 2 to Annex 1 to the Delegated Regulation ​ ​ ​ ​ Contracts entered into or novated before the date that is 2 months after the date of entry into force of the Delegated Regulation Contracts entered into or novated after the date that is 2 months after the date of entry into force of the Delegated Regulation but before the date that is 5 months after the date of entry into force of the Delegated Regulation Contracts entered into or novated after the date that is 5 months after the date of entry into force of the Delegated Regulation Category 1 50 yr. 6 mo. 6 mo. Category 2 50 yr. 50 yr. 6 mo. Category 3 50 yr. 50 yr. 50 yr.   Minimum Remaining Maturities: FRAs and OISAs described in Table 3 and Table 4 to Annex 1 to the Delegated Regulation ​ ​ ​ ​ Contracts entered into or novated before the date that is 2 months after the date of entry into force of the Delegated Regulation Contracts entered into or novated after the date that is 2 months after the date of entry into force of the Delegated Regulation but before the date that is 5 months after the date of entry into force of the Delegated Regulation Contracts entered into or novated after the date that is 5 months after the date of entry into force of the Delegated Regulation Category 1 3 yr. 6 mo. 6 mo. Category 2 3 yr. 3 yr. 6 mo. Category 3 3 yr. 3 yr. 3 yr. Notably, ESMA recently commented[20] on the European Commission’s public consultation on EMIR, stating that the frontloading requirement should be removed.  The European Commission is likely to pay particular attention to ESMA’s comments.  However, it seems that there could be challenges in removing the frontloading obligation before compliance with the clearing obligation is required, given the timing involved and the process necessary to change the text of EMIR. When are the requirements expected to become effective? The Delegated Regulation has been sent to the European Parliament and the Council of the EU for review.  This review process can take about three months, after which the Delegated Regulation will be published in the Official Journal of the European Union and will become effective 20 days following such publication.  Upon the effective date, the phase-in timeframes will begin taking shape, with compliance with the mandatory clearing obligation for interest rate swaps (discussed herein) between clearing members beginning six months later. What should market participants do to prepare? NFC corporate groups should work to determine whether or not their corporate group exceeds the clearing threshold and whether or not they will become NFC+s and therefore subject to the mandatory clearing obligation for interest rate swaps.  To make such a calculation, NFC groups will need to calculate the gross notional amount of all of the non-hedging OTC derivatives activities (including non-EU exchange-traded derivatives) of all entities within the worldwide corporate group for each asset class specified to determine whether non-hedging activities exceed the thresholds for a particular asset class.  Further, FC and NFC+ entities should begin determining the universe of swaps that may become subject to frontloading requirements.  As the frontloading requirements will begin on the relevant compliance dates, it will be important for entities that are subject to the clearing requirements to understand which OTC derivatives contracts must be frontloaded onto CCPs. Finally, market participants, including non-EU counterparties that transact with European counterparties, should expect their European counterparties to request a representation of a particular entity’s status, either through completion of the International Swaps and Derivatives Association 2013 EMIR NFC Representation Protocol or through some other representation.  Swap dealer counterparties in particular will want to understand whether certain swaps need to be cleared or if they are exempt from clearing because their counterparties qualify as NFC‑s.  Making such representation will require an NFC entity to make the calculation described above for their worldwide corporate group.        [1]   See European Commission, Commission Delegated Regulation supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on the clearing obligation (Aug. 6, 2015), provisional version available at http://ec.europa.eu/finance/financial-markets/docs/derivatives/150806-delegated-act_en.pdf; see also European Commission, Annex to the Commission Delegated Regulation supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to the regulatory technical standards on the clearing obligation (Aug. 6, 2015), provisional version available at http://ec.europa.eu/finance/financial-markets/docs/derivatives/150806-delegated-act-annex_en.pdf.    [2]   See Regulation (EU) No 648/2012 on OTC Derivatives, Central Counterparties and Trade Repositories, available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2012:201:0001:0059:EN:PDF.  EMIR is also referred to as the European Market Infrastructure Regulation and can be compared to Title VII of the U.S. Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.    [3]   See Commodity Exchange Act Section 2(h)(7).  Commodity Exchange Act Section 2(h)(7)(C)(i) defines the term "financial entity" to mean:  (i) a swap dealer; (ii) a security-based swap dealer; (iii) a major swap participant; (iv) a major security-based swap participant; (v) a commodity pool; (vi) a private fund as defined in section 80b-2 (a) of title 15; (vii) an employee benefit plan as defined in paragraphs (3) and (32) of section 1002 of title 29; (viii) a person predominantly engaged in activities that are in the business of banking, or in activities that are financial in nature, as defined in section 1843 (k) of title 12.      [4]   See European Commission, Public consultation on the Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories (May 21, 2015), available at http://ec.europa.eu/finance/consultations/2015/emir-revision/docs/consultation-document_en.pdf.  The comment period for the consultation closed on August 13, 2015.    [5]   The EEA is comprised of the countries within the European Union, plus Iceland, Liechtenstein and Norway.    [6]   See ESMA/2014/799, Consultation Paper, Clearing Obligation under EMIR (no. 1) (July 11, 2014, amended July 17, 2014), available at http://www.esma.europa.eu/system/files/esma-2014-799_irs_-_consultation_paper_on_the_clearing_obligation_no__1____.pdf.    [7]   See ESMA/2014/1184, Final Report, Draft technical standards on the Clearing Obligation – Interest Rate OTC Derivatives (Oct. 1, 2014), available at http://www.esma.europa.eu/system/files/esma-2014-1184_final_report_clearing_obligation_irs.pdf.    [8]   See Article 5 of EMIR.  According to the procedure set forth in paragraph 1 of Article 10 of Regulation (EU) No 1095/2010, within 3 months of receipt of the draft RTS from ESMA, the European Commission shall decide whether to endorse it and has the ability to endorse it with amendments.  The European Commission then sends the amended draft RTS back to ESMA and ESMA may amend the draft RTS on the basis of the European Commission’s proposal and resubmit it as a formal opinion to the European Commission.    [9]   See Letter from the European Commission to ESMA (Dec. 18, 2014), available at http://www.esma.europa.eu/system/files/rts_for_irs_-_lettre_signee.pdf.    [10]   See 2015/ESMA/223, Draft RTS on the Clearing Obligation on Interest Rate Swaps (Jan. 29, 2015), available at http://www.esma.europa.eu/system/files/2015-223_opinion_on_draft_rts_on_the_clearing_obligation.pdf.   [11]   See 2015/ESMA/511, Revised Opinion, Draft RTS on the Clearing Obligation on Interest Rate Swaps (Mar. 6, 2015), available at https://www.esma.europa.eu/system/files/2015-511_revised_opinion_on_draft_rts_on_the_clearing_obligation.pdf.   [12]   FCs are investment firms, banks, insurers, funds registered under the Undertakings for the Collective Investment of Transferable Securities Directive 2009/65/EC ("UCITS"), pension funds or alternative investment funds managed by an alternative investment manager (as defined by the applicable EU legislation authorizing those entities).  See Article 2(8) of EMIR.   [13]   See Commission Delegated Regulation (EU) No 149/2013 (Dec. 18, 2012) supplementing Regulation (EU) No 648/2012 of the European Parliament and of the Council with regard to regulatory technical standards on indirect clearing arrangements, the clearing obligation, the public register, access to a trading venue, non-financial counterparties, and risk mitigation techniques for OTC derivatives contracts not cleared by a CCP (Feb. 23, 2013) ("RTS No 149/2013"), available at http://eur-lex.europa.eu/LexUriServ/LexUriServ.do?uri=OJ:L:2013:052:0011:0024:en:PDF.   [14]   Article 10(3) of EMIR.  Further, Article 10 of RTS No 149/2013 sets out the precise definition for derivatives contracts falling within the "hedging" definition, which (i) covers risks incurred in the normal course of business; (ii) covers risks arising from fluctuations in interest rates, inflation rates, foreign exchange rates, credit risk, etc.; or (iii) qualifies as a "hedging contract" pursuant to International Financial Reporting Standards.    [15]   See id.  Further, Article 2(16) of EMIR defines "group" very broadly as: "the group of undertakings consisting of a parent undertaking and its subsidiaries within the meaning of Articles 1 and 2 of Directive 83/349/EEC or the group of undertakings referred to in Article 3(1) and Article 80(7) and (8) of Directive 2006/48/EC".   [16]   The derivatives activities of FCs within the corporate group would not be included in the calculation.   [17]   Article 1(2) of the Delegated Regulation provides that the following criteria must be met with respect to covered bond issues or with cover pools for covered bonds in order to be excluded from the clearing obligation: "(a) They are used only to hedge the interest rate or currency mismatches of the cover pool in relation with the covered bond; (b) They are registered or recorded in the cover pool of the covered bond in accordance with national covered bond legislation; (c) They are not terminated in case of resolution or insolvency of the covered bond issuer or the cover pool; (d) The counterparty to the OTC derivative concluded with covered bond issuers or with cover pools for covered bonds ranks at least pari-passu with the covered bond holders except where the counterparty to the OTC derivative concluded with covered bond issuers or with cover pools for covered bonds is the defaulting or the affected party, or waives the pari-passu rank; and (e) The covered bond meets the requirements of Article 129 of Regulation (EU) No 575/2013 and is subject to a regulatory collateralization requirement of at least 102%.   [18]   The calculation for these purposes would include all non-centrally cleared foreign exchange forwards, swaps and currency swaps.  See Article 2(2) of the Delegated Regulation.  When an applicable counterparty is either an alternative investment fund or an undertaking for collective investment in transferable securities as defined in Article 1(2) of UCITS, the EUR 8 billion threshold applies at the fund level.   [19]   A third country is a country other than an EEA Member State.   [20]   See ESMA, EMIR Review Report No. 4, ESMA input as part of the Commission consultation on the EMIR Review, pp. 11-14 (Aug. 13, 2015), available at http://www.esma.europa.eu/system/files/esma-2015-1254_-_emir_review_report_no.4_on_other_issues.pdf.           Gibson, Dunn & Crutcher’s Financial Institutions Practice Group lawyers are available to assist in addressing any questions you may have regarding these developments.  Please contact any member of the Gibson Dunn team, the Gibson Dunn lawyer with whom you usually work, or the following: Michael D. Bopp – Washington, D.C. (+1 202-955-8256, mbopp@gibsondunn.com)Arthur S. Long – New York (+1 212-351-2426, along@gibsondunn.com)Patrick Doris – London (+44 (0)20 7071 4276, pdoris@gibsondunn.com)Jeffrey L. Steiner - Washington, D.C. (+1 202-887-3632, jsteiner@gibsondunn.com) Amy Kennedy – London (+44 (0)20 7071 4283, akennedy@gibsondunn.com) © 2015 Gibson, Dunn & Crutcher LLP Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice