Insights

On 1 February 2022, the MFSA issued a Circular presenting its findings resulting from supervisory inspections carried out in relation to adherence by derivatives market participants to the obligations imposed in terms of the European Market Infrastructure Regulation^[1] (“EMIR”).

The Circular is addressed to all market participants which enter into derivative contracts and fall within the scope of EMIR obligations. It provides valuable insight as to the approach taken by the MFSA in relation to such supervisory inspections as well as the pertinent issues raised during these supervisory interactions.

The Circular also sets out recommendations of what are considered by the MFSA to be good practices for adherence to EMIR obligations and is therefore exceedingly helpful for market participants to assess their compliance with these obligations and ensure that they are adequately prepared for any future supervisory visits should these arise.

Counterparty Classification and Clearing Obligation Thresholds

One of the issues addressed in the Circular relates to the applicability of the clearing obligation under EMIR. By way of background, on 17 June 2019 EMIR was amended by means of a separate Regulation^[2] (“EMIR Refit”) which streamlined various obligations under EMIR in an effort to make regulatory obligations more proportionate.

In particular, EMIR Refit made clearing of derivative transactions subject to a threshold. As a general rule certain classes of OTC derivative contracts are subject to a mandatory clearing obligation, however post EMIR Refit, the applicability of this clearing obligation depends on two main factors namely:

1. the classification of the entity as a financial counterparty (“FC”)^[3] or a non-financial counterparty (“NFC”);^[4] and
2. the notional amounts of the derivative transactions entered into by the entity which would classify the entity entering into the derivatives transaction as an NFC- or an NFC+.

NFC- entities entering into derivative transactions are not required to clear the transactions entered into. In addition, NFC+ entities are only required to clear OTC derivative transactions in the class for which the threshold is exceeded.

If an FC calculates its positions and the result of the calculation exceeds the clearing threshold, the FC is required to clear all OTC derivative contracts pertaining to any class of OTC derivatives in relation to which the clearing obligation is applicable, regardless of whether it exceeds the clearing threshold of each asset class.

In the event that the clearing threshold calculation is not carried out, counterparties to the derivative transaction become subject to the clearing threshold for all OTC derivatives pertaining to any class of OTC derivatives for which the clearing obligation is applicable, irrespective of whether they are classified as an FC or an NFC.

Counterparties are required to immediately notify the MFSA:

1. if they decide not to calculate their positions against the clearing thresholds;
2. when the result of the calculation exceeds the clearing threshold; and
3. when they no longer exceed the clearing thresholds.

In the Circular, the MFSA noted that during the supervisory inspections, counterparties failed to provide the clearing threshold calculation in accordance with their obligations and therefore became subject to the clearing obligation for all OTC derivative contracts falling within asset classes subject to the clearing obligation.

Therefore, it is important that parties entering into derivative contracts are aware of this obligation to carry out the calculation referred to above in order to determine the extent of their regulatory obligations.

Risk Mitigation Techniques

Another important aspect to consider is ensuring that appropriate arrangements are in place in order to mitigate risks when entering into OTC derivative contracts which are not cleared.

In this regard, the supervisory findings of the MFSA were that while generally, the majority of market participants satisfied their risk mitigation techniques requirements in practice, a number of them did not have the necessary documentation in place to document this.

In its comments the MFSA refers to the importance that all risk mitigation techniques are documented and the documentation must be adequate and complete so that the documentation includes all necessary risk mitigation requirements under EMIR. This includes cases where market participants make use of industry standard master agreements and protocols to ensure compliance with EMIR as the documentation may not include all the necessary provisions. In addition, in cases where the master agreement was in place prior to the coming into force of EMIR, such agreement should be updated by means of an amendment agreement in order to ensure that all provisions required to be in place in line with current regulatory obligations are included.

EMIR Procedures

The documentation which needs to be in place is two-fold. Firstly, the market participant must have documentation in place regulating its relationship with its counterparty to the derivative transaction, which documentation as mentioned must be up-to-date, complete and encompass the provisions required under EMIR (including risk mitigation techniques). Secondly, the market participant must also have internal written procedures documenting the processes which are in place to comply with its EMIR requirements.

The MFSA has noted that a number of market participants were unable to provide such written procedures and recommended that all counterparties entering or intending to enter into derivative contracts should have a detailed set of procedures to ensure their compliance with EMIR.

Transaction Reporting

Market participants should also bear in mind that the supervisory work of the MFSA is not limited solely to reviewing the documentation requested during its supervisory visits. In addition to such visits, the MFSA carries our offsite monitoring of transaction reports which are submitted by market participants to trade repositories (“TRs”) as required in terms of EMIR. In this regard, Article 9 of EMIR requires the details of derivative contracts entered into by a counterparty to be reported to a TR recognised by ESMA no later than the working day following the conclusion, modification or termination of a derivative contract (T+1).

During its offsite monitoring of reports submitted to TRs, the MFSA noted that counterparties failed to report derivative transactions in a timely manner and sometimes failed to report the transactions entirely. It further noted that counterparties did not report all the required mandatory data fields or filled in the incorrect field details.

The Circular is particularly emphatic in setting out the MFSA’s expectation that market participants are fully compliant with EMIR transaction reporting requirements. It draws particular attention to the fact that failure to submit timely and complete derivative transaction reports in breach of Article 9 of EMIR could warrant regulatory action in terms of Article 11 of the Financial Markets Act (OTC Derivatives, Central Counterparties and Trade Repositories) Regulations (the “FMA Regulations”).[5] In terms of Article 11 of the FMA Regulations, a person who is responsible for reporting requirements for derivate contracts contravenes or fails to comply with any provisions of EMIR or the EMIR Regulations, the MFSA may by notice in writing and without recourse to a count hearing impose an administrative penalty not exceeding €150,000.

^[1] Regulation No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories

^[2] Regulation (EU) 2019/834 of the European Parliament and of the 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 derivative contracts not cleared by a central counterparty, the registration and supervision of trade repositories and the requirements for trade repositories

^[3] The following entities are considered to be FCs: (i) MiFID investment firms; (ii) credit institutions; (iii) insurance undertakings; (iv) UCITS funds and their managers; (v) institutions for occupational retirement provisions; (vi) Alternative Investment Funds (AIFs) and their managers; and (vii) Central securities depositaries.

^[4]  An NFC includes any party to a derivative transaction that does not qualify as an FC.

^[5] Subsidiary Legislation 345.17