Pension funds and clearing: are you ready?...2 Regulation (EU) No 648/2012 of the European...

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Pension funds and clearing: are you ready?October 2015

1 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR).

Pension funds and clearing: are you ready? | October 20152

© Allen & Overy LLP 2015

EMIR1 is about to present a series of new challenges for institutions entering into OTC derivative contracts, including the introduction of the mandatory clearing obligation. Many pension funds will be able to benefit from the pension scheme exemption to the mandatory clearing obligation, but:

– the pension fund will need to notify its counterparties that it intends on using the pension scheme exemption (or its clearing categorisation if it cannot benefit from the exemption) – see section 2;

– even if the pension fund is within the scope of the pension scheme exemption, the exemption may not apply to all OTC derivative contracts entered into by the pension fund, in which case, these transactions would need to be cleared – see section 2; and

– in some circumstances the pension fund may prefer to clear an OTC derivative contract rather than relying on the pension scheme exemption – see section 3 for more detail. In these circumstances, the pension fund will need to consider and negotiate its client clearing arrangements. Preparation now may help keep the pension fund’s options open as this wave of change sweeps through the industry.

This briefing will help you understand the key issues; to find out more, please get in touch with one of the contacts listed at the back.

2 Regulation (EU) No 648/2012 of the European Parliament and of the Council of 4 July 2012 on OTC derivatives, central counterparties and trade repositories (EMIR).

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Pension funds and clearing: are you ready?

EMIR2 introduces a number of key obligations for counterparties in the derivatives market. Already in effect are the obligations to report to a trade repository and most of the risk mitigation requirements (including daily valuation, timely confirmation, portfolio reconciliation, dispute resolution and portfolio compression). Still to take effect are the two requirements seen by many as the most challenging: mandatory clearing and the mandatory exchange of margin for uncleared trades.

The scope of the mandatory clearing obligation and margin requirements will not be limited to financial services counterparties established in Europe, but will also apply to certain end-users of OTC derivative contracts, including pension funds. To the extent they have not already done so, end-user institutions that may be subject to the mandatory clearing obligation or margin requirements should now start to take steps to establish when the obligations will likely apply to them and what they need to do to comply.

INTRODUCTION

The EC has adopted a delegated regulation in August 2015 relating to the introduction of the mandatory clearing obligation for certain interest rate swap transactions3 (the IRS Clearing RTS). The final draft must now be accepted by the European Parliament and the Council and published in the Official Journal of the EU before it takes effect. However, it is not expected that there will be any amendments. Once the IRS Clearing RTS comes into force, in-scope counterparties may need to comply with: (a) the clearing obligation: this requires all IRS Contracts

between in-scope counterparties that are entered into on or after the effective date for the clearing obligation for that counterparty pair to be cleared through an authorised or recognised central counterparty (CCP), unless an exemption applies; and

(b) the frontloading obligation: this requires all IRS Contracts between in-scope counterparties that are entered into (i) after the effective date for the frontloading obligation for that counterparty pair but (ii) before the effective date for the clearing obligation for that counterparty pair, to be cleared by the effective date for the clearing obligation for that counterparty pair through an authorised or recognised CCP, unless an exemption applies.

3 The IRS Clearing RTS will apply to basis swaps, fixed-to-float interest rate swaps, forward rate agreements and overnight index swaps, in each case, which satisfy the applicable seven characteristics listed in the Annex to the IRS Clearing RTS (IRS Contracts).



1 Clearing: sooner than you think

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Frontloading period for Cat 1

Frontloading period for Cat 2

Clearing Obligation phase-in dates Category 1 (Clearing Members) = 6 months after the date the RTS enters into force Category 2 (FCs and NFC+ AIFS above clearing threshold) = 12 months after the date the RTS enters into force Category 3 (FCs and NFC+ AIFs below clearing threshold) = 18 months after the date the RTS enters into force Category 4 (other NFC+s) = 3 years after the date the RTS enters into force

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Following finalisation of the IRS Clearing RTS, it is expected that further RTS relating to additional asset classes will be published and will be substantially similar in content.

Although the exact timing for the clearing obligation and frontloading obligation will depend on when the IRS Clearing RTS are published, we anticipate that the first counterparties subject to the clearing obligation will need to start clearing by May 2016 as well as ensuring that in-scope transactions entered into from January 2016 are cleared by May 2016 to comply with the frontloading obligation. Although pension funds are unlikely to fall into the first wave of clearing, it is possible that they could fall into Category 2.

If so, such pension funds could be subject to the mandatory clearing obligation from November 2016 as well as needing to clear all in-scope transactions entered into from April 2016 to November 2016 to comply with the frontloading obligation.

The categorisation of the pension fund will, therefore, be an important determinant in the timeframe for clearing. In addition, whether (a) the pension fund and (b) the transaction can benefit from the pension scheme exemption will also impact the date by which pension funds need to start clearing.

Frontloading obligation phase-in dates Category 1 = two months after RTS enters into force to Category 1 clearing start date Category 2 = five months after RTS enters into force to Category 2 clearing start date Category 3 and 4 = no frontloading

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Note: (1) based on the IRS Clearing RTS; and (2) assuming the IRS Clearing RTS comes into force in November 2015

4 Article 4(1) of EMIR. 5 Article 2(1) of the IRS Clearing RTS.



2.1 ARE YOU SUBJECT TO THE CLEARING OBLIGATION / FRONTLOADING OBLIGATION?

EMIR prescribes that all EU financial counterparties (FCs) and EU non-financial counterparties which are above the clearing threshold (NFC+s) will be subject to the clearing obligation when they transact with another FC or NFC+ or a non-EU entity which would be classified as an FC or an NFC+ if it was established in the EU (in-scope counterparties)4. The IRS Clearing RTS includes a further categorisation of in-scope counterparties5 which impacts: (a) whether the frontloading obligation applies; and (b) the clearing obligation start date.

It is, therefore, crucial for pension funds to know whether they and their counterparty are subject to the clearing obligation and both their own clearing categorisation and that of their counterparty. To do so, pension funds should be able to answer the following questions:

2 What does this mean for pension funds?

The clearing obligation is fast approaching, not just for financial institutions but also for end-users such as pension funds. Crucially, there will be a number of steps for pension funds to take before we reach any of the phase-in dates.

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Question Outcome

1. Are you or your counterparty an “exempt entity” Note: “exempt entities” are those entities listed in Article 1(4) and 1(5) of EMIR.

Yes = no clearing obligation No = clearing obligation may apply

2. Are you an EU FC or a third county equivalent of an FC? Note: “FCs” includes institutions for occupational retirement provision within the meaning of Article 6a of Directive 2003/41/EC.

Yes = clearing obligation may apply No = clearing obligation may apply depending on your answer to question 3 below

3. Are you an EU NFC+ or a third county equivalent of an NFC+? Yes = clearing obligation may apply No = no clearing obligation

4. Is your counterparty an in-scope counterparty? Yes = clearing obligation may apply No = no clearing obligation

5. If you and your counterparty are both third country entities, do the “direct, substantial and foreseeable effect” rules apply?

Yes = clearing obligation may apply No = no clearing obligation

IS THE COUNTERPARTY PAIR SUBJECT TO THE CLEARING OBLIGATION?

Question Outcome

1. Are you a clearing member of a CCP authorised to clear at least one type of IRS Contract at the date the IRS Clearing RTS enters into force?

Yes = Category 1 counterparty No = other categorisation may apply

2. Are you an FC or an NFC+ which is an “alternative investment fund? Yes = you may be Category 2 or 3 (see question 3 below)No = you may be Category 4 (see question 4 below)

3. Do you or your group have an aggregate month-end average of outstanding gross notional amount of non-centrally cleared derivatives for each of the three months after the publication of the IRS Clearing RTS in the Official Journal (excluding the month of publication) of above EUR8 billion? Note: for the purpose of the calculation, all of the group’s non-centrally cleared derivatives, including foreign exchange forwards, swaps and currency swaps shall be included.

Yes = Category 2 counterparty No = Category 3 counterparty

4. Are you an NFC+? Yes = Category 4 No = no clearing obligation

WHAT IS YOUR CLEARING CATEGORISATION FOR THE PURPOSES OF THE IRS CLEARING RTS?

Question Outcome

1. Is the OTC derivative contract of a type which has been declared subject to the clearing obligation? Note: The IRS Clearing RTS only applies to certain interest rate contracts. The next product class which may be subject to the clearing obligation is credit default swaps.

No = No clearing obligation Yes = Clearing obligation may apply

2. Does the OTC derivative contract satisfy all relevant product characteristics? Note: The IRS Clearing RTS specifies seven characteristics which the contract must satisfy in order for it to be subject to the clearing obligation. These characteristics relate to: type, reference index, settlement currency, maturity, settlement currency type, optionality and national amount.

No = No clearing obligationYes = Clearing obligation may apply

3. Is: (a) the date that the OTC derivative contract is entered into; or (b) the date of any trade event in respect of an outstanding OTC derivative contract, on or after the clearing obligation start date? Note: trade events are those events which would cause an out of scope OTC derivative contract (because it was entered into before the relevant start date for the clearing obligation) to be in scope. There is no definitive guidance on what will constitute a trade event but may include: material amendments, novations or the contract arising from a compression.

No = Clearing obligation may not apply (see question 4 below) Yes = Clearing obligation may apply, subject to any applicable exemptions

4. Is: (a) the date that the OTC derivative contract is entered into; or (b) the date of any trade event in respect of an outstanding OTC derivative contract, on or after the frontloading start date but before the clearing start date?

No = Clearing obligation will not apply Yes = Clearing obligation may apply, subject to any applicable exemptions

IS THE OTC DERIVATIVE CONTRACT SUBJECT TO THE CLEARING OBLIGATION?



2.2 WHAT SHOULD YOU DO WITH THIS INFORMATION?

(a) Undertake internal compliance assessmentsIt is important to understand: (a) the pension fund’s and its counterparty’s classification under EMIR; (b) the pension fund’s and its counterparty’s categorisation for the purpose of the IRS Clearing RTS; and (c) whether the OTC derivative contract is within scope of the IRS Clearing RTS for your internal regulatory compliance assessments. To the extent the pension fund enters into an IRS Contract which needs to be cleared – either because it is subject to the clearing obligation or the frontloading obligation – the pension fund must be prepared to clear that transaction (see paragraph 3 below for further discussion on this). Alternatively, if the OTC derivative contract is not subject to the clearing obligation, the pension fund will need to consider whether the margin obligation applies along with the other risk mitigation requirements.

(b) Answer the pension fund’s counterparty’s questions

We expect that pension funds’ counterparties will begin (if they have not already done so) asking for confirmation of the pension fund’s classification for the purposes of EMIR and categorisation for the purposes of the clearing obligation and the frontloading obligation. The pension fund’s counterparties will require this information to undertake their own assessments of which OTC derivative contracts will need to be cleared, by when and whether the frontloading obligation applies.

(c) How can you answer these counterparty questions?

Counterparties may differ in how they want you to answer their questions. Some may require bilateral confirmations (for example, using the ISDA EMIR Classification Letter); others may ask you to use an industry tool such as the ISDA Amend EMIR Clearing Classification Tool, a web-based system for market participants to notify each other of their classification information.

In responding to the pension fund’s counterparty’s questions, you will need to consider the form of your confirmation and any knock-on effects. For example, (i) are you providing a formal representation as to your status and (ii) will breach of such representation constitute an event of default under any transaction documented with that counterparty?

(d) What should you do if the pension fund’s status changes?

If the pension fund’s status changes, you should notify your counterparties of this change. If you represent your status on a bilateral basis, the pension fund’s counterparties will need to be notified “manually”. If you use the ISDA Amend EMIR Clearing Classification Tool, you can update each of the pension fund’s counterparties also using the ISDA Amend EMIR Clearing Classification Tool.

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2.3 CAN YOU USE THE PENSION SCHEME EXEMPTION?

(a) What is the pension scheme exemption?The pension scheme exemption6 exempts pension funds (and, by implication the counterparties they are trading with) from the clearing obligation and frontloading obligation in respect of certain transactions entered into during the temporary exemption, subject to certain conditions. The pension scheme exemption is available to pension funds until 16 August 2017; any new contracts within the scope of the clearing obligation/frontloading obligation entered into after the expiry of the pension scheme exemption would have to be cleared.

(b) Who qualifies for the pension scheme exemption?

The pension scheme exemption is available to pension funds which satisfy the definition of a pension scheme arrangement set out in Article 2(10) of EMIR. It is also available to entities established for the purpose of providing compensation to members of pension scheme arrangements in the case of default. It is unlikely that non-EU pension funds can use the pension scheme exemption.

Whether a pension fund can automatically use the pension scheme exemption or whether it needs to take any further action will depend on the type of pension fund it is classified as under EMIR. Subject to paragraph 2.3(c) below, the pension scheme exemption will automatically apply to: institutions for occupational retirement provision within the meaning of Article 6(a) of Directive 2003/41/EC, including any authorised entity responsible for managing such an institution and acting on its behalf as well as any legal entity set up for the purpose of investment of such institutions, acting solely and exclusively in their interest; and occupational retirement provision businesses of institutions referred to in Article 3 of Directive 2003/41/EC.

Other pension scheme arrangements must make an application to the relevant competent authority to use the pension scheme exemption. The relevant competent authority and the European Insurance and Occupational Pensions Authority will then consider whether to grant the exemption. The timing for making the application is not entirely clear but we understand that applications can be made to competent authorities after the IRS Clearing RTS has entered into force.

6 Article 89 of EMIR and Article 2 of Commission Delegated Regulation (EU) 2015/1515 of 5 June amending Regulation (EU) 648/2012 of the European Parliament and of the Council as regards the extension of the transitional periods related to pension scheme arrangements.



(c) Which transactions does the pension scheme exemption cover?

Importantly, the pension scheme exemption is not a blanket exemption covering all transactions entered into by pension funds. If a pension fund qualifies for the pension scheme exemption, it will need to assess on a transaction by transaction basis whether the exemption applies. Only those in-scope transactions which satisfy the following conditions will be able to benefit from the pension scheme exemption:

– the transaction must be “risk reducing” – only those transactions which are objectively measurable as reducing investment risks directly related to the financial solvency of pension fund will qualify; and

– the transaction must be entered into before the pension scheme exemption expires – the pension scheme exemption expires 16 August 2017 so, unless the pension scheme exemption is extended (the European Commission has the power to extend the pension scheme exemption by a further period of one year), any in-scope transactions entered into after this date will need to be cleared.

Any in-scope transactions that do not satisfy these conditions, for example, because they are entered into for speculative purposes or because they are entered into after the pension scheme exemption expires will, therefore, need to be cleared.

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3 The move to clearing

3.1 WHY WOULD A PENSION FUND START CLEARING?

There are two reasons why a pension fund may start clearing:

(i) it is subject to the clearing obligation (and frontloading obligation) and cannot use the pension scheme exemption; or

(ii) it can achieve better pricing on a cleared basis than an uncleared basis for the same transaction.

In this regard, it is important to consider how the clearing obligation may interact with the other obligations under EMIR – primarily the margin obligation – when assessing the price implications of transacting on a cleared versus an uncleared basis. If an OTC derivative contract is not

cleared, for example, because it is not a transaction in-scope of the clearing obligation or because the counterparties to that transaction benefit from the pension scheme exemption, then the rules relating to the mandatory exchange of margin may apply to that transaction.

There is no similar exemption for pension funds under the margin rules. As a result, pension funds should consider whether it will actually be more expensive to trade on an uncleared basis, but comply with the margin obligations (if they apply), than it will be to clear the transaction.



3.2 WHAT DO PENSION FUNDS NEED TO DO TO START CLEARING?

(a) Assess which CCPs the pension fund will clear through

The pension fund will need to clear through a CCP which is authorised or recognised in accordance with EMIR. However, not all CCPs clear, or are authorised to clear, all types of transactions. Moreover, the client clearing offering – including the protections available to the pension fund – will differ between CCPs. The pension fund needs to consider which CCPs it wants to access and diligence the applicable rules to understand what protections are available to it.

(b) Decide how the pension fund will access the CCP

It is unlikely pension funds will be able to directly access CCPs (as a clearing member). Therefore, pension funds will need to appoint a clearing member through which they can access the CCP (this is generally referred to as “client clearing”). To the extent a pension fund wants to access multiple CCPs it may need to appoint different clearing members. It may also wish to appoint “back-up” clearing members to mitigate the risk of not being able to access the CCP if anything happens to its primary clearing member.

(c) Review and negotiate relevant documentationCompared to uncleared transactions, there are two main documentation considerations. First, the cleared transaction will be subject to the rules of the CCP which clears the transaction. Secondly, the documentation between the pension fund and its counterparty (assuming the counterparty is also its clearing member) will need to be amended (or put in place if the counterparty is not also the clearing member) to facilitate cleared transactions. This is generally referred to as the client clearing agreement.

As the clearing obligation and frontloading obligation are rapidly approaching, pension funds should ensure that sufficient time remains in order to negotiate their client clearing agreements. There may be an advantage to pension funds which start this process sooner rather than later, as not only will they have more time to negotiate, but they will avoid any “bottleneck” which arises from in-scope entities all trying to finalise their client clearing agreements close to the start date of mandatory clearing. If a pension fund fails to have in place its client clearing agreement with its clearing member by the time it needs to comply with the clearing obligation, it will be unable to access clearing. This may prevent it from entering into in-scope transactions until it has negotiated its client cleating agreement and can access clearing.

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Action Complete?

1. Establish whether the pension fund is subject to: (i) the clearing obligation; and (ii) the frontloading obligation:

a. Ascertain the pension fund’s classification under EMIR (FC, NFC+, NFC-, third country equivalent

or exempt entity) b. Ascertain the pension fund’s categorisation for the purpose of the EMIR clearing obligation/frontloading

obligation (Category 1, Category 2, Category 3, Category 4) and be aware of the “start date” for the clearing obligation for that category and, if applicable, the dates of the frontloading window

2. Respond to the pension fund’s counterparties’ questions on the pension fund’s classification under EMIR / categorisation for the purpose of the EMIR clearing obligation

3. Establish whether the pension fund can benefit from the pension scheme exemption

4. If applicable, make application to use the pension scheme exemption to the pension fund’s competent authority

5. In respect of the IRS Clearing RTS, following the “start date” for the clearing obligation, or, if applicable, the beginning of the frontloading window for the pension fund:

a. Review the types of OTC derivative contracts the pension fund enters into and whether they constitute an IRS Contract

b. If the OTC derivative contract is an IRS Contract and the pension fund is able to use the pension scheme exemption, assess whether the IRS Contract is being entered into: (i) for risk reducing purposes; and (ii) before the pension scheme exemption expires

6. If the pension fund has to clear a transaction or wishes to clear a transaction:

a. Choose a CCP and diligence the rule set

b. Appoint a clearing member (and, possibly a back-up clearing member) for each CCP service c. Negotiate the client clearing agreement

7. Watch out for any further OTC derivative contract types which become subject to the mandatory clearing obligation

Clearing checklist: from a legal perspective



Däna BurstowPartner PensionsTel +44 20 3088 3644 [email protected]

Maria StimpsonPartner PensionsTel +44 20 3088 3665 [email protected]

Emma DwyerPartner Derivatives and Structured FinanceTel +44 20 3088 3754 [email protected]

Neil BowdenPartner PensionsTel +44 20 3088 [email protected]

CONTACT INFORMATION

Stephen RichardsSenior Associate PensionsTel +44 20 3088 2025 [email protected]

Helen PowellPSL Counsel PensionsTel +44 20 3088 4827 [email protected]

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NOTES / FOLLOW-UP QUESTIONS

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Pension funds and clearing: are you ready?...2 Regulation (EU) No 648/2012 of the European...

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