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The EU active account requirement – installing the pipework for EU derivatives clearing

Who is this blog for?

CEOs, CFOs, COOs, Executives responsible for Business Strategy

At a glance

  • EU policymakers consider post-trade market infrastructure as a fundamental aspect of the Capital Markets Union (CMU) and a “cornerstone of the EU financial stability”. One of their key concerns is an excessive concentration of clearing for systemically important derivative contracts in UK central counterparties (CCPs) which may pose a financial stability risk to the EU or one of the member states (MS).
  • The latest iteration of the European Market Infrastructure Regulation (EMIR 3.0) introduces a new active account requirement (AAR) for derivatives clearing to tackle this concern. This move comes in the context of other EU initiatives aimed at securing the autonomy of its banking and capital markets, such as finalisation of CRD VI.
  • To comply with the AAR, all financial and non-financial counterparties that are subject to the derivatives clearing obligation in the EU will have to meet operational and activity requirements. In this note we assess the challenges of the implementation and potential consequences for the EU derivatives clearing landscape.
  • Although the final version of EMIR 3.0 is less ambitious compared to previous drafts, the changes will provide the essential pipework that will allow EU policymakers to make future amendments faster and more efficiently. Ultimately, we see the current changes laying the foundation for the EU’s longer-term ambition for achieving strategic autonomy and creating the CMU.

Part 1: The AAR - an overview

In February 2024 the EU Council and EU Parliament (EP) reached a political agreement on the latest iteration of EMIR 3.0. One of its objectives is reducing EU’s dependency on systemically important third country CCPs (Tier 2 CCPs). To achieve this the regulation introduces a requirement for financial and non-financial counterparties subject to the derivatives clearing obligation in the EU to maintain an active clearing account at an EU CCP.

Scope of AAR

The scope of AAR covers all categories of derivatives subject to clearing, identified by ESMA as being systemically important. Currently, these are:

  • OTC interest rate derivatives denominated in EUR and Polish Zloty.
  • Short-term interest rate derivatives (STIR) denominated in EUR.

In future, the list of contracts in scope could be amended based on the European Securities and Markets Authority’s (ESMA’s) assessment of systemic importance for the EU or one of the MS and following a comprehensive cost benefit analysis.

In determining the applicability of the AAR, firms that are part of a group headquartered in the EU should take into account the derivative contracts of systemic importance cleared by any entity within the group, including in third countries, to assess the exposure of the group as a whole and to prevent the group moving the clearing activities outside of the EU to avoid the AAR.

Operational requirements

The active account will have some operational and activity requirements. Operationally, the account will need to be:

1) “permanently functional” which means that it should have the necessary IT connectivity, internal processes, and legal documentation in place; and

2) sufficiently resilient to allow clearing of large volumes of derivative contracts at all times (proportionate to the OTC volume in AAR scope). The account should be able to withstand a sudden increase in clearing activity if the clearing volume moves away from Tier 2 CCPs and be suitable for clearing all new trades in systemically important derivative contracts.

These operational requirements should be stress-tested at least once a year.

ESMA, in cooperation with other regulatory bodies , will develop regulatory technical standards (RTSs) further specifying operational, stress testing and reporting requirements. The requirements will be proportionate which means that firms which clear more trades will be subject to more stringent operational and reporting requirements.

Activity requirements

From the activity perspective, EMIR 3.0 contains a representativeness requirement which means that trades cleared through the active account should be representative of the overall portfolio of trades cleared by the counterparty in a reference period based on different classes of derivative contracts, maturities, and sizes.

ESMA will specify a maximum of three classes of derivative contracts and will set a maximum of five subcategories per class based on the most relevant trade size and maturity ranges. To fulfil the representativeness obligation, counterparties will need to clear at least five trades per reference period (calculated on an annual average basis) in each subcategory per class of derivative contract. The reference period will be not shorter than six months for counterparties with less than €100bn outstanding notional clearing volume and not shorter than one month for larger counterparties.

This means that a firm with exceeds €100bn of outstanding notional clearing volume will need to clear at least five trades at a maximum of fifteen subcategories per month which is equivalent to 900 trades per year.

However, there are some exemptions. The representativeness obligation will not apply to counterparties with a notional clearing volume outstanding of less than €6bn in respective derivative contracts or to client clearing services .

In addition, to ensure a proportionate approach, the requirement will be scaled down to one trade in a reference period instead of five for specific EU pension schemes which only make a limited number of concentrated long-term interest rate derivative trades.

Counterparties which already clear at least 85% of their trades in systemically important derivative contracts at an EU CCP will be exempt from the AAR altogether.

Reporting and disclosure requirements

The introduction of the AAR will lead to additional reporting obligations. Financial and non-financial counterparties that are subject to the AAR will need to calculate activities and risk exposures in the categories of derivatives which are subject to representativeness requirements and report this information to national competent authorities (NCAs) every six months to demonstrate compliance with the representativeness obligation. The reports will also need to demonstrate that all other aspects if the AAR including legal documentation, technological connectivity, internal processes and resources, and systems that ensure resilience are fit for purpose .

In addition, counterparties that clear at a third country CCP will need to report on an annual basis the type of contracts and average value cleared , the amount of margins collected, the default fund contributions, and the largest payment obligation. ESMA will develop an RTS specifying the information to be reported and the level of detail.

Counterparties that provide clearing services to clients will need to disclose (at least quarterly) fees and other costs associated with the provision of clearing services. Those that provide clearing services at a third country CCP will need to inform their clients about the option to clear a derivative contract in the EU in order to encourage clearing in the EU. ESMA will develop RTS to specify the type of information to be disclosed.

Supervision and enforcement

ESMA will establish and chair a Joint Monitoring Mechanism (JMM ) which will monitor, among other things: (1) the AAR implementation and its effect on the overall exposure to Tier 2 CCPs; (2) fees charged by CCPs for setting up the account and for clearing; and (3) other developments in clearing which can affect EU CCPs such as cross-border client clearing relationships, concentration risks due to integration of EU financial markets, and cross-border risks. The JMM will also monitor the effectiveness of the measures aimed at improving the attractiveness of, and encouraging clearing at, EU CCPs.

If the AAR is breached, NCAs can impose a one-off penalty or periodic penalty payments. These payments should be “effective and proportionate” and should not exceed 3% of the average daily turnover in the previous business year.

Timelines and next steps

We expect EMIR 3.0 to enter into force in Q4 2024 following the Plenary vote and publication in the Official Journal. The active account should be set up within six months from the regulation entering into force or from when the counterparty becomes subject to the clearing obligation. Within this period ESMA is likely to develop RTSs on operational, resilience and reporting requirements. It is uncertain how the representativeness requirement will be enforced at the outset as ESMA is only expected to submit the representativeness RTS to the Commission within six months after the date of entry into force of the regulation.

18 months after entry into force of the regulation (or earlier if there is a threat to financial stability) and then annually, ESMA will report back to policymakers on the extent to which the AAR has resulted in the reduction of exposure to Tier 2 CCPs. If the desired outcome has not been achieved, ESMA could propose additional measures, including quantitative thresholds for notional volume cleared through an active account. Any additional measures will require ESMA to produce an impact assessment and cost-benefit analysis. The Commission should react to ESMA’s proposals within six months of receiving the report. Any revised requirements will also include an adaptation period (not exceeding 12 months).

Part 2: AAR effect on firms and the derivatives clearing landscape in the EU

In setting up a new account at an EU CCP, firms may incur administrative and operational costs. This however is likely only to affect a proportion on firms in scope as, according to some press reports, c60% of firms already have an active account in the EU. Ensuring the resilience of an active account could be more challenging. The ultimate cost of ensuring and maintaining the resilience of the account, including regular stress testing, will depend on the RTS developed in due course. The RTS will also more precisely define the reporting and disclosure burden for firms.

In addition to operational and administrative costs, the industry has previously expressed its concerns that the AAR could have other negative effects. In September last year, the EU trade associations issued a joint statement on the AAR identifying potential negative consequences including market fragmentation and loss of netting benefits, a competitive disadvantage for EU firms and challenges for the best execution principle.

These concerns echo the Bank of England’s 2019 working paper on the cost of clearing fragmentation which considered the implication of clearing in comparable products being spread across multiple CCPs. The research ultimately found that, from a collateral savings perspective, it is most efficient to concentrate clearing activity in a single CCP and that fragmentation of clearing and the associated break-up of netting sets cause price distortions and lead to increased collateral costs.

That said, it seems that the policymakers have addressed some of the industry concerns and the final version of AAR has been somewhat scaled back from the initial ambition. A representativeness requirement of a maximum of 900 trades per year, calculated on an annual average basis (meaning that trades can be cleared through an EU CCP at any time within the year) is a relatively small number of trades for a large firm. The flexibility for firms to choose which trades to clear through the active account, within defined trade size and maturity ranges, will also somewhat mitigate the impact on clearing costs and best execution.

The effect of AAR may become much more significant, however, if additional quantitative thresholds are introduced which could cause a substantial market fragmentation or if the scope of the regulation is extended to a larger range of products, such as Credit Default Swaps (CDS).

Firms may find it helpful to consider how the cost of clearing could change for them for each of the products in scope and start preparing for setting up the active account. In moving clearing volumes, firms will also need to consider client interests and best execution principles.

Part 3: Conclusion

EMIR 3.0 has undergone some intense negotiations amongst EU policymakers. Although the final version is less ambitious compared to previous drafts, the changes will provide the essential pipework that will allow EU policymakers to make future amendments faster and more efficiently. Ultimately, we see the current changes laying the foundation for the EU’s longer-term ambition for achieving strategic autonomy and creating the CMU.

If the current (relatively straightforward) requirements do not result in a sufficient shift of the clearing activity away from Tier 2 CCPs, there is a likelihood of additional measures being introduced which may include quantitative thresholds or the scope being extended to a wider variety of products. If a threshold is introduced, it is likely to be phased in and carefully calibrated to reflect considerations around competition and competitiveness. However, even with careful calibration, the quantitative thresholds are likely to increase the cost of clearing in the EU in addition to the initial cost of setting up an active account or improving the resilience of an existing ones.

Overall, we expect the uncertainty around clearing equivalence to continue but the possibility of it not being extended beyond June 2025 remains low, at least until there is a significant shift in clearing activity away from UK CCPs.