1. Freshfields Bruckhaus Deringer LLP European Market Infrastructures Regulation ESMA Level 2 measures, segregation and porting James Smethurst Elisabeth Øverland 18 October 2012

2. G20 Commitment The G20 Summit in Pittsburgh in September 2009 laid the future path for OTC derivatives: “All standardized OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end 2012 at latest. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

3. Background EMIR EMIR contains the EU requirements in respect of ­(i) central clearing of standardised OTC derivatives ­(ii) reporting of derivatives transactions to TRs ­(iii) risk mitigation (including collateral requirements) for non-cleared trades EMIR also introduces provisions in relation to porting of positions on the insolvency of a clearing member and a requirement to offer both omnibus and individual segregation to clients The final text of EMIR entered into force on 16 August, but most obligations will not take effect until next year when Level 2 technical standards come into effect Level 2 process – ­September 2012 ESMA published recommendations to EU Commission ­Commission has 3 months to endorse or amend ­EU Parliament & Council has a month (or 3 months if amended) to object ­Target end 2012?

4. Overview ESMA’s Final Report (Level 2) Feedback from the second consultation and proposed changes made by ESMA Three sections focusing on: 1.OTC clearing, including indirect clearing arrangements, clearing obligation procedure, non-financial counterparties, risk mitigation techniques for contracts not cleared by a CCP and intra-group exemptions 2.CCP requirements 3.Trade repositories (TRs) and reporting obligation Porting and segregation Requirement to offer different levels of segregation to clients CCPs to facilitate porting of assets and positions on the default of a clearing member HMT is proposing changes to English law and the FSA is proposing changes to the client money regime to facilitate porting

5. EMIR Level 2: clearing obligation Clearing obligation procedure Bottom up – competent authority authorises CCP to clear class of OTC derivatives and notifies ESMA Top down – ESMA identifies classes of OTC derivative Clearing obligation criteria Criteria for determining whether mandatory clearing will apply ­standardisation ­common legal documentation, operational standardisation ­volume and liquidity ­proportionality of margins, historical stability ­availability of fair, reliable and generally accepted pricing ESMA to determine date from which clearing obligation to take effect ESMA to operate public register with classes of OTC derivative subject to clearing obligation

6. EMIR Level 2: non-financial counterparties Clearing thresholds (once threshold crossed all OTC derivatives caught) Credit derivatives€1 billion gross notional Equity derivatives€1 billion gross notional Interest rate derivatives€3 billion gross notional FX derivatives€3 billion gross notional Commodity and other derivatives€3 billion gross notional

7. EMIR Level 2: non-financial counterparties Hedging Contracts objectively measurable as reducing risks relating to commercial or treasury financing activity excluded from threshold calculation Derivative covers: (i)risks arising from potential change in value of assets, services, inputs, products, commodities or liabilities that NFC owns, produces, manufactures etc. (ii)risks arising from potential impact on value of assets etc. within (i) resulting from fluctuation in interest rates, inflation, fx or credit risk (iii)qualifies as a hedging contract under IFRS Will include risks arising from acquisition of companies

8. EMIR Level 2: risk mitigation for non-cleared derivatives Overview of risk mitigation requirements All FCs and NFCs must have procedures and arrangements to measure, monitor and mitigate operational and counterparty credit risk, including: ­timely confirmations (by electronic means where available); and ­reconciliation, risk management and resolution of disputes FCs and NFCs (above clearing threshold) must mark-to-market (or model) the value of outstanding contracts on a daily basis FCs and NFCs (above clearing threshold) must have procedures for timely, accurate and appropriate segregated exchange of collateral (which may include variation margin and initial margin – details to be determined in technical standards at Level 2 post Basel/IOSCO consultation) FCs must also hold capital to manage risk not covered by exchange of collateral

9. EMIR Level 2: timely confirmation of non-cleared derivatives FCs and NFCs above threshold Credit default swaps and interest rate swaps To 28/2/2014 2 business days After 28/2/2014 1 business day Equity swaps, FX swaps, commodity swaps and other derivatives To 31/8/2013 3 business days To 31/8/2014 2 business days After 31/8/2014 1 business day FCs and NFCs below threshold Credit default swaps and interest rate swaps To 31/8/2013 5 business days To 31/8/2014 3 business days After 31/8/2014 2 business days Equity swaps, FX swaps, commodity swaps and other derivatives To 31/8/2013 7 business days To 31/8/2014 4 business days After 31/8/2014 2 business days

10. EMIR Level 2: reconciliation of non-cleared derivatives FCs and NFCs (above clearing threshold) ≥500 contracts Daily 51 – 499 contracts Weekly ≤50 contracts Quarterly NFCs (below clearing threshold) ≥101 contracts Quarterly ≤100 contracts Annually

11. EMIR Level 2: other risk management measures Portfolio compression FCs and NFCs with 500 or more outstanding OTC derivative contracts with a single counterparty must look at compression at least twice per year Dispute resolution FCs and NFCs must agree detailed processes and procedures for: (i) identification, recording and monitoring of disputes (ii) timely resolution of disputes (including specific process for disputes longer than 5 days) Notification to competent authority of disputes over €15 million outstanding for more than 15 business days Mark-to-market / mark-to-model FCs and NFCs must mark-to-market on daily basis unless market conditions prevent Market conditions: (i) market inactive (ii) significant range of fair value estimates and probabilities cannot be assessed Criteria for using model incl: (i) validated and independently monitored by different division; (ii) documented and approved by the board

12. EMIR Level 2: intra-group exemption Intra-group transactions meeting certain criteria are exempt from collateral requirements – Exemption must be applied for from competent authority demonstrating (i) adequate risk management procedures; and (ii) no practical or legal impediments to prompt transfer of own funds or repayment of liabilities – Level 2 measures expected on impediments from ESMA, EBA and EIOPA – ESMA Level 2 on information on exemption to be notified to (i) competent authority; (ii) ESMA; and (iii) publicly disclosed – Requirement for legal opinion for notification to competent authority dropped

13. EMIR: Level 2: indirect clearing Indirect clearing EMIR envisages indirect clearing arrangements (e.g. clients of clients of clearing members) Indirect clearing clients to benefit from equivalent segregation and portability protections as direct clients ESMA’s earlier consultation quite prescriptive on Level 2 indirect clearing e.g. obligation to offer indirect clearing Final report more flexible and non-prescriptive: -clearing members may facilitate indirect clearing -if they do then must do so on reasonable commercial terms -clearing member must implement measures to achieve segregation -clearing member’s default procedures to include “credible mechanism” to enable porting

14. EMIR: Segregation and porting Different levels of segregation Under Article 39 of EMIR, CCPs and clearing members must offer clients both individual client segregation and omnibus client segregation Where clients choose individual segregation, margin in excess of the CCP’s requirement must also be held at the CCP, whereas for omnibus accounts, margin excess will be held by the clearing member Porting of positions and assets Under article 48 of EMIR, on the request of an underlying client, a CCP must trigger procedures for the transfer of assets and positions held by a defaulting clearing member (DCM) to a non-defaulting clearing member (NDCM) designated by the client without the consent of the defaulting clearing member Where porting cannot occur, the CCP may manage its risk according to its rules, including liquidating assets and positions Any collateral balance owed by the CCP after completion of the default management process must be returned to the clients when known to the CCP or, if not, to the clearing member ‘for the account of its clients’

15. EMIR: Segregation and porting (cont) Level 2 measures? No level 2 measures are required under articles 39 and 48 Provisions are expected to come into force upon authorisation of CCPs under EMIR, so will potentially apply to different CCPs at different times Interaction with English law EMIR is a regulation, which means that it is directly applicable EMIR requirements on segregation and porting ‘should... prevail over any conflicting laws, regulations and administrative provisions of the Member States that prevent the parties from fulfilling them’ (recital 64) Relying solely on the EMIR provisions would result in significant uncertainty as to the operation and effect of the porting provisions under English law HMT has taken the view that porting under EMIR should be specifically recognised under English law in order to ensure certainty as to the operation and protection of porting on the insolvency of a clearing member The FSA is also seeking to amend the client money rules to allow porting of client money

16. EMIR: Segregation and porting (cont) The FSA’s Consultation and Discussion Paper (CP 12/22) The FSA paper is divided into three parts, with Part I discussing changes required by EMIR The introduction of multiple client money pools in Part II of the FSA paper is also relevant to porting To facilitate porting, CCP client transaction accounts must not be pooled Under EMIR, CCPs will attempt to transfer assets and positions of a client from a DCM to a NDCM Under current FSA rules, the default of a clearing member will trigger a primary pooling event with all cash held in client money bank accounts and client transaction accounts (including with CCPs) being pooled and each client receiving a sum rateable to their client money entitlement Pooling is incompatible with porting The FSA is therefore proposing to amend the client money distribution rules so that client money held at a CCP will not be pooled, but will be available for porting

17. EMIR: Segregation and porting (cont) What if porting is not possible? If the CCP is unable to return balances directly to the client, but instead returns them to the DCM ‘for the account of its clients’ the FSA proposes the following: ­individual segregation – the firm should remit the money to the client as soon as possible and it will not form part of the client money pool ­omnibus segregation – the money will form part of the client money pool available for distribution to the firm’s clients How will the client money rules deal with margin excesses? Individual segregation – client money rules need to be amended to allow any excess margin above the CCP net requirement to be posted to the CCP Omnibus segregation – EMIR does not provide for porting of excess margin, but a NDCM will want sufficient margin to cover exposures to each client and will require additional margin if the excess cannot be ported ­under current FSA rules, excess margin held by the DCM would form part of the general client money pool ­the FSA is therefore proposing that excess margin is kept in a separate sub- pool ready for porting

18. EMIR: Segregation and porting (cont) Discharge of client money responsibilities The FSA is proposing to amend the client money rules so that a firm will have discharged its client money responsibilities when money is ported or paid directly to the client by the CCP Need to be clear about exactly when the duty is discharged Treatment of title transfer collateral arrangements Where a client transfers full ownership of money to a firm to secure present or future obligations under a title transfer arrangement, the money is not treated as client money under the FSA rules The FSA states that firms must still offer clients a choice between individual and omnibus segregation at the CCP in such circumstances Firms will therefore need separate accounts at the CCP for client positions margined with the firm’s own money

19. EMIR: Segregation and porting (cont) Indirect clearing The assets and positions of an indirect client must benefit from protection with equivalent effect to the client segregation and portability arrangements in Articles 39 and 48 of EMIR CCPs must enable clients to distinguish assets and positions of clients from those held for the account of indirect clients of the client Clearing members and clients must offer omnibus segregation and individual segregation of indirect clients Clearing members must establish ‘robust procedures’ to manage the default of a client providing indirect clearing services, including a ‘credible mechanism’ for porting indirect clients’ assets and positions to an alternative client or clearing member The clearing member’s procedures must also allow for prompt liquidation of assets and positions of indirect clients and for the clearing member to pay monies due to indirect clients

20. Conclusion Level 2 nearly but not yet final – limited change from here? Clearing obligation unlikely to apply until Q2 2013 at the earliest? NFCs can start to assess now whether caught by clearing obligation FCs and NFCs can consider risk mitigation arrangements required Clearing members prepare for segregation and porting

21. LON22725598 This material is for general information only and is not intended to provide legal advice. © Freshfields Bruckhaus Deringer LLP 2012