The EMIR riptide
A major change that took effect in 2019 under the European Market Infrastructure Regulation (EMIR) was the EMIR Refit, which among other things reclassified all AIFMs – wherever located – who manage EU-domiciled alternative investment funds (AIFs) as “financial counterparties” and non-EU AIFMs managing non-EU AIFs as “third-country entity” financial counterparties, subject to reduced burdens compared to those AIFMs operating within the EU. Just as AIFMs have come to terms with these changes, new considerations and developments continue pull them back to sea.
With the UK’s imminent withdrawal from the EU, questions remain about how the EMIR requirements will be incorporated into UK law post-Brexit. It is likely that the UK will be considered a "third country" under EMIR, meaning EMIR will no longer apply directly in the UK following the transition period. Although the UK already agreed to compliance with EMIR in its EU withdrawal documents and UK Treasury regulations reflect this approach.
In any case, trades between a UK entity and an EU entity will still need to comply with the collateral exchange and clearing provisions of EMIR. However, central counterparties (CCPs) in the UK may no longer be presumed eligible to clear trades for EMIR purposes once the UK becomes a third country. In this case, much depends on how the EU treats the UK as “equivalent” — the devil will be in the details and there may be unanticipated effects. For example, even if equivalence decisions under EMIR are made regarding the UK, managers in the US (for example) who are subject to EMIR requirements will need to consider whether UK CCPs will be treated as equivalent by non-EU (e.g., US) regulators. Currently, the US Commodity Futures Trading Commission treats EU CCPs as equivalent for US purposes, but once the UK leaves the EU, whether it will continue to do so remains to be seen.
Another major development taking effect under EMIR in 2020 — and having particular effect on investment managers — is what used to be referred to as Phase 5 of the implementation of initial margin (IM) requirements for OTC derivatives.
In recognition of the broad state of unpreparedness of impacted sectors, regulators announced in September 2019 they were putting in place a revised timetable for the “final” phase, dividing Phase 5 in two and thereby providing smaller market participants with additional time to prepare by pushing back their compliance date to the new Phase 6 in 2021.
Firms with an aggregate average notional amount (AANA) of more than $50 billion will need to comply with the rules by September 2020 (revised Phase 5) and an estimated several hundred smaller investment management firms and regional banks with an AANA of more than $8 billion will be required to comply by September 2021 (new Phase 6).
Once a firm is determined to be in scope, market participants must carry out several steps ahead of the compliance deadline. These include engaging with counterparties in order to confirm scope of the impact, including which legal entities are covered, putting in place agreements confirming how IM is to be calculated, agree eligible collateral and haircuts with each counterparty and with third-party custodians or tri-party collateral agents. The length of time and complexity for putting necessary arrangements in place should not be underestimated.
AIFMD and UCITS: Keeping the records straight
A less obvious development potentially impacting investment managers is a change being made to the bookkeeping and records requirements for depositaries of AIFs and UCITS funds. 2018 amendments to both AIFMD and the UCITS Directive — which take effect April 2020 — will require depositaries to maintain their own sets of books and records that are “independent” of any sub-custodians to whom they delegate “custody” of the investment fund’s assets. Such “delegates” typically include prime brokers and collateral agents.
While some depositaries (depending on jurisdiction and local practice) may already comply with these requirements, some may not. Local regulators historically have varied in their approach to this issue, but the 2018 amendments are intended to foster harmonization across all EU member states. The industry in some countries is still waiting to see how their local regulator will implement the revised rules. Any meaningful deviation from a harmonized approach may trigger intervention by the European Securities and Markets Authority (ESMA), who is charged with preventing divergence by member states.
Here, too, the devil will be in the details: if requirements are imposed in a way that is too stringent, or that requires depositaries to effectively intervene in the process flow between buy-side investment managers, prime brokers, and collateral agents, investment managers may find that the arrangements they have established will become more complicated. The custodian industry has sought to ensure this does not happen while still demonstrating an “independent” view of investment fund positions as an added measure to protect investors against risks to fund assets.
Another concern worth watching in 2020 is the fallout from a likely final Brexit decision by the UK in January on fund managers based outside the EU. We mentioned potential indirect impacts on clearing arrangements but, more fundamentally, the European Commission has made clear that it will not be “business as usual” for fund management firms operating in London and hoping to do business in the European Economic Area.
Many fund management firms already have transferred staff from London to places like Dublin, Frankfurt, and Paris. What is still up in the air are the so-called substance requirements needed to be considered an EU-based fund. Individual member states – such as the Luxembourg CSSF – have provided clarity regarding requirements for local management and operations but other jurisdictions have been less clear on this aspect. Meanwhile, ongoing post-Brexit transition discussions between the EU and the UK will likely determine whether some form of mutual equivalence can minimize disruption for fund managers. If negotiations do not go well, UK-based fund managers may need to restructure further or find alternative means of access to the EU market (with EU managers possibly facing similar barriers by the UK).