OTC derivatives reform – where are we five years on?
Six years on since the global financial crisis, Europe has made great progress in transposing the G20’s regulatory framework to reform the over-the-counter derivatives market into law and incorporating that workflow into the single market project. The G20 Leaders Summit in Brisbane in November is an opportune time to reflect on this transit and what remains to be done as the industry seeks to restore the integrity of the global financial system.
By Alex McDonald, CEO, and David Clark, Chairman, Wholesale Markets Brokers’ Association (WMBA)
The derivatives aspect to the project has focused on three key tenets, namely: ensuring that all eligible OTC derivatives be traded on electronic trading platforms, cleared through central counterparties and reported to trade repositories. In Europe, trading and transparency will be transformed under new rules agreed in the revision of the Markets in Financial Instruments Directive, and its accompanying Regulation while the post-trade piece will be governed by the European Markets Infrastructure Regulation. The market abuse (Market Abuse Directive II/Market Abuse Regulation) and capital adequacy (Capital Requirements Directive IV/Capital Requirements Regulation) regimes have been extended and strengthened, whilst new rules around short selling and traded energy have also been founded in the Short Selling Regulation and the Regulation on Energy Market Integrity and Transparency.
Trade execution – liquidity and transparency
At the heart of MiFID II, which is set to be implemented from early 2017, are the issues of transparency and liquidity. The much wider scope for a set of rules still rooted in retail equity markets has driven a requirement for a comprehensive waiver system to be necessary from the outset. Wholesale and derivatives markets, other than in equities, are afforded treatment so as not to harm liquidity, diminish participation and raise costs. Thresholds exempt some trades from pre-trade disclosure requirements and will allow post-trade disclosure deferrals. Three different waivers are important - for all illiquid instruments, for indications of interest on request-for-quote and voice trading platforms if they are above a size specific to the instrument which would expose liquidity providers to undue risk, and orders that are large-in-scale compared to normal market size. The large-in-scale waiver is analogous to the US’s block trade rules for derivatives, albeit that they are set to capture wholesale markets rather than the predefined very small US exceptions. The first two waivers have no direct comparison to US regulation, which raises some concerns that the European rules may not be deemed equivalent to those in the US.
Before implementation, the European Securities Markets Authority will define what a ‘liquid’ instrument is, what the thresholds are for these particular non-equity instruments, and what the consequent deferral regimes will look like. This is all the more important given that these instruments vary so much in respect of their details, their usage and their lifecycles. It remains essential that ESMA adheres to the view it currently holds, that the concept of a liquid market is relevant for transparency purposes.
The Organised Trading Facility
MiFID II’s mandate for new trade execution venues for non-equity instruments is an OTF. This provides the venue operator discretion over arranging and execution using voice and electronic broking, often combined in a form of a hybrid model which deploys multiple methods of liquidity discovery. Since the aim behind the OTF category is to codify current and evolved market practices by wrapping them into a venue format with formalised conduct and reporting standards, an OTF should therefore not be particularly viewed as a ‘new venue’.
OTFs embody the Pittsburgh agenda (alongside Swap Execution Facilities in the US) and are essential to the current growth and trade objectives of the G20 by helping to facilitate ‘Capital Markets Union’. Additionally, OTFs as defined currently will also capture the maximum number of OTC transactions for central clearing and expand the number of OTC transactions which can be reported to regulators and supervisors.
Similar to US SEFs, instruments can be offered on OTFs and Multilateral Trading Facilities regardless of any mandate. However, the converse is not true, certain derivatives will be required only to trade on venues as determined by their activity and liquidity profiles. However ‘Made Available to Trade’, as US term that translates as the listing of reference data under MiFID II and a mandatory trading requirement for certain derivatives, is not to be formally linked to ESMA’s mandate in Europe.
MiFID II struggles to deal effectively with commodity markets and these are likely to be high on the list for ‘level 3’ regulations and indeed for MiFID III. The job conferred to ESMA here does therefore become close to impossible. This is because the text loses its transparency-led focus to divert into participant regulation and post-trade controls, consequently interfering with CRD, EMIR and REMIT. This has confused participants and regulators alike, especially in determining when an OTF is suddenly no longer an OTF and in trying to control the future distant delivery of the yet to be struck contract. In particular, derivatives and forward markets remain ill-defined in the Perimeter Guidance and are then segregated, whilst the non-competitive notion of ‘open interest’ and therefore intellectual property rights become enshrined within legislation, putting it at odds with its own founding principle. Furthermore, commodity position reporting requirements have been ill-thought out and need to be conferred to the post-trade scope of EMIR.
MiFID II/R require trading venues to publish reference data underlying the financial instruments traded to national competent authorities before trading in that instrument commences on that particular venue and also whenever changes are made to that instrument. However, in pasting across the listing rule sets applicable to on-exchange equities, authorities must be cognisant of the wider scope of the new text which now applies to non-equity instruments.
Firstly, derivatives confer the obligations to future sets of cash flows, either real or notional, therefore have never been ‘listed’ as they are in the proxy of exchange contracts but they can be negotiated around any particular factor. Secondly, they can only be identified and categorised at a high level, following the parameters of characteristics which may be applied to that instrument such as strike, maturity and clearing venue. Listing these facets a priori and separately may give rise to an indefinable and ever growing list of potential financial instruments. The most appropriate solution would be for these venues to provide national competent authorities with information outlining the perimeters and value ranges which describe each financial instrument traded on its venue, and notify them of any changes. This would, in turn, generate more relevant and meaningful listing information and competition for derivatives markets.
MiFID II witnesses a notable convergence of trade reporting towards transaction reporting. As with EMIR, which places the reporting obligations onto market counterparties, the operators of trading venues are required to make those reports on behalf of firms not subject to MiFIR, common across wholesale markets. Evidently, the series of locational rules within Dodd-Frank have undermined its efficacy, and MiFID II needs to be equally vigilant against the building of trade walls around Europe which could be the consequence of both strict equivalence and a full passporting regime. Operators cannot be held responsible for the completeness or accuracy of those reports which they may not have access to, such as the entity data and other necessary details of transactions by non-MiFIR firms for reporting purposes. Equally Europe cannot afford to shut out the rest of the world via an initial requirement for subsidiarisation when it needs to support both the Transatlantic Trade and Investment Partnership and the General Agreement on Tariffs and Trade. Holding trading venues responsible for the completeness and accuracy of reports may lead them to close their markets to non-MiFIR firms altogether. Moreover, substituted compliance remains critical; any inconsistency in enforcement by national competent authorities may lead to regulatory arbitrage. This would also prevent unnecessary duplicative reporting where venues and financial market infrastructure between regimes are linked in transactional chains.
All clear to clear
And now to the post-trade piece. For derivatives this means the determination of clearing obligations and the reauthorisation and recognition of clearing houses. This is almost complete within Europe at the time of writing (13 CCPs have been authorised under EMIR), however third country recognition of CCPs remains a battleground.
ESMA plans to stagger the implementation of the clearing obligation by putting different types of derivatives and counterparties into sequential obligations, with only the wholesale and dealer market currently timetabled. It remains widely understood that most of this initial segment is already pre-compliant in clearing trades voluntarily. On 1 October 2014, ESMA published final draft regulatory technical standards on the clearing of interest rate derivatives which will likely be endorsed by the European Commission, the member states and the Committee on Economic and Monetary Affairs by Christmas. These were closely followed by draft RTS on credit and foreign exchange derivatives with comments due by 6 November 2014. The earliest date that clearing will be mandatory for interest rate derivatives is therefore July 2015. ESMA will then produce draft final RTS for endorsement by the European Commission. Interestingly, unlike the credit and interest rate derivatives market where the trading and clearing mandates are already underway in the US, there appears to be agreement between regulators that the trading mandate for non-deliverable forwards should enter into force in Europe and the US at the same so as not to fragment liquidity in the NDF market. Notably, there is no consensus whatsoever across market participants that this is a worthwhile project or that it contributes to the efficiency of the market. It seems like the authorities have again mislaid their ‘where appropriate’ clause in Pittsburgh.
Progress has also been made regarding resolution and recovery frameworks for Financial Market Infrastructures, which of course is where the authorities should have begun in 2010. You cannot regulate life until you can organise death! This immediate cross defaulting of derivatives and unpacking of the balance sheets was the oxygen for the scale of the disastrous impact of both Bear-Stearns and Lehman Brothers. On 5 August 2014, ESMA published guidelines and recommendations regarding the implementation of the Committee on Payment and Settlement Systems-International Organization of Securities Commissions Principles for Financial Market Infrastructures in respect of CCPs. The translations of these guidelines published on 4 September triggered a two months ‘comply or explain’ period with guidelines applying from 4 November 2014.
Equally as important, on 11 October 2014, 18 major global banks (G-18) agreed to sign a new International Swaps & Derivatives Association Resolution Stay Protocol, developed in coordination with the Financial Stability Board, to support cross-border resolution and reduce systemic risk. This represents as important a step in strengthening systemic stability than anything that has emanated from Pittsburgh. It also reduces the ongoing concerns that banks are considered ‘too big to fail’. This aligns with the structures put in place for other investment firms where evidently Europe now has its Single Resolution Mechanism in place and even more importantly, the world has agreed at FSB level to adhere to a single point of resolution methodology.
Trade reporting has been alive for almost a year in Europe, but could hardly be said to be kicking. Dual sided reporting together with problems relating to the pairing of unique trade identifiers means that most trades remain unmatched.
Notwithstanding the progress market participants have made in reporting their trades to trade repositories and the large amount of data that has been collected, European regulators and their global counterparts must overcome a number of challenges before they can understand and make sense of the data and use it to identify risk. One of these challenges is the lack of globally agreed reporting standards which would enable regulators to more easily aggregate and interpret the data that is reported to them. The second challenge relates to legal requirements and indemnification clauses imposed by some jurisdictions which prohibit data from being shared. For example, the Dodd Frank Act in the US prevents non-US regulators from viewing data held by US trade repositories.
In an effort to address these challenges, the FSB has recently published a feasibility study on the various options for a mechanism to produce and share global aggregated OTC data. The report compared three options for aggregating this data: a physically centralised model; a logically centralised model; and the collection and aggregation by authorities themselves of raw data from trade repositories. Preparatory work is currently being carried out before any formal project is launched to implement a global aggregation mechanism.
National and global management of systemic risk remains the key goal of G20 aspirations. Measures taken so far by regulators fall well short of this crucial objective and resources should be diverted to assure that it is achieved.
The more contentious topics around OTC derivatives reform have been the interoperability of regulatory regimes and FMIs especially CCPs and trade repositories, both of which are battling against entrenched vested interests.
The ongoing lack of trust between regulators has often been cited as an impediment to mutual recognition such that any one nation’s structures are sufficient to mitigate the migration of systemic risk. The US proposes a ‘substituted compliance’ approach, whereas Europe seeks ‘equivalence assessments’.
Some progress has been made regarding these coordination principles. Earlier this year, US and European regulators reached an agreement to exempt European-approved derivatives trading platforms from US trading rules until equivalent rules come into force under MiFID II in 2017. Agreement has also been reached that work on margin requirements for uncleared derivatives will also be determined at a global level by IOSCO and then implemented consistently by each jurisdiction.
However, new contentions have arisen between the US and Europe regarding the recognition of foreign CCPs. In June 2014, the European Commission decided to grant equivalence for the central clearing regimes of Australia, Hong Kong, India, Japan and Singapore but not the US. If US central clearing regimes are not recognised as equivalent by 15 December, using a US CCP will become prohibitively expensive for European banks. In the same vein, a non-US CCP is not permitted to clear for US clients unless it has registered as a US CCP, a capital intensive exercise.
Whilst great progress has been made in coordinating these markets, an agreement needs to be reached on an international level on the tools and processes that should be employed by jurisdictions when implementing equivalent rules on a cross-border basis. IOSCO is in fact looking into the challenges that jurisdictions face in dealing with cross-border implementation. WMBA has placed great stead in a market participants’ cross-border regulation forum which has delivered advice to IOSCO, and believes that national regulators should confer powers around recognition entirely across to IOSCO to ensure consistent implementation of rules. Failure of markets to operate in harmony means we simply risk derailing the progress made to date in bringing transparency to the derivatives markets.
In Europe, the past six years has been a period of lobbying and debate bringing the industry to what is now the implementation phases of EMIR, REMIT, MAD II and MiFID II. While we have certainly made great progress in reforming the post-trade landscape there is still a long way to go before Europe’s trading and transparency regimes can settle ‘under new management’.
This article originally appeared on Global Capital on 23 October 2014.
Date Published: 03/09/2018
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