As we pointed out in our third piece on regulatory reporting, and at an Infoline conference for the buy-side this week in London, the overarching question is how will firms’ derivative activity be judged to be ‘good enough’ in 2017?
There is no single answer, and we won’t really know until the results are judged. Perhaps this is why ‘fear’ is a prominent thread in discussions across the globe. As we have noted at other events we attend with the buy-side, there are a number of key strategic questions for those that choose to stay in the derivatives space over the next few years.
How much time and effort should you be spending now to define what you want to look like in 2017? That’s your call but, ultimately, you need to decide whether you want to do a quality job, an inexpensive job or a timely job. Your shareholders will ultimately be the ones to work out whether you got it right.
In this article we take stock of the transatlantic regulatory approaches and discuss some of the key decisions buy-side firms will be faced with over the next year.
EU derivatives regulation
Derivatives trading in the UK is regulated through a range of EU regulations and directives, in particular, the European Market Infrastructure Regulation (EMIR), the Capital Requirements Directive and Regulation (CRD IV/CRR), the Markets in Financial Instruments Directive and Regulation (MiFID II/MiFIR) and the Markets Abuse Directive and Regulation (MAD II/MAR), which were extended in scope to include OTC derivatives.
Since 2013, all EU-based entities trading derivatives have to report their transactions to a trade repository under EMIR. EMIR also includes an obligation for certain classes of derivatives to be made subject to clearing, but mandatory clearing is not yet in place. Since the authorisation of CCPs in 2014, ESMA has analysed several asset classes and worked on finalising proposals for classes that should soon be mandated for clearing, based on whether or not they are sufficiently liquid. In our summary of Verena Ross’ speech at IDX we provide an update on these proposals.
With regard to capital requirements, the Basel III enhanced capital requirements for cleared and non-cleared derivatives have been implemented in the EU through CRD IV/CRR. On the other hand, margin requirements for uncleared derivatives contracts are still in development. Over the summer, the ESAs are to publish a proposal for margin requirements. This proposal is expected to be in line with the final policy framework published in March by the Basel Committee on Banking Supervision (BCBS) and the International Organization of Securities Commission (IOSCO). Lastly, MiFIR aims to ensure that trading in derivatives contracts eligible for clearing will take place on organised trading venues.
US derivatives regulation
In the US, the Dodd-Frank Act Title VII provides a comprehensive framework for the regulation of derivatives markets with the CFTC and the SEC jointly being responsible for undertaking rulemaking. Since 2013, oversight has been established for many new entities, such as swap dealers, major swap participants, clearing houses, trading platforms and swap data repositories. There are also obligations to report and broad categories of instruments have been made subject to clearing.
Furthermore, the CFTC has proposed rules on capital and margin requirements. Similar to the EU, the US is committed to implementing Basel III, requiring more capital from swap dealers and major swap participants. For the margin requirements, the CFTC proposed rules do differ from the BCBS/IOSCO standards. Instead of demanding that dealers post and collect initial margin for non-cleared derivatives from financial end-user counterparties with a material swap exposure of $11 billion, the CFTC puts this exposure at $3 billion.
Similar intentions, different approaches?
The highly cross-border nature of derivatives markets requires that conflicts, duplications, gaps and inconsistencies between regulations are addressed. If not, the G20 goals may be in danger as the Financial Stability Board (FSB) has warned. There are a number of differences in approaches that exist between the EU and US. This shines through, for example, in the protracted discussions on the recognition of US rules on derivatives trading clearing as equivalent to EU standards. Talks to recognise each region’s rules on clearing houses have so far ended with no agreement, causing unnecessary uncertainty in the derivatives markets.
Clearing houses are critically important as risk managers in the derivatives market. European rules require EU institutions to hold up to 30 times more capital if they clear trades through any jurisdiction not deemed equivalent to EU standards. Lacking EU recognition of equivalence, third country clearing houses are unlikely to clear EU-mandated derivatives. Although ten third party CCPs in Australia, Hong Kong, Japan and Singapore have recently been assessed as equivalent by the European Commission, there are still 31 non-EU CCPs awaiting recognition, including US CCPs, most notably the Chicago-based CME.
For now, EU institutions are still exempted from the requirement to hold more capital when trading derivatives at unapproved foreign exchanges. The question is for how long are they allowed to keep funnelling business to the US clearing houses? If no agreement is reached between the European Commission and the CFTC, market fragmentation seems inevitable ultimately leading to higher costs for end users.
According to the International Swaps and Derivatives Association (ISDA), one of the problems in reaching an agreement is an overly granular approach to equivalence. It suggests a number of resolutions, such as a global equivalence passport or automatic equivalence for G20 countries.
Regulators and industry, what lies ahead and how to get ready?
Resolving problems with regard to harmonisation in rules will be crucial in order for OTC derivatives regulation to be effective. “Global markets need global standards” as the FEMR report reminded us. But it’s not all up to the regulators, as we also discuss in our third reporting article.
The review of EMIR in the EU also offers an opportunity for the industry to provide input on whether the rules on OTC derivatives trading are proportionate to the risks posed by it and whether there are areas where the regulation could be improved, and to put forward possible solutions.
Firms, in the meantime, need to understand what is coming and change their trading business accordingly. Despite there still being questions, firms can be certain that the new trading landscape will look very different in 2017.
As we emphasised at Infoline’s conference for buy-side firms, the market is moving quickly to a big bang that will force new decisions about how business is done. Fundamental questions about how a firm ‘knows their business’ need to be addressed by front, middle and back-office all at once. For example, in considering how an order is done, the MiFID Implementation Group is looking at a large risk register that cuts across all trading activity. Examples include:
- What parts of my business are now within MiFID II?
- Is the instrument in scope?
- Who can we trade with? Do I know the decision maker?
- What channels can we take orders through?
- When is the AIOI given?
- Where is the trade going to be executed?
- Are my algos under control?
- What market reference data are we using?
- How do I prove ‘end to end’ best execution?
- What records need to be kept?
What is evident from the breadth of these questions is that this is a big change programme. Firms that start now by assessing their business capabilities, making an effort to understand the regulatory deltas and defining their target operating model will be better placed to survive in the new order.
The bottom line is that, while it may not feel like it, we are only one year away from market integration testing and difficult conversations across both the value chain and supply chain. Everything – from the type of relationship you have with your customers, the way you make decisions, which suppliers you work with and your reporting line – is up for grabs. Those that grasp the detail and move now will be most likely to be judged to be ‘good’.