Regulatory reform still faces delays and disagreements between the US and UK, which could have dire consequences on the derivatives industry if harmonisation is not achieved and all potential implications are not given appropriate attention. Roger Barton of Financial Reform Consultancy offers his personal predictions and questions to be answered regarding EMIR, MiFID II, systemic risk and global regulatory harmonisation.
It hasn’t been a good few months in Brussels. Apart from the Greek debt crisis, progress on derivatives regulatory reform has been painful and slow. European member states have failed to agree the European Market Infrastructure Regulation (EMIR), dealing with derivatives clearing and reporting. Also, the European Commission has had to delay production of its MiFID II proposals, dealing with derivatives execution amongst other things. Perhaps this is no surprise: MiFID II is a huge piece of regulation – a sequel to the original and far-reaching Markets in Financial Instruments Directive (MiFID), which came into effect in 2007. There have also been a number of studies and speeches emanating from US and UK acknowledging (belatedly) the potential systemic scale of the proposed reforms, and the need to get them right – particularly in the crucial importance of CCPs at the heart of the structure. And to spice it all up there have been a number of seemingly bad tempered and often baffling exchanges between the European and US administrations, apparently putting at risk the much heralded and important close trans-Atlantic co-operation.
Clearly, the business of wholesale reformation of the derivatives industry is proving more difficult than originally envisaged. This is perhaps an inevitable consequence of the scale and ambition of the reform programme. Each one of the large number of major regulatory initiatives has far-reaching and subtle impacts on the financial eco-system – not all of them as intended. Worse still, the different regulatory initiatives are generally drafted independently, with particular focus on the subject at hand, and generally little reference to the bigger picture or to changes already being formulated. The result is sometimes to magnify the cumulative impact – and sometimes to make the cumulative impact difficult to predict with any certainty. In addition, each of the 27 European member states has its own national interests and political imperatives which often conflict with each other – let alone with the US. To complicate matters further there is a view that, given the somewhat all-encompassing nature of the reforms, it is necessary to address all significant potential problem areas. In other words, exclusion of any part of the financial eco-system from the scope of reform would be a tacit endorsement of that area, given the scale of intended reform. Sleeping dogs everywhere should be wary!
So what happens next? Will the overwhelming complexity and overblown scope of the reforms lead to a continuing spiral of delay, and dispute between Europe and US? Or will political imperatives for progress prevail? Of course, the wild card in Europe is the Greek debt crisis, which could blow all European initiatives off course. Assuming that this issue continues to be effectively delayed, here are my personal predictions for the European derivatives reform agenda to the end of the year:
1. Despite current widespread predictions of protracted disagreements, I would expect agreement on EMIR to be reached before the end of the year. The highest profile area of disagreement relates to the possible extension of scope to include listed derivatives. A reasonable approach to resolution of this issue is to require that all listed derivatives must be cleared through a CCP, and to stick with the scope set out in the original G20 commitment (ie OTC derivatives) for the contentious issue of access arrangements. Similarly, agreement should be attainable before year-end in the other outstanding points. Even then, I do not believe that the target timescales of end 2012 will be achievable, but at least debate on the level 1 policy issues relating to EMIR can be put to bed, and focus can be turned to MiFID II.
2. MiFID II is a monster, with potentially profound and far-reaching impacts for all major financial markets, including fixed income markets, equities and commodities. The European Commission is grappling with some fundamental questions in compiling proposals. Just in the area of derivatives execution there are some weighty questions to be addressed: how to achieve the G20 commitment of moving business to regulated electronic platforms; how to square this with the stated desire to minimise impact on the way derivatives business is done; how far should transparency go; what role should Organised Trading Facilities (OTFs) play, etc, and how to square this with what the US is doing in the same area? Whenever these proposals are produced (mid-October as some expect, or later according to others) they will inevitably be the source of substantial debate, disagreement and controversy. There is no chance of the target implementation date of end 2012 being achieved for these reforms.
3. The public war-of-words between the US and Europe is of course not all that it sometimes appears. In both jurisdictions, concerted efforts continue to be made to keep the reforms in tandem. Whilst it is likely that there will be occasional ill-judged, ham-fisted and baffling public statements, this should not derail the intensive harmonisation efforts. There will be a big test over the territoriality of each jurisdiction’s regulations. This is a difficult and complex area, both technically and politically. If not resolved properly, overlapping and conflicting regulations could have far-reaching cost and commercial implications for all market participants: buy-side, sell-side and infrastructure providers.
4. There will continue to be a debate about the systemic implications of the plethora of regulatory reforms, and the consequences of systemic failure at any point in the process. It is right that this debate should be held, and important that the appropriate framework be put in place. There is a tendency in places to become increasingly prescriptive and detailed in some of the resulting regulations. Unless we believe that regulators have superhuman insight into the relatively complex interactions between different parts of the financial eco-system, such detailed prescriptions are dangerous: they will result in unforeseen and undesirable knock-on effects and lack of flexibility in times of financial stress. For this reason, legislators and regulatory organisations need to back away from the detail & refocus on the broad principles. They should then leave the qualified market participants – whether at exchanges, CCPs, buy-side or sell-side firms – to apply their expertise to ensure that these regulatory principles are upheld. I am hoping that this happens soon. It will greatly assist in the progress and effectiveness of regulatory reform.
