A brief recap of regulatory reform of the OTC derivatives industry in 2014. David Wigan explores the dominate issues and milestones of the past 12 months including EMIR trade reporting, CCP clearing and execution via SEFs.
Early in 2014, the Basel-based Financial Stability Board (FSB) made plain its frustration at what it saw as a lack of progress in regulating derivatives markets, saying in an April letter to the G20 heads of government that concerted action “is overdue”.
It appears regulatory authorities got the message, and in its latest report at the beginning of November the Financial Stability Board noted “the shape of the regulatory landscape has become clearer”, with an evolving market infrastructure helping support legislative efforts.
From a market participant’s point of view the past 12 months will likely be remembered as the year in which Europe played catch up with the US, matching it on trade reporting but continuing to lag on electronic trading and central counterparty (CCP) clearing. Cross border issues, meanwhile, were partially resolved, but conflicts and inconsistencies remained.
At the beginning of the year the date on the calendar that loomed large for European market participants was February 12, after the European Commission late in 2013 rejected an attempt by the European Securities and Markets Authority (ESMA) to extend the deadline to January 2015.
With the date set firm, European market participants scrambled either to put in place the necessary internal controls or to outsource trade reporting to third parties.
The basic requirements of trade reporting in Europe are that information must be provided on both counterparties to each trade (counterparty data) and derivative contracts (common data).
There are a minimum 26 counterparty data items and 59 common data items required under European Market Infrastructure Regulation (EMIR), and counterparties and CCPs must make a report when a contract is entered into, modified and terminated. Unlike in the United States, where responsibility for reporting can be outsourced, the parties to the transaction retain responsibility for reporting and its accuracy, even if they delegate the reporting itself.
“What caught everybody out was that banks were looking to offer their clients reporting services and were running to get those agreements in place, and then the trade repositories were trying to on-board high numbers of market participants, and it’s fair to say they struggled with the volume and complexity,” says Kunal Patel, London-based principal consultant at Capco. “Buyside clients were unsure of what was being reported and not being reported and there was a lot of confusion.”
Trade reporting has also been a source of frustration for regulators and considerable differences remain between approaches in the US and Europe, in areas including the operational separation of ancillary services, details to be reported, the scope of the collected data (e.g. collateral exposures are required to be reported in Europe but not the US) and restrictions on foreign authorities’ access to trade repository data.
One particular bug bear among market participants is the issue of what in Europe are called Unique Trade Identifiers (UTIs) and in the US are known as Unique Swap Identifiers (USIs). The problem is that the U.S. Commodity Futures Trading Commission (CFTC) has one formula for what USIs should look like and ESMA has another.
Meanwhile policy makers at the FSB are concerned over their ability to aggregate data, which may come in a variety of formats from the 23 trade repositories already in operation.
“People underestimated how complicated it was to aggregate data on a cross border basis,” says a source at IOSCO.
One area where some progress has been made is so-called legal entity identifiers (LEIs), which are 20-digit, alpha-numeric codes that enable unique identification of companies. The Swiss-based Global LEI Foundation (GLEIF) was established in June to run a project to establish a global LEI system, and the FSB in November reported “considerable progress.”
Around the same time of year as Europe was grappling with trade reporting, US rules under the Dodd Frank Act to move swaps trading onto electronic platforms were starting to bite, with a number of interest rate swap (IRS) products mandated to be traded on swap execution facilities from February 15.
Over the first few weeks of trading, volumes of SEF-traded products rose, but in the following months volumes were erratic, with interest rate swap trading, accounting for around 80 per cent of the market, declining.
“We saw several brokers registering early and looking to take a large market share but it didn’t turn out like that,” says Capco’s Patel. “We haven’t seen the big move onto SEFs and it seems market participants still prefer the liquidity they get on the phone, and are going out of their way to avoid the additional costs associated with clearing.”
According to a Tabb Group report, SEF Trading October 2014: An Expanding Universe, published in October, more than three in five market participants are moving to non-standardized swaps to avoid SEF execution mandates, while 43 percent suspect swaps trading of moving overseas where regulations have not kicked in, and 37 percent say they think volume is migrating to futures.
While 2013 was the year in which the US introduced mandatory clearing for certain classes of swaps, 2014 was the year in which Europe talked about it, with ESMA over the summer consulting on what should be cleared based on the clearing houses that had been authorised. The list was similar to that published by the CFTC in November 2012, and included fixed to floating IRS and basis swaps, forward rate agreements and overnight index swaps. In credit, a narrower set of index-based swaps were considered.
ESMA published draft regulatory technical standards for IRS in October but has delayed its final reports on credit default swaps and foreign exchange non-deliverable forwards. Lawyers Shearman & Sterling predict the first clearing obligations (for clearing house members) will come into force around the middle of next year (at the earliest) with other categories of counterparties unlikely to be required to clear until 2016 or later.
For the 14 CCPs authorised to offer clearing services under EMIR the delays are a source of frustration.
“When the RTS are finally applied it will be a good step forward,” says Matthias Graulich, an executive board member and chief client officer at Eurex Clearing. “We are now way behind the US, which puts European CCPs at a disadvantage, because people have flexibility as global institutions to move their business to the US regime.”
European CCPs have lobbied European regulators in 2014 over what they see as prejudicial rules on margining and custody. Modeling of initial margins for over-the-counter (OTC) business in Europe must be at a 99.5% confidence level, compared with 99% in the US. European clearing houses must offer clients individual and omnibus segregation of assets held by the clearing house, while US clearers are permitted to offer the arguably less secure ‘legally separated operationally comingled’ (LSOC) framework.
“Some people have decided to go with the US side, so equivalence matters, and there should be one standard without the chance of regulatory arbitrage,” Graulich says.
One area in which Eurex may have an advantage over rival clearing houses is in cross-margining of futures, which it clears through its exclusive partnership with Deutsche Borse. CME has a similar opportunity in the US.
US CCPs meanwhile are sweating European recognition for operation in Europe, without which they will be exposed to punitive capital requirements. European authorities have recognised CCPs from countries including Australia and Hong Kong, but has held back on US recognition following disagreements earlier in the year over US ‘no action’ relief to qualified Multilateral Trading Facilities (MTFs) overseen by EU regulators. Under the relief, MTFs no longer must register with the Commission as SEFs to handle certain swap transactions on behalf of US persons. However, the issue continues to rankle.
“The US no action relief for European MTFs continues on a conditional basis,” says Thomas Donegan, a London-based regulatory partner at Shearman & Sterling. “However, issues with US access haven’t been resolved to everyone’s satisfaction, meaning that many MTFs are still restricting access to US participants.”
The move towards more central clearing, alongside proposed new rules for margins on uncleared derivatives, has increased pressure in 2014 on market participants to improve access to and management of collateral.
“There is a huge challenge, particularly for buyside firms that do not hold large stores of cash, to make sure they have the liquidity to meet collateral calls given much shorter notice in the cleared environment than in the bilateral space,” says Mark Higgins, managing director, business development EMEA at Bank of New York Mellon.
Although the wider repo market may be showing some signs of pressure, participants are turning more often to tri-party or quad-party solutions, Higgins says, with transactions processed and managed via an agent.
He said: “Another trend we are seeing is for banks to pay a lot more attention to asset transformation and making sure they hold the right assets on their balance sheets in terms of risk weightings. The ‘upgrade’ trade is an activity that is proving increasingly popular.”
In summary, a year of progress from a regulatory point of view. But that light at the end of the tunnel – its probably a mirage.
