The European Securities and Markets Authority (ESMA) recently released its final edict on the Markets in Financial Instruments Directive (MiFID II) derivatives trading obligations. DerivSource reporter Lynn Strongin Dodds spoke with industry observers to assess their conclusions and discuss any outstanding issues.
There were no surprises in the European Securities and Markets Authority’s (ESMA) final edict on the MiFID II derivatives trading obligations. As flagged, fixed to floating interest rate swaps denominated in euro, sterling and dollars, as well as index credit default swaps (such as iTraxx Europe Main and iTraxx Europe Crossover) will be making the move to electronic venues.
“ESMA managed expectations so there was no impact on the derivatives market,” says Nadine Jatto, government affairs and regulatory development specialist at UK-based financial markets consultancy Catalyst. “It is linked to the European Market Infrastructure Regulation (EMIR) clearing obligation although not everything that is being cleared falls under the clearing obligation. At the moment, the only problem is that the trading obligation has not been approved by the European Commission and we are not sure if it will be ready for the start date on 3 January 2018.”
Michael Thomas, partner at Hogan Lovells, also notes that the final draft was in line with market expectations. “The backdrop is the G20 commitment and the push to make the derivatives market more transparent and to move more instruments on an electronic marketplace. The rules should progress along the same lines as EMIR in terms of generating increased liquidity and volumes, which will lead to better pricing.’
Under EMIR, ESMA is required to take the universe of contracts covered by the clearing mandate and further analyse product characteristics to see if regulators should impose mandatory venue trading and the reporting and reference data publishing obligations that are connected to it. “They applied a number of tests to ensure that there was sufficient liquidity for these instruments to go onto an exchange and be subject to the clearing obligation under EMIR,” says Thomas.
According to Radi Khasawneh, senior analyst at TABB Group, ESMA adopted a two-pronged approach for the trading obligation that focused on the suitability of the venue as well as liquidity. In terms of venues, it determined that trading would take place on EU regulated markets, multilateral trading facilities (MTFs), organised trading facilities (OTFs), which do not come into force until MiFID II, or third country venues. Systematic Internalisers are off the list.
As for the liquidity assessment, a number of factors were analysed including average frequency, size and spreads of trades over a range of market conditions, as well as the number and type of active market participants. ESMA also factored in some of the comments it received in the consultation period, most notably requests for greater granularity. This translated into adding new parameters such as notional type, optionality, and the day count convention of the floating leg of the swap.
Khasawneh also notes that instead of looking at the obligation at the individual level, the watchdog adopted a holistic approach similar to what US regulators employed for the Made Available to Trade (MAT) determinations for swap execution facilities (SEFs). “One of the question marks though is that OTFs are not yet up and running, so it is difficult to judge how liquid they will be. Also, the orders on an OTF are to be carried out on a discretionary basis and they may not be fit for purpose to match client flow.”
Questions remain around packaged transactions
Other outstanding issues revolve around so-called packaged transactions, which are deals involving two or more components, contingent on each other and executed at the same time. Many regulated funds rely on such deals to execute investment strategies and under MiFID II, if one part of the transaction has traded on an electronic venue, then the rest must follow. The concern is that this will increase the costs of hedging which is why asset management lobby groups such as ICI Global are asking for ESMA to be given the powers to grant exemptions.
In the US, the Commodity Futures Trading Commission (CFTC) are able to provide relief in the form of no-action letters which excludes certain swaps executed as part of package transactions from the requirement to trade on a SEF. While in its final tome, ESMA recognised the need for a response, it does not have the authority to provide for a tailored regime for these transactions. It said though that it currently working on a number of Q&As for further clarification.
In the meantime, the International Swaps and Derivatives Association (ISDA) has put an alternative solution on the table. In its consultation response, the trade body suggests that only packages where all components are subject to the mandatory clearing obligation under EMIR and where at least one of those components forming the package is subject to the trading obligation should be brought in scope. The theory is that this will ensure that only the most standardised and liquid packages are required to be traded on venue as required under MiFID II.
“No one knows what will happen with the OTFs and what type of volumes they will attract, but the post-trade transparency requirements are sharper under MiFID II than Dodd-Frank and more expensive. For example, the EU involves greater complexity in terms of determining who should and who should not report the transaction. Also, there is one clearinghouse versus the multitude in Europe,” Octavio Marenzi, CEO, Opimas.
Progress on US/EU equivalency
More progress has been made on the US and European equivalency front. Market participants had warned that a lack of convergence would have created an unequal playing field between jurisdictions and firms as well as fragment liquidity in a global market. In fact, electronic market maker Citadel echoed the views of many in its consultation response, when it said that the liquidity profile of an OTC derivatives instrument does not drastically change based on geographical boundaries. Therefore, both US and EU market participants interact with the same core group of liquidity providers, and experience similar pricing and liquidity dynamics.
“As a result, we believe that ESMA should only adopt a narrower approach than the US trading obligation where it is absolutely clear that there is insufficient liquidity in a particular instrument,” said Citadel. “This will reduce regulatory arbitrage and ensure US and EU market participants are on a level playing field when transacting in the OTC derivatives market.”
Over the past few months though, the EU and CFTC have reached a long-sought agreement that saw the margin requirements for uncleared swaps under European Union law deemed “comparable in outcome” to those under CFTC rules. This means that European and US groups can trade on each other’s registered derivatives platforms and that each region accepts the other’s rules on collateral or margin requirements for derivatives trades.
Moreover, CFTC Chairman Christopher Giancarlo and Valdis Dombrovskis, EC vice president for financial stability, financial services and capital markets have agreed to work to adopt equivalency determinations on swap execution. Dubbed a “common approach“, CFTC-approved SEFs would receive EC equivalence approval if the venues meet the requirements of MiFID II and venues approved by the EC would be exempt from registering with the CFTC as a SEF.
Research from Chris Barnes, founder of XOIS, shows that there has been significant convergence with swaps that are currently made available to trade (MAT), or required to be traded on a SEF. He found that there are just four swaps that do not have a dual trading obligation (euro 8-, 9- and 12-year plus US dollar 1-year MAC, or market agreed coupon, swaps). The most notable differences between the two jurisdictions are the eight and nine-year swaps versus six-month Euribor.
The agreement is the second major deal between the EC and CFTC this year. In February, the regulators agreed to implement equivalence rules for central counterparties which allowed European and US CCPs to operate without additional regulatory requirements.
In his speech, Giancarlo said that these cross-border measures will provide certainty to market participants and also ensure that our global markets are not stifled by fragmentation, inefficiencies and higher costs.
Despite the move to greater harmonisation and equivalency, Octavio Marenzi, founder and CEO of consultancy Opimas, believes that derivatives trading could move out of the EU and to the US due to the costs involved with complying with the new regulation. “No one knows what will happen with the OTFs and what type of volumes they will attract, but the post-trade transparency requirements are sharper under MiFID II than Dodd-Frank and more expensive,” he adds. “For example, the EU involves greater complexity in terms of determining who should and who should not report the transaction. Also, there is one clearinghouse versus the multitude in Europe.”