MiFID II has finally arrived, but market participants will have their hands full all year implementing the weighty new rules and coping with any Brexit fallouts. Lynn Strongin Dodds reports.
As 2018 dawned, the long-awaited Markets in Financial Instruments Directive II (MiFID II) came into effect – but instead of entering the financial world with a bang, it arrived with a whimper. In fact, the impact was even gentler for the derivatives world, where major exchanges were given a 30-month grace period to implement the controversial open access model.
The Financial Conduct Authority (FCA) granted an almost three-year reprieve for ICE Futures Europe and the London Metal Exchange, while Eurex, the Frankfurt-based futures exchange owned by Deutsche Börse, as well as exchange operator Euronext NV, were allowed the same breathing space by the German and French watchdogs, the Federal Financial Supervisory Authority (BaFin) and Autorité des Marchés Financiers (AMF), respectively.
Open access is one of the key planks of MiFID II’s drive towards transparency and greater choice. The aim is to enable trading venues and clearing houses non-discriminatory access to their services. This means investors can trade a future or derivative contract on one exchange and clear it at a central counterparty (CCP) owned by a completely separate group.
It has been a well-documented, hotly contentious issue with the London Stock Exchange Group, owner of LCH, the world’s largest clearing house for derivatives, Nasdaq and NEX Group (formerly ICAP) on the proponent side. They contend that open access will not only lower trading costs but also encourage competition. Their views are not shared by ICE Futures Europe and Eurex, which both operate vertical frameworks, whereby contracts are traded and cleared at the same exchange. They have sounded warnings over the financial stability risks posed from opening up derivatives clearing to competition.
The recently approved transitional arrangements will allow these arguments more air time, but also the space for the exchanges to get their clearing models in order. However, some market participants believe that Brexit may throw a spanner in the works. In fact, last November, ICE’s chief executive officer Jeffrey Sprecher told analysts that exchanges and regulators were discussing whether the open access requirement made sense in the context of Brexit.
At the time, he said, “If we think of MiFID II as being essentially forced fragmentation of markets in order to stimulate competition, you’ve got this overlay now of a population that voted for fragmentation. And is there still a role right now for government to implement forced fragmentation when the market itself is fragmenting in ways that none of us sitting here today can fully comprehend?”
Sprecher has support from Markus Ferber, a German MEP who was the MiFID II rapporteur in the European Parliament. In a recent interview with the Financial Times, he commented that policymakers had long been aware that applying open access was “very difficult from a technical perspective” and that the UK leaving the European Union does complicate matters further.” He believes that the delay to open access will provide the much-needed time to analyse the impact of Brexit.
The euro clearing battle rages on
There is no doubt that euro clearing overall will be one of the main frontlines. Paris and Germany have been trying for years to wrest the lucrative business away from the City of London, which accounts for roughly three quarters of the volumes. LCH processes the bulk and the impact of the legislation such as the European Market Infrastructure Regulation to push more contracts through exchanges and central clearing is reflected in its 2017 figures.
The London CCP cleared a record $873 trillion of over-the-counter derivatives notional in 2017, which was a hefty 31% hike over 2016. The rise was attributed to significant on-boarding of new clients across Europe, the Americas and Asia Pacific. Breaking it down, inflation swaps came in over the $3.1 trillion mark, almost three-times the volume processed in the previous year, while the compression figures also steadily climbed by 58% to more than $608 trillion from 2016 levels.
Meanwhile, its ForexClear handled over $11 trillion notional in FX derivatives, including non-deliverable forwards, a three-fold increase over the previous year volume, while EquityClear processed more than $1 billion trades, with CDSClear reporting €1.1 trillion notional across credit default swap indices and single name CDS.
The European Central Bank which was thwarted in its attempt two years ago by the European Court of Justice to move the business to the continent is more likely to be successful in the post-Brexit era. It is already laying the foundations and is proposing that it, alongside the European Securities and Markets Authority (ESMA), have broader oversight of clearing houses. This would entail ESMA determining which overseas clearing houses were systematic, using the metrics of “nature, size and complexity” of their business, as well as the amount of volumes that flowed through their system.
Those that passed the test would be subject to strict requirements if they wanted to offer services to EU banks and non-financial corporate customers. Equally as important, when handling transactions denominated in currencies used in the EU, they would need to respect requirements set by that currency’s issuing central bank on “liquidity, payment or settlement arrangements”.
In a statement, the International Swaps and Derivatives Association (ISDA) expressed “serious concerns” and cautioned that forcing parts of the clearing business to migrate to Europe would break up markets and create instability. Banks have also warned that splitting off a piece of the clearing market to a new venue could increase the amount of capital they would have to hold against those trades. This in turn would make it more expensive for clients to hedge risk.
As the arguments fly back and forth, Paris and Frankfurt will continue to jostle for top position. Eurex has already stepped up its game by introducing a new profit-sharing programme this year with its ten most active participants. They will not only be eligible for what the bourse has dubbed a significant share in revenues of IRS clearing, but also have the ability to contribute to the strategic direction of the German CCP. Despite the misgivings of some, to date the Bank of America Merrill Lynch, Citigroup, Commerzbank, Deutsche Bank, JPMorgan and Morgan Stanley have already signed up to the scheme.
“The fight over euro-clearing will continue to be one of the major battlegrounds.” according to Russell Dinnage, Head of the Capital Markets Intelligence Practice at GreySpark Partners. “The fact that the activity has been in London will become increasingly inconsequential after Brexit. Paris and Frankfurt will make a land grab, but I suspect it may go to Paris because the infrastructure, as well as the majority of clearing brokers, are already there.”
“The fact that the activity has been in London will become increasingly inconsequential after Brexit. Paris and Frankfurt will make a land grab, but I suspect it may go to Paris because the infrastructure, as well as the majority of clearing brokers, are already there.” Russell Dinnage, Head of the Capital Markets Intelligence Practice at GreySpark Partners.
The never-ending implementation
While many believe Brexit will be front and centre this year, the continued thorny implementation of MiFID II will also be a major theme. As Matt Gibbs, product manager at Linedata put it, “I think the bedding down of MiFID II will be hit or miss until June, but after the first half things will start to calm down and the systems needed for the processing of derivatives and data management will be in place and ready. As for the impact, I am expecting big moves in the industry towards standardisation with the vast majority of OTC contracts being centrally cleared.”
Fraser Bell, chief revenue officer (CRO) at BSO Network agrees, adding, “In the immediate aftermath post January 3rd, it is fair to say that trading of these assets on-exchange may take a bit of getting used to. Let’s face it, having to manage a huge volume of potentially risky assets on venue is no easy task. It is unlikely to get any easier looking further ahead, with market participants likely to increase their use of derivatives now they are seen as a less risky option under MiFID II. This will lead to more trading being done and greater volumes, which needs to be underpinned by robust and reliable infrastructure.”
There will be greater question marks over the development of systematic internalisers (SIs) which are firms that deal on their own account by executing client orders outside regulated markets, such as a multilateral trading facility (MTF) or organised trading facility (OFT). While pre- and post-trade transparency rules will apply to SIs from January 2018, regulators will not begin to designate SIs until September. Although there has been a wave of institutions such as JP Morgan, Deutsche Bank and Morgan Stanley that have registered as SIs, there is no guidance in the legislation as to how they should define the scope of instruments they offer.
“The development of SI’s will be interesting to watch,” says Tim Cave, analyst at Tabb Group. “It is unclear whether it will be enough to be an SI in a number of cash instruments, or if clients will expect their counterparts to also be SIs in related futures, swap instruments, and government bonds. Some of the biggest banks, such as JP Morgan, Goldman Sachs and Deutsche Bank, have stated their intention to be an SI in a broad range of instruments, while others have a narrower focus. In the area of interest rate swaps, dealers can be very specific about which instruments they intend to be an SI in, and which they don’t. It will also depend on how ESMA applies the rules. They only came out with their Q&A last October so it will take time.”
The industry will also be scrutinising the development of the OTFs. There hasn’t been that much activity, with BGC Partners being among the most high-profile signatories. It is uncertain as to how it will be adopted but Bell believes interest could increase. “OTFs are allowed to engage in matched principal trading, with client consent, in derivatives which do not have to be centrally cleared,” he says. “This should greatly add to their appeal as more and more firms look to save on clearing costs wherever possible. However, all this points to a significant shift in how markets operate. As these venues emerge, the industry will face a growing need to reliably connect multiple data feeds to numerous destinations, allowing for the market to manage the huge volumes of derivatives assets arriving on venue.”
The other big developments to watch this year will be on the technology front. At the end of 2017, the Commodity Futures Trading Commission (CFTC) gave the green light to the CME Group and CBOE Global Markets to launch bitcoin futures under the self-certification process. This entails a designated exchange filing a submission to the CFTC confirming the product complies with the Commodity Exchange Act and CFTC regulations – including a key provision that requires that the contract is not susceptible to manipulation.
Meanwhile, the Depository Trust and Clearing Corporation (DTCC) is expected to launch its distributed ledger technology platform during the year to handle post-trade processing of over-the-counter derivatives. The first step in conjunction with fintech partners Axoni, IBM and industry consortium R3, will be to re-engineer the DTCC’s Trade Information Warehouse (TIW), which maintains records on more than $11 trillion of cleared and bilateral credit derivatives transactions.
Although new initiatives and partnerships will continue to be a major theme in 2018, regulators may also tighten the creative screws. South Korea is already proposing a ban on digital currency trading, while the CTFC and Securities and Exchange Commission (SEC) could also be cracking down. The derivatives regulator will be holding two meetings in the next few months to discuss the procedure and operational controls for listing and trading digital currency futures, amid rising concerns over the risks bitcoin poses to the financial system.
The SEC and the North American Securities Administrators Association (NASSA) are also looking at the inner workings of digital currencies and blockchain, and have cautioned investors that the regulators may not be able to protect them from fraudsters.
Check in with DerivSource.com regularly throughout the year to keep up with these and other trends in the world of derivatives.
