Ongoing derivatives regulatory reform will reach a critical juncture in 2015. Derivatives market participants must work towards ongoing initiatives such as CCP clearing but also begin preparations for more regulatory reform including MiFID. David Wigan reports.
The coming 12 months is set to be frantically busy for derivatives users as the regulatory momentum that has been building over recent years finally reaches critical mass.
After numerous proposals, consultations and technical standards, clearing will be launched sometime over the summer, led by interest rate derivatives, and buy-side firms in particular are scrambling to finalised their counterparties and choose clearing venues.
Meanwhile, the ongoing fundamental review of the trading book is expected in the coming months to put risk models under further scrutiny, with margins requirements on uncleared contracts scheduled to be launched at the end of the year.
Numerous cross-border issues remain to be resolved and looming on the horizon is implementation of MIFID II, bringing with it new rules on pre- and post-trade transparency, and Europe’s version of the swap execution facility regime already up and running in the US. A final consultation on MIFID II was published in early December, and much time in the coming weeks will be spent attempting to understand and digest its contents, lawyers say.
The first business of the year, however, will for many market participants be clearing. Final standards for clearing of interest rate swaps (IRS) will become effective 20 days after publication in the Official Journal of the European Commissions, expected in the coming days. Six months after the standards become effective the first of four categories of IRS users will be required to clear the following:
- basis swaps denominated in EUR, GBP, JPY, USD
- fixed-to-float swaps denominated in EUR, GBP, JPY, USD
- forward rate agreements denominated in EUR, GBP, USD
- overnight index swaps denominated in EUR, GBP, USD.
Members of central counterparties (CCPs) will be first in line to adopt clearing, and many are already doing so. Next will be financial counterparties and alternative investment funds with business above the clearing threshold. That is their month-end average notional amount of non-centrally cleared derivatives is above €8 billion.
The threshold is on a legal entity basis, which may exclude many firms. For example individual funds at large asset managers are often discrete legal persons. Category 2 counterparties will have to comply within 12 months after the final standards become effective.
For many market participants a big concern in respect of clearing has been the issue of front loading, unique to Europe, which concerns the requirement to load to a CCP trades conducted between when the European Securities and Markets Authority (ESMA) is told a clearing house has been authorised to clear certain derivatives classes and the start of a clearing obligation for those products.
The problem for market participants was that they could not tell which products would eventually be mandated for clearing or whether the frontloading requirements applied to them. That decision was based on derivatives notional outstanding figures in the three months prior to the official publication of the final rules, meaning the assessment would have been based on criteria not yet finalised.
However, in late December the European Commission changed the rules, with the assessment period for non-clearing-member financial institutions now running in the three months after the RTS come into force, creating greater legal certainty for those entities. Those categories of firms subject to frontloading will also have two months to get the necessary systems, controls and procedures in place and to inform counterparties of their status.
Of course some firms are already clearing voluntarily, either for reasons of margin efficiency based on their use of exchange-traded derivatives (a marginal impact given most investment firms have one way exposures) or to mitigate counterparty risk. However, only a few are likely to have taken the step.
“Some asset managers with US-based funds will be clearing there and there may be risk management or netting rationales, but the vast majority of buyside firms have yet to make a selection of clearing houses and clearing firms,” says John Wilson, a consultant and former head of OTC clearing at Newedge.
Buy-side firms have no sight of CCP risk models, which are only published to clearing members. On that basis the key focus for buy-side firms will be fees, says Wilson, both at an account and margin level.
He said: “Clearing house account fees vary considerably and of course as margins are protection against your own default, which you do not expect, it makes sense to seek out the cheapest possible. In addition, once clearing becomes mandatory it makes sense that fees will start to rise, so there may be some players who tie down their terms as early as possible.”
On the other side of clearing member beauty parades will be clearing members themselves, who are in the midst of the pre-January 2017 leverage ratio observation period. With cleared trades set to contribute to the denominator of the ratio, banks are likely to wish to ensure that the provision of clearing services is justified by the client relationship.
One issue for foreign clearing houses wishing to operate in Europe is recognition by European Commission, which when granted exempts those non-EU firms from additional capital charges. The EC has not yet officially recognized as equivalent clearing houses overseen by the Commodity Futures Trading Commission or the Securities and Exchange Commission. However, European regulators on December 11 agreed to postpone the imposition of higher capital charges on unrecognised CCPs by six months to June 15.
“I still believe the CCP recognition problem will be resolved, even if just temporarily until a more permanent solution is found,” says Michael O’Brien, director of global trading at Boston-based Eaton Vance.
Of course clearing house recognition is one of a long list of items that international regulators must continue to work on in the coming months if they are to achieve a level regulatory playing field. In its report to the G20 in November the OTC Derivatives Regulators Group said more work was needed to harmonise treatments of organised trading platforms, including mandating trading determinations, margin payments on uncleared derivatives( through ISOCO) , trade reporting and overseas branches and affiliates.
The latter issue is a particular concern after some US banks last year removed guarantees from some of their London-based swaps businesses and boosted capitalisation at those entities to enable dealing as a “non-US person” under CFTC rules. That means they do not need to transact standardised swaps denominated in euro, yen and sterling on US swap execution facilities (SEFs), effectively transferring a large chunk of the US-based swap market to Europe.
In respect of margin payments on uncleared derivatives, national regulators are expected to finalise new rules by April. However, amid industry protests that more time is needed to prepare internal models, ISDA in November wrote to the CFTC that initial margin requirements on uncleared trades should take effect two years after the rules become final, rather than starting at the end of 2015 as planned. An answer is awaited.
One problem yet to be addressed by the industry is how to address competing margin models that disagree, and ISDA in September proposed a standardised initial margin model. However, challenges remain, not least differing threshold levels in Europe and the US ($11 billion and $3 billion respectively).
Another area of difference is trading venues. MIFID II provides for three types of venues for derivatives; regulated markets, multi-lateral trading facilities (MTFs) and organised trading facilities (OTFs). OTFs are a new category of venue which is designed broadly to match the US SEF. However, there are some major mismatches.
“One thing I am interested to see is how OTFs and SEFs will relate, because a big difference at present is that a SEF operator does not have discretion as to access while an OTF operator does have discretion, which is supposed to reflect the dealer environment,” says Christian Voigt, senior regulatory advisor at Fidessa. “I don’t understand how OTFs will fit, because what the CFTC calls a SEF sounds a lot to me like an MTF.” The final definition of an OTF is for now an unresolved issue.
Amid a busy schedule, the elephant in the room for 2015 is a piece of legislation which does not come into force until 2017, but which already commanding vast swathes or compliance officer time, bankers say. That is the MIFID II, the follow up to the 2007 legislation aimed at harmonising regulation for investment services across Europe. The latest, and final, MIFID II consultation was published in late December, and contains detailed proposals for pre- and post-trade transparency for securities including derivatives and for electronic trading.
One of the most closely studied sections of the document concerns the definition of liquidity, because that is the benchmark that will define whether any particular contract will qualify for pre-trade transparency and trading on an organised venue.
ISDA in July of last year observed that under existing rules the definition of a liquid market should be one with ‘continuous buying and selling activity’, and that the thresholds for trading frequency should be set such that a liquid instrument trades every day and at least 15-40 times that day.
In the event ESMA decreed in the case of interest rate derivatives traded on venue that in order to be deemed liquid a particular sub-class of had to record both an average of one trade per day or more and an average notional amount per day of €5,000,000 or more.
For OTC contracts the definition of liquid was an average notional amount per day greater or equal to €500 million, the number of days traded greater or equal to 80% of the available trading days in the period and the average number of trades per day greater or equal to 100. There are similar provisions for securitised derivatives, equity derivatives and commodity derivatives.
There is also a waiver for “large-scale” orders for each asset class, alongside deferred publication of post-trade data, and it will be incumbent on market participants over the coming months to respond to the proposed waiver thresholds, initial reaction to which has been mixed.
“Some of the thresholds seem very high and with ticket sizes generally falling I suspect ESMA may need to look at those again,” says one market participant.
For post-trade transparency ESMA amended its 5 minute reporting rule for derivatives to 15 minutes, reflecting the US requirement. However the concession is only for three years, following which it proposes a reversion to 5 minutes.
Securities financing transactions are exempted from post trade reporting. For large transactions there are deferrals running to 48 hours, a considerable extension on the periods proposed in the first consultation, which ran from 60 minutes to “end of day”.
A full list of contracts deemed liquid is available at Annex III of draft RTS 9 of the consultation.
“We are now at the level of granulated tests for transparency requirements and there is a lot of very complex detail in there that banks and other market participants are going to spend the next few months getting their heads round,” says Jonathan Herbst, a London-based partner at law firm Norton rose Fulbright. “Whether or not the proposed regime suits you will probably depend who you are. From a market maker point of view increased pre-trade transparency is unlikely to be a good thing, but from the buyside perspective it may be.”
What is certain is that 2015 will be the year in which European banks and investors can finalise the role of derivative in the regulatory playing field of the future.
