MiFID II may have been delayed recently but there were still key announcements. Lynn Strongin Dodds provides a progress report on the regulation.
It is hard to keep track of all the moving parts of regulation especially when there are numerous delays. This is certainly the case with MiFID II which has expanded its reach into different asset classes such as derivatives and fixed income as well as recently extended its deadline by a year to 2018. More changes are likely on the horizon but below are some of the latest proposals and concerns.
Derivatives
The march to central clearing for certain standardised OTC derivatives is inevitable because it forms such a large component of Europe’s efforts to comply with the G20’s 2009 commitment to reform those markets. This trading obligation will specifically apply to instruments such as credit derivatives and interest rates, which account for just over 80% of the $630 trn OTC market, according to November 2015 statistics from the Bank for International Settlements.
The starting date for the largest trading firms has been moved to 21 June 2016, two months later than expected while asset managers with outstanding gross notional amount of non-centrally cleared derivatives above €8bn will have until December 2017 to prepare for central clearing.
Once an instrument begins clearing under EMIR, the European Markets and Security Authority (ESMA) will then develop technical standards to determine the class of derivatives subject to the trading obligation and the launch date. One of the most important criteria is whether or not a derivative is sufficiently liquid to be traded on exchange. This will be determined by the average size of the spreads as well as the frequency and size of trades over a range of market conditions. Also on the checklist are the number and type of active market participants, including the ratio of market participants to products/contracts traded in a given market.
If the derivative is deemed liquid enough, it will be forced onto to a regulated exchange, multilateral trading facility or a new type of venue known as an Organised Trading Facility (OTF). They share many of the same similarities with Multilateral Trading Facilities (MTFs) in that they are both multilateral and subject to the same pre and post trade transparency requirements. They will also not be permitted to use proprietary capital which means that interdealer brokers are the most likely operators.
The key differences are that OTFs are limited to bonds, structured finance products, emission allowances and derivatives, and that the operator will be required to exercise discretion in the execution of client orders. As a result they be required to comply with the investor protection obligations in articles 24 (information to clients), 25 (suitability), 27 (best execution) and 28 (client order handling) of MiFID II.
Open access
MIFID II contains provisions that will require exchanges and clearing houses to offer open access to any participant that meets the minimum criteria. This has been a long standing discussion and if successful, it would force competition on Europe’s derivatives clearing market for the first time – and also level the playing field for trading venues.
The rules pit the siloed model adopted by operators such as the Intercontinental Exchange (ICE) and Deutsche Börse against the London Stock Exchange and Nasdaq, which support open access. Many deny open access requests in certain circumstances, such as capacity issues, operational risk, undue complexity, the cost of facilitating access and national law.
Earlier in the year, the opponents Deutsche Börse and ICE along with Euronext, the London Metal Exchange, Bolsas y Mercados Españoles, the Athens Exchange and the ICE-owned Holland Clearing House made their views known to ESMA in a letter . They warned that forcing the interlinking of clearing houses with different risk management models and capital buffers clashed with European rules and global standards. Moreover, they noted that derivatives and equities are two different asset classes and interoperability would introduce new risks and threats to market stability and customer protections, “especially in distressed conditions”.
Equities went down interoperable route in 2011, when a number of venues in Europe including UBS MTF, SIX Swiss Exchange and others opened their doors, enabling participants to use the clearing house of their choice. Proponents underscore the move has been successful in terms of lower trading prices, reduced spreads, creating faster and more resilient technology, and fundamentally rebalancing the relationship between the providers of infrastructure and its users.
They believe that the same benefits will apply to derivatives by creating deeper pools of liquidity, lowering costs and promoting enhanced risk management across the whole financial system, through netting and cross-margining. In addition, it has significant potential to deliver margin and collateral efficiency while spurring responsible innovation, benefiting investors, market participants and the EU’s overall economy.
Whatever the outcome, given that complex nature of clearers and their obligation to operate to high standards of reliability, the rules are subject to a long transition period – up to six years.
Fixed income
Esma published its technical standards at the end of Septermber 2015 which outlined which bonds would be deemed liquid enough to be subject to increased transparency. The regulator adopted a two-stage approach with the first plank being that newly-issued instruments will be assessed on a class-by-class basis, known as COFIA, depending on their issue size. For example, any corporate bond will be included if it is issued in a size of at least €500m, and will be subject to enhanced disclosures for up to five and a half months. Different thresholds apply to sovereign bonds and so on.
The second phase comprises a bond-by-bond, or IBIA approach, with each individual bond assessed every three months. It is deemed liquid if it meets three criteria: the average daily amount traded over the period is at least €100,000; it trades at least twice daily on average; and trades take place on at least 80% of days over the three-month period.
According to ESMA, based on current data, around 4% of European bonds – or 2,000 instruments – would fall under the new transparency requirements. For most other non-equity asset classes, it has decided on a COFIA for assessing liquidity. However, the transparency rules will not apply to large trades in each asset class because the approach was “calibrated to introduce a judicious level of light into this market but with sufficient safeguards in place to avoid drying up fragile liquidity,” according to Steven Maijoor, chairman of the European Securities and Markets Authority, in a speech at L’Agefi in December.
Not everyone is happy with the brighter light. Several fixed income products, particularly corporate bonds, are typically illiquid and dealers facilitate trading by taking positions onto their own books and offloading them at a later date. There are concerns in the trading community that too much transparency would harm their ability to trade without showing their hand to the wider market and therefore hurting their ability to make a market. This would reduce the already low levels of liquidity in the bond markets.
While their fears have not fallen on deaf ears, ESMA is not budging from its original intentions of greater transparency. In his speech, Maijoor made it very clear that criticism of the rules was not unexpected: “These markets are important and there are big interests at stake such as the profitability of the market making businesses.” He added that the new rules would strike the “right balance between transparency and protection and this, I believe, will contribute to fostering liquidity”.
