Derivatives market braced for regulatory onslaught
The two main pieces of regulation about to hit European financial markets and the derivatives market, in particular – Mifid and EMIR – have sparked fears over their unintended consequences to collateral velocity, liquidity and transparency. But some industry participants believe these regulatory shifts will yield benefits.
Since the fall of Lehman, global regulators have found common cause in the push for tighter regulation of the derivatives market, which has been blamed for exacerbating the credit crisis through leverage and systemic risk. Enter the Markets in Financial Instruments Directive II (Mifid II) and the European Market Infrastructure Regulation (EMIR), the European-wide push to reduce opacity and market abuse. Both measures share common objectives but differ in crucial respects.
EMIR is Europe’s version of the Dodd-Frank financial regulation, which is being phased in across the pond to address systemic risks in modern financial markets. Specifically, it shares the same objectives as Title VII of the US code focuses on OTC derivatives markets and trading. As a pan-European piece of legislation, it will be passported into all member states without need for local codification.
Mifid II is a European directive, which updates the previous Mifid in a variety of areas including market abuse, capital requirements and oversight of hedge funds. Like all European directives, Mifid II leaves it to individual member states to decide the exact rules that will be adopted to achieve the legislations mandated outcome.
So far, so clear. Potential confusion arises, however, when the objects of the two pieces of regulation are considered. For example, EMIR establishes the organized trading facility (OTF) as the European equivalent of Dodd Frank’s swap execution facility (SEF) and mandates central clearing for swaps. It also contains important new rules relating to pre- and post-trade transparency.
Transparency is also in-scope for Mifid II, but within the context of market abuse. It also mandates OTFs and says that certain instruments have to trade on certain venues.
“The difference between EMIR and Mifid II is hard to pin down,” says Stu Taylor, CEO and co-founder of Algomi, a London-based technology platform supplying a number of global banks. “but in overview Mifid II is focused on extending controls against market abuse and encouraging price transparency whereas EMIR is focused on putting market infrastructures in place to help prevent systemic risk developing in the future. Certainly there’s some overlap as both will define new types of trading venues, market participants and reporting requirements and its not clear yet what the precise points of difference and overlap will be until all the details are hashed out."
“That said, it’s clear that EMIR is coming from a G20 centre of gravity with a prescriptive focus on OTC derivatives. EMIR will be the first piece to become legally binding, and is more tangible in terms of its requirements and standards.”
Indeed, the European Securities and Markets Authority (ESMA) is awaiting the outcome of a European Parliamentary committee vote on regulatory technical standards that will determine whether the rules as proposed will become binding as expected in 2013.
Although Mifid II is focused on much of the same infrastructure mandated by EMIR, its emphasis is on the elimination of pricing advantage and improving the ability of buy-side players to know where the market is trading. This anti-market abuse construct is also explicit in its restrictions on high-frequency trading and limits on commodity positions.
“The market abuse construct is implicit or explicit in all of the regulatory themes contained within Mifid II,” Taylor adds.
With both pieces of regulation destined to change the way banks conduct their trading activities, especially in derivative markets, trade associations and other industry lobbyists are focusing to push back on EMIR, which is expected to be the first set of rules to become binding in Europe.
“Unsurprisingly bankers are resisting proposed rules which will significantly affect the way they currently undertake their swaps business,” says Bradley Wood, founding partner at GreySpark, a capital markets consultancy. “Very soon, some clients will not go to banks to trade swaps, but to OTFs and SEFs directly.
“Banks must learn how to operate in this disintermediated world, and recalibrate to drive a bottom line result in the new regulatory paradigm. We expect dealers to de-emphasise execution, and bring renewed focus to providing post-trade services, clearing, research and aggregation-capable, single-dealers platforms.”
Industry voices are similarly raised in opposition to some of the transparency provisions proposed by Mifid II, for example those that address the minimum and trade-size time a price can be displayed on an OTF.
Constantinos Antoniades, CEO at Vega-Chi, a new multilateral trading facility in Europe, dismisses these voices as short-termist and self-interested. “There is a big cry from people that have much to lose if transparency is improved, and they will argue that the reduction of the available margin to these players is a bad thing.
“However, transparency will generate confidence in the fixed income market, and that will drive more volume. Investors need good information to make investment decisions and more will increase market liquidity in the medium term.”
The hope is for regulators that market participants come to share this bullish view.