Beyond clearing: MiFID, EMIR and the implications for OTC derivatives
It won’t have escaped your notice but there are further regulatory changes coming down the track. Hard on the heels of European Market Infrastructure Regulation (EMIR), the second iteration of Europe’s Market in Financial Instruments Directive (MiFID II) and the Markets in Financial Instruments Regulation are under way.
The European Securities and Markets Authority’s (ESMA) recently issued Regulatory Technical Standards (RTS) indicate that any firm with substantial involvement in over the counter (OTC) derivatives, such as interest rate swaps, needs to be braced for some demanding new market infrastructure requirements.
It may be over a year before MiFID comes into effect (and there is now talk of a delay until 2018) but here are some key questions market participants should be asking about the regulation now.
1. Are firms ready for the clearing obligation?
Before we even concern ourselves with MiFID II, there’s an even more urgent deadline to address. EMIR is set to move from voluntary to mandatory clearing for certain OTC derivative products, using an authorised/recognised central counterparty clearing house (CCP) to sit between buyer and seller.
Policymakers have confirmed that the clearing obligation (CO) could take effect from April 2016 (excluding some pension scheme arrangements). However, delays on EMIR consultation have been such that many participants, particularly smaller financial counterparties (FCs) and non-financial counterparties (NFC+s) have still failed to take action.
To meet the EMIR clearing mandate, firms have a choice – either clear directly as a clearing member on one of the 16 authorised EU CCPs (or 10 non-EU recognised CCPs) or outsource to a clearing member. For NFC+s, the latter is clearly the simpler option and selection should consider:
The clearing member’s coverage of CCPs and the products you trade
Access to segregated as well as omnibus accounts
Availability of services such as net settlement, margin funding, collateral solutions and regulatory reporting
Availability of a user-friendly portal plus helpdesk support
Financial size and strength of the clearing member.
FCs and NFC+s will be subject to different deadlines depending on their categorisation. But bear in mind that whatever the date for your CO to take effect, frontloading of certain contracts – for example, OTC interest rates swaps with six months-plus to expiry – may need to happen earlier.
2. What are the trading requirements of MiFID II?
If EMIR was about improving market stability and reducing counterparty risk in derivative markets, then MiFID II is focused on improving transparency.
Primarily, in line with the G20’s 2009 Pittsburgh commitment, it seeks to move as much derivative trading activity as possible from the opaque bilateral OTC market to the highly regulated and transparent exchange-traded world.
To this end, all standardised OTC derivatives transactions with sufficient liquidity (including all those with a clearing obligation under EMIR) will need to be executed on a regulated exchange or electronic platform, with the venue required to publish current bid/offer prices.
The only OTC contracts that will not need to be traded on-exchange are non-standard contracts or transactions of an unusual size. However, ESMA will regularly monitor these to check for sources of potential systemic risk and signs of regulatory arbitrage between contracts that are, and are not, subject to the trading obligation.
The trading obligation has many implications. One of the biggest infrastructure challenges is the clearing certainty requirement, which is set to stipulate that CCPs accept or reject a derivative transaction within just 10 seconds of submission. Equally, a transaction needs to be submitted to a CCP within 10 seconds of execution if transacted electronically.
While it’s accepted that the majority of exchange-traded transactions currently meet, or nearly meet, these requirements, the infrastructure changes needed to guarantee that all exchange-traded transactions achieve these requirements are substantial.
The likely solution will be for middleware providers to step in and provide clearing members and CCPs with aggregated connectivity for clearing.
But these recommendations still demand intensive technical spend for participants, clearing members and CCPs in order to deliver the necessary straight-through-processing.
Ultimately, if these stringent timeframes are enforced, the cost of trading both cleared and bilateral derivatives is likely to rise, with costs being pushed downstream to the end-user in terms of the bid-offer spread they pay.
3. How will OTF build affect transaction costs?
Along with the regulated market (RM) and multi-lateral trading facilities (MTFs) originally defined by MiFID, MiFID II has introduced a new trading venue, the Organised Trading Facility (OTFs). Designed to capture standardised non-equity bilateral OTC trades, OTFs will provide the pricing transparency that up until now has been lacking from the bilateral market. But unlike RMs and MTFs, OTFs offer the operator discretion as to how orders are filled.
The pricing transparency, and therefore greater competition provided by OTFs for bilateral trades, should be very welcome to market participants. But again the key issue is the cost to operators of building out these new platforms. That will only be answered as solutions are developed and priced into transactions.
4. How will firms manage their margining requirements?
To help reduce systemic risk, regulation (EMIR and BIS/IOSCO) will require initial and variation margin to be posted for both cleared and non-cleared OTC derivatives. It is estimated that the additional collateral burden demanded by new OTC clearing regulation will be significant, compounded by the addition and onerous requirements for bilateral margin.
Given that the non-cleared OTC market alone is set to remain a multi-trillion-dollar market, global demand for high-quality collateral is set to become intense. To manage this, firms will need to adopt strategic processes to identify and deploy eligible assets efficiently across their business. Controlling collateral can reduce cost, adding profitability to the bottom line.
Unless a firm considers collateral management to be a core competence, outsourcing to a specialist should be given serious consideration.
5. How might ‘open access’ principles impact fees?
MiFID II aims to foster greater choice and competition by requiring non-discriminatory access between CCPs and trading venues, so participants can choose where they trade and clear contracts.
Additionally, open access rules will require CCPs to accept to clear financial instruments on a non-discriminatory and transparent basis, including as regards collateral requirements and fees relating to access, regardless of the trading venue on which a transaction is executed. These moves are clearly intended to put derivatives on a par with equities, which adopted open access following MiFID I.
But they could lead to unintended consequences, such as fees having to correspond to the average credit quality of a CCP’s client pool or to CCPs seeking to cherry-pick clients to keep fees competitive.
Open access has the potential to bifurcate liquidity, which may in turn impact volumes and the need for CCPs to raise clearing fees to cover their costs. Interoperability will also have an impact on fees and liquidity, albeit the development of interoperability arrangements for OTC derivatives will be a far greater challenge to implement and not likely to materialise in the short term.
6. What are the capital requirement implications?
A final conflict facing market infrastructure regulation is that it has been developed independently of the Basel capital requirement directive (CRD IV) and in particular the basis for calculation of the leverage ratio.
Restrictions on netting of contract positions mean that banks that act as general clearing members for their clients’ exchange-traded and OTC derivatives transactions face substantially increased capital requirements to avoid breaching the 3% ratio limit.
The US has already seen the number of clearing members in the US decline as participation in central clearing becomes uneconomic. A lot of pressure is being brought to bear to review the leverage ratio calculation, as clearing members warn that balance sheet capacity for mandatory clearing of contracts will otherwise rapidly diminish.
Given the regulator’s desire to increase competition in derivatives trading, we would expect this conflict to be addressed as a matter of priority.
Conclusion: A battle of transparency vs cost
By moving a vast amount of derivatives activity to exchange trading and centralised clearing, European market regulation should fulfil its aim to increase transparency and reduce systemic risk.
But the infrastructure and capital demands of delivering ‘real-time’ OTC derivatives trading and clearing (as well as the margining requirements on both cleared and non-cleared contracts) are such that participants need to be braced for trading and clearing costs, which potentially could rise sharply in the short term.
MiFID II may now be more than two years from implementation, but firms will need to start formulating a strategy and lining up third-party providers to deliver the market connectivity and support services that will enable activity to continue compliantly and cost-effectively.
The final RTS contains 65 fields versus the draft version’s 81. Twenty-five fields have either been removed (such as country of residence and postcode fields) or are no longer required due to the ISO 20022 messaging format. Nonetheless, it’s a significant implementation effort which is made more complex by items requiring further clarification.
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