Firms are eager for Esma, the new EU markets regulator, to be
formed so that they can get some idea how it is going to
interpret the law. As Mareen Goebel discovers,
the prophesies of doom have gone – but
they’ve been replaced by knowledge that reform is
going to involve an enormous amount of work and
Commitments made by politicians at international summits often
seem more like bromides concocted to soothe public opinion on
the day than anything like concerted policymaking.
Yet wording agreed at the G20
summits in London and Pittsburgh in the depths of the 2008-9
financial crisis has acquired tremendous force for the
World leaders vowed
to agree on guidelines to make the
financial markets safer and
more stable by encouraging mandatory clearing and by bringing
OTC derivatives on to regulated markets.
These commitments have been taken
by the European Commission (the EU itself is one of the G20) as
the guiding principles for the design of far-reaching reforms
to financial regulation across the 27 member bloc.
Known as Emir (European
Market Infrastructure Regulation), it aims to regulate the over the counter
derivatives market, central counterparties and trade
repositories, as well as many other aspects of using and
After a year of public
consultation, draft legislation was published in September and
is now passing through the European Parliament. A first exchange of views is scheduled for
November 30 and a
vote is expected on March
Though Emir is probably the
most important regulatory business facing European derivatives
firms, it is far from the only one.
While Emir is a separate piece
of legislation, industry insiders expect it to become part of
Mifid 2, the likely result of the Mifid review.
This process started before the
financial crisis and seeks to gauge whether the
EU’s Markets in Financial Instruments Directive,
introduced in November 2007, was successful in fostering
Besides Emir and Mifid 2, the
Market Abuse Directive or Mad deals with market abuse and short
At a global level, Basle III,
which defines higher capital requirements for banks, caused a
stir in the industry when it was released, but discussion has
since died down.
However, the industry expects a
full consultation paper on Mifid 2 in November. Sceptical
voices suggest that Mifid 2 might spell a lot of trouble for
derivatives – not because it might be restrictive, but
rather because it was not designed with derivatives in
The main problem with Mifid 2 is that was designed for the cash
equity markets, but fixed income, FX, money and commodity
markets don’t work the same way and nor do their
derivatives," cautions Alex McDonald, chief executive of the
Wholesale Market Brokers’ Association in
adds that a lot of the Mifid regulations are geared towards the
retail market. And most of these "currently make very little
sense when they are transposed to the workings of wholesale
markets," McDonald contends.
The consultation paper will remain open for consultation
until Christmas, after which the European Commission will start
to draft legislation which might be published in the summer and
then passed to Parliament.
This narrow timeframe, market participants say, is at odds
with the complex nature of the legislation’s
"Unlike Emir, Mifid is a directive, and personally,
I’m worried they will not have much time to work
on areas beyond equities during that time, despite the
Commissioner’s emphasis on commodity markets,"
Especially with the political agendas of European
parliamentarians, and controversial topics such as
short-selling and commodity speculation, the process might not
only take longer, but attention might turn away from
derivatives to focus on the hot topics of the day.
"One concern is that the whole Mifid 2 process may get tied up
in questions relating to the Mad (Market Abuse Directive) and
short-selling legislations currently going through the
Parliament, such as what are speculators and what constitutes
market abuse," explains McDonald. "[Commissioner Michel]
Barnier’s personal agenda seems very focused on
soft commodities. In this area, draft rule making may seek to
divorce derivatives from cash markets."
Reading the runes
While all this is going on in Brussels and Strasbourg, market
participants across the continent – and elsewhere
– are combing the rules, trying to determine, article
by article, what they will mean for their daily
All agree that changes will be significant, and will come from
several angles at once.
"There is no doubt that significant change is on the way and
that it is being driven by changes in the EU and UK regulatory
infrastructure, changes in regulatory practice and policy,
changes in supervision and enforcement and the adoption of a
much more commercially interventionist approach," warns Anthony
Belchambers, chief executive of the Futures and Options
Association in London.
New pairs of eyes
To begin with, in September, the
European Parliament approved the creation of four new
regulatory bodies, which will begin work on January
These are the European Securities and Markets Authority (Esma),
European Banking Authority (Eba), European Insurance and
Occupational Pensions Authority (Eiopa) and a macro-prudential
overseer, the European Systemic Risk Board (ESRB). Going
forward, they will draw up standards and flesh out the
framework of the bill.
Some market participants harbour mixed feelings about this new
structure. While all agree that an international financial
industry needs to be regulated internationally, some raise
"While it’s expected that people from CESR [the
Committee of European Securities Regulators] will likely carry
over [into Esma] and there will be some staff continuities, the
body hasn’t been formally mandated yet, so it
can’t really do anything, let alone provide
guidance on how they will interpret and formulate certain
rules," says Rory Cunningham, c
hairman of the European Association of CCP Clearing Houses
(Each) and director of public affairs at
LCH.Clearnet in London.
Others note that while the US has created facts, the situation
in Europe is hazy.
"Compared to the US, where the CFTC went on a hiring spree, the
EU bodies haven’t deployed the same amount of
manpower yet," says McDonald.
Although Esma is still a mirage on the (fast-approaching)
horizon, its impact will undoubtedly be felt deeply.
"As a supervisor with real powers, Esma shall be a completely
different kind of body to CESR," McDonald predicst. "It could
even be both judge and jury. The most appropriate roles for
Esma involve macro-prudential issues and the regulation of
cross-border financial entities that may live internationally
but would die nationally."
While the market welcomes Esma’s reach and scope,
participants point out that many of the issues that might arise
in the future come from the more complex regulatory
architecture that is being introduced, and that this may only
be the beginning of further centralisation.
"There are bound to be tensions upstream with the European
Commission over the formulation of regulatory policy, and
downstream with the national supervisors in the area of
supervision," says Belchambers. "CESR/Esma has made its
supervisory ambitions very clear right from the outset. Their
establishment has all the hallmarks of a 'baby
steps’ approach with a lot more centralisation to
Central clearing – preventing the next
The new legislation’s pushes towards more clearing
and reporting are similar to measures in the US. The Depository
Trust and Clearing Corporation has launched an equity
derivatives trade repository to gather some of the asked-for
Yet in the EU, this round of regulatory change reaches further
"What a lot of people don’t grasp about the
current legislation is that a lot of it goes beyond
derivatives, unlike in the US," says Cunningham. "On a much
broader scale, this [bill] also defines rules for CCPs clearing
equities and bonds. Many people are confused by the scope of
Firms will have to post more collateral against trades, and not
only for products newly mandated for clearing. Collateral
requirements for uncleared trades will also rise.
According to the new rules, CCPs must not limit their links to
execution venues with which they have a relationship or which
are part of the same group. A CCP authorised to clear eligible
derivatives will have to clear those contracts on a
non-discriminatory basis, irrespective of the execution
So far as interoperability goes, the bill effectively obliges
clearing houses to open their doors to trades from all sources,
but allows exchanges to keep their doors shut –
insisting users clear at only one clearing house.
National authorities will continue to authorise and supervise
CCPs, but Esma will also play a part in authorising them, and
will draft technical standards for them. CCPs in non-EU
countries will have to meet the conditions set by Esma. The new
regulator will also supervise trade repositories and grant or
withdraw their registration.
Segregate and protect
The new rules throw into relief some of the present regulatory
inconsistencies across Europe.
"We’d like to see a clear procedure and harmonised
rules in case of insolvency of CCP users. However, insolvency
laws across Europe vary," says Stefan Mai, head of market
policy and European public affairs at Eurex/Deutsche
With its broad scope, Emir directly affects
the way CCPs operate and how they are run. For example, CCPs
are required to separate the accounts of clearing
members’ clients. At present, the accounts are
separated at the level of the clearing member, rather than the
Another requirement is that a CCP must ensure client assets are
protected in case it collapses.
"Taken literally, that could mean CCPs won’t be
able to take cash assets on their own balance sheets," warns
Cunningham. "The new regulations could fundamentally change the
relationship between CCPs, clearing members and
Other rules deal with the ownership and oversight of CCPs. "We
are still looking at how the rules on ownership and corporate
governance will develop. The new law requires that one third of
the directors on the board be independent. That is a
significant amount," Cunningham observes.
His concern is echoed by McDonald: "Both the risk committees
and the new laws on either side of the Atlantic may require the
clearers to split pools of open interest into silos, to
separate different asset classes."
Other market participants point out potential conflicts of
interest. "Another issue," Mai says, "is that of financial
governance and the CCPs’ neutrality. Who controls
CCPs? There are potential conflicts of interests when dominant
users own them above our specific proportion and control the
profits. Most major exchanges are listed and have a freefloat
of up to 90%, so they are indeed publicly owned
The industry is carefully watching the liquidity requirements.
According to the rules, CCPs are required to have 'adequate
"A major question is how that requirement is determined and how
it can be sourced," Cunningham says.
Another hot topic being discussed is the issue of collateral.
While many believe some leeway may be given to put up the
underlying as collateral for derivative trades, "the overall
drive is to restrict collateral to cash, near-cash and highly
liquid instruments," argues Belchambers. "For some end-users,
those kinds of constraints could be a real problem with further
While the expected cost of the changes has provoked protests
from some derivatives users, others disagrees. "Those that say
it’s too costly to implement a better market
structure forget how much the financial crisis has cost us in
the last three years," Mai maintains.
The regulatory changes may push CCPs closer towards banks, and
some argue that CCPs should have access to central bank funds
in case of emergency to ensure that they cannot fail. But this
brings up further questions, as access to central bank funds
would require CCPs to have banking licenses. The exact same
issue has cropped up in the US.
"Another question," Belchambers says, "is whether clearing
houses will be regulated more like banks. The resulting high
level of supervisory intensity will translate into higher
clearing fees, with the inevitable 'safety-first’
approach leading to higher levels of margin, called
increasingly on an intra-day basis, with further adverse cost
consequences for end-user cashflow and risk management
Bottom-up or top-down?
One of the most contentious issues
throughout this whole phase of regulatory reform has been the
new principle that some derivative contracts will have to be
centrally cleared, by law.
The legislation sets out how
regulators will decide which contracts will fall in the
mandatory clearing net. They will use two approaches.
In the 'bottom-up’
method, a central counterparty would seek permission from its
national authority to clear a certain contract. Having approved
it, the authority would inform Esma, which would decide whether
a clearing obligation should apply to all such contracts in the
In the top-down approach, Esma and
its macro-prudential counterpart, the European Systemic Risk
Board, decide which contracts should be subject to mandatory
This explanation is not enough for
Cunningham, who complains: "There are no details yet on how
exactly Esma will determine what will be subject to the
His main concern is how it will
pan out with the US. But Cunningham also wants to know how the
transition process will be managed. "More specifically," he
says, "clearing houses are required to seek authorisation to
clear certain products within two years of the implementation
of the regulation. But how will it work up to that time? Will
they be able to clear certain products in the meantime
– those subject to the mandate?"
But at the most fundamental level,
it is not the details that bother the clearing houses. They
just want to keep the right to choose what they clear.
"The new law could ask clearing houses to expend a lot of
capital and manpower on trying to clear derivative products
that may not be profitable – of choice, a CCP would
rather concentrate on straight forward, high volume products,"
Some clearing houses, he says, which originally welcomed the
regulation as a commercial opportunity, "have grown more
sceptical about accepting the wide scope and varying lifetime
characteristics of many OTC derivatives".
Many derivatives users resent being forced to use central
counterparties, and some question the strict rules that seek to
compel CCP-cleared contracts to be executed on a regulated
market or an alternative execution facility.
"If bilaterally executed transactions become subject to
accepted levels of post-trade transparency, are trade-reported
to repositories, CCPs or the regulators directly and post-trade
processing efficiency accords with Emir, what is the risk that
demands that execution choice should be taken away from
end-users?" asks Belchambers.
Still, some are sanguine about mandatory clearing, even though
there are no details yet on how the regulators will
"I believe that the market will create facts in those two years
and create products that fit the requirements before the
regulators get to that decision," says Cunningham.
Many flavours of arbitrage
One of the current buzzwords is 'regulatory
arbitrage’ – although the moral colour
attached to it is the reverse of what it was a few years
In the 1990s and 2000s, bankers in fields like structured
finance delighted in achieving regulatory arbitrage for their
bank clients with techniques such as securitisation. Now, banks
mention it in tones of horror, hoping by the threat of it to
dissuade the authorities from imposing this or that
As one experienced public affairs official in the US
derivatives industry told FOW, legislators’
ignorance of what their counterparts on the other side of the
Atlantic are doing has frequently left them at the mercy of
lobbyists warning that business might drain away to the east or
However, the top regulators on both continents are aware of
this and have gone to great lengths to develop their rulebooks
in tandem to minimise potential for reg arb.
Fuelled by the G20 discussions, there is a lot of impetus and
political will to make the EU and US laws consistent with each
other," says Cunningham.
Yet the drive to make laws consistent across the Atlantic might
mean not better laws, but worse, and could turn out to be a
step backwards for Europe, warns Belchambers.
US insistence on multilateral execution of CCP-cleared
contracts is misconceived," he insists. "While it is important
to secure transatlantic consensus, that should not be bought at
the price of copying out bad law. After all, end user choice as
to execution methodology was one of the prime objectives of the
While both the US and EU are using the G20 agreements as
guiding principles and have fleshed out many details together,
there might still be some small potential for
regulatory arbitrage between the blocs.
However, as the West is increasingly discovering, that might be
yesterday’s problem. Tomorrow’s
threat is that business shifts to Asia. Most Asian market
participants do not consider that clearing is a proven tool for
reducing systemic risk at all.
McDonald says the perceived threat from Asia is why the EU has
been escalating the importance of the International
Organisation of Securities Commissions (Iosco) committee so
much, hoping to create a set of global standards for OTC
derivatives. "A focus on participants rather than place, as the
FSA have practised, would be a sensible way to circumvent any
loopholes," highlights McDonald.
But market participants do not even have to look that far
afield. "We already have a notable amount of regulatory
arbitrage happening inside Europe – with a lot of
hedge fund-related business migrating to Switzerland," McDonald
The City under siege?
Some are worried about the complexity of the new supervisory
arrangements and their effect on competition with non-EU
For CCPs domiciled in the EU, the regulatory framework would
look much too complex following the proposed regulation," Mai
believes. "They are regulated by national regulators, a college
of supervisors including the national regulators of the three
countries where a CCP does most of its business. In addition,
they also have to deal directly with Esma."
He believes CCPs from the US or Asia face a much more simple
supervisory framework: "They deal with their home regulators
and apply at Esma for recognition to serve the EU
In a nutshell, Mai predicts, "we expect a competitive
disadvantage for EU CCPs from such a complex structure. Surely
not what the regulator had in mind with the reform of the EU
supervisory framework aiming to make the EU financial system
more secure, safe but also more competitive."
As the European derivatives hotbed, any restrictive
interpretation of the rules (which still need to be written)
will affect London disproportionately.
While the industry broadly welcomes the new regulations, it
also warns politicians not to go too far.
"In pursuing their understandable objective to make markets
more secure, it is important that the regulators do not also
make them less diverse and less competitive in the process,"
says Belchambers. "Economic growth is now more needed than
ever, so it is essential to get this balance right."
Some industry insiders have described the aim of regulating the
financial industry as being "driven by a spirit of vengeance",
a sentiment that is more stark in the discussions of
Dodd-Frank, but recently also came to the fore during food
commodity spikes and Germany’s unilateral decision
to move against short-selling.
The daily business of politics may do more harm than good, warn
"Another real worry is the increasing politicisation of the
regulatory agenda. Of course, it is difficult for politicians,
who have their own party political objectives, but those
objectives are more populist than practical and are often
significantly, even dysfunctionally, at odds not just with the
industry (and by that I mean customers as well as providers),
but also with the regulators themselves," says
Others fear that the regulation may be missing the original
goals set during the G20 meetings, as lobbying has derailed the
I feel there is a real possibility," Mai says, "that all the
regulation that is passed after the G20 resolution is not
actually addressing all the issues of the G20 or even the main
drive to clear as much as possible. In fact, I think intense
lobbying has confused the politicians and needlessly
complicated the whole process, which could have been fairly
simple and straightforward if it had just attempted to
implement the G20 guidelines."