News analysis: EU set to take tough stance on derivatives

Copying and distributing are prohibited without permission of the publisher

06 October 2011

A leaked draft of proposed European financial reforms has revealed that the European Parliament is planning to take extreme steps to reform market infrastructure and transparency requirements in Europe.

The reforms, an update of the Markets in Financial Instruments Directive (Mifid), which were leaked last month, took many in the industry by surprise with their scope and potential impact on the derivatives landscape within Europe.

In particular, the fact that one of the documents was being proposed as regulation rather than a directive meaning that it is immediately enforceable across the 27 European member states was widely viewed as an unexpectedly bold move by the European Parliament.

The proposals are still in draft form and will be amended prior to their publication this month before a debate and vote is held, a process that is expected to complete in the first quarter of 2012.

Open access

However, the two documents, the draft regulations Mifir and an update of Mifid, provide some clues as to how drastic the EU regulation will be. Under the proposals, exchanges will have to provide open access to clearing, an idea that was dropped from the parallel Emir reforms earlier this year.

The inclusion of the open access to clearing clause in Mifir appears to extend the remit of the Mifir/Mifid, which has traditionally been concerned with pre and post trade transparency and best execution.

However, if introduced, open access to clearing will radically alter the infrastructure for exchange traded derivatives in Europe and reverse the growth of vertically structured exchange ownership of clearing houses.

Advocates of this proposal argue that open access to clearing will foster competition. The proposals have significant implications for the merger between Deutsche Börse and NYSE Euronext, which will bring together the two largest European derivatives exchanges, Liffe and Eurex.

The deal is currently under review by the DG Comp, the competition arm of the European Commission. It is assumed that the open access to clearing set out in the Mifir proposals will be harmonised with the DG Comp review, the results of which are due in December.

However, there are fears that mandating open access to clearing will fragment liquidity across European clearing houses, increasing the collateral burdens on end users as well as handing a competitive advantage to clearing houses outside the EU (although a controversial proposal by the ECB to require clearing houses that clear more than 5% of euro-denominated instruments to be based in the eurozone could counter this).

Organised trading

Also contained within the draft proposals is the blueprint for the establishment of Organised Trading Facilities (OTFs), or European SEFs as they have been termed due to the similar purpose of Swap Execution Facilities being established under Dodd-Frank in the US.

Brokers have widely welcomed the plans for OTFs, which will allow discretion over who trades on the platforms and how the trades are conducted, preserving the hybrid brokerage model that was threatened by the migration of derivatives onto electronic platforms. The ability to use voice to trade is viewed by many as essential to maintaining liquidity during periods of market stress.

However, there are concerns over the workability of transparency requirements set out in the draft proposals, which appear to suggest that operators of OTFs and other exchange platforms will be responsible for position management and position limits.

This would require platform operators to have a holistic view of their clients’ trades on other platforms, a “completely unrealistic” proposal according to one broker.

The European proposals go further than those in the US, mandating that all derivative instruments be cleared on organised trading platforms rather than just swaps under Dodd-Frank.

The proposed regulation will centralise the power of Esma, the newly created pan-European regulator. In conjunction with local authorities, Esma will be granted the power to impose temporary or permanent bans on financial instruments as well as enforcing position limits.

Technology providers would be the big winners from the proposals in their current form as data requirements on exchanges and exchange members will be significantly increased as part of the push to boost pre and post trade transparency.

Market participants will see data requirements rise in the pre-trade publication of quotes, the post-trade publication of trade information (with some exceptions) and the risk management of trading members and their clients.

Highlights from the October issue of FOW:

News

News analysis: Data gap remains in commodity speculation row