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Review of the year: regulation

23 December 2011

2011 was intended to be the year that reforms to the derivatives industry took shape. However, it will be remembered as a year of delays and confusion as regulators struggled to get on top of complex issues within the industry, write David Wigan and William Mitting.

In 2009, the G20 pledged to implement rules that would enable “all standardised OTC derivative contracts to be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest”.

It is now clear that the mandate was too ambitious both in its scope and its deadline. In the US, the Dodd-Frank Act was passed into law in July 2010. Following the approval of the law by congress, the burden falls on regulators to write the individual rules to implement the laws.

It has proved a long and laborious process, dogged by conflict of definitions and delays. Concerning futures and options, the Securities and Exchange Commission and the Commodity Futures Trading Commission have clashed over the definitions of swaps, the structure of swap execution facilities and other key areas of the new rules.

The disagreements have meant that rather than a year of action, 2011 has become a year of delays with few rules being passed in the year. Of most concern to market participants is the apparent politicisation of the rule making process, with votes within the CFTC passing down party lines.

This was most apparent in the October approval of position limits for certain physical commodity derivatives. On a vote of three to two, the CFTC voted to approve a two-part phase in of position limits despite Commissioner Dunn, who voted in favour of the rule along party lines, acknowledging that there was scant economic evidence that commodity speculation led to higher spot prices.

Following the passing of the rule, the Securities Industry and Financial Markets Association and International Swaps and Derivatives Association took legal action against the CFTC to prevent the rule from being implemented claiming it had "grossly misinterpreted its statutory authority".

Few question the need for the Dodd-Frank Act and the need reform the financial sector after the financial crisis but criticisms that it is now over-reaching its mandate are justified. Many Republicans remain outspoken critics of the Act as a whole and will look to delay the passage of laws beyond next November’s election. If they triumph, we might well see parts of the Act repeal.

The much maligned Volcker Rule, which would prohibit bank’s proprietary trading, also fell victim to problems with definition in 2011, The deadline for comments on the rule is January but with banks lobbying hard against certain elements of the proposals, its implementation too could face delays.

European moves

Meanwhile, in Europe the European equity options market stands on the cusp of transformation as the proposed merger between Deutsche Börse and NYSE Euronext is battled out against a backdrop of regulatory reform that may eventually bring the sector in line with its booming US counterpart.

The driving force behind the change is European legislation -- in particular the Market in Financial Instruments Directive II (Mifid), the draft of which was published in October and comprises part of Europe’s response to the G20 mandate.

Under the proposed rules, CCPs must offer “non-discriminatory treatment in terms of how contracts traded on its platforms are treated in terms of collateral requirements and netting of economically equivalent contracts and cross-margining with correlated contracts cleared by the same CCP”.

The inclusion of that clause, which was not in the leaked draft that circulated prior to the publication of the official documents, has significant implications for the vertical silo clearing model and marked a significant victory for the London Stock Exchange, which has campaigned for the inclusion of open access to cross margining.

Also, inserted into Article 30 of the regulations since the draft was leaked is the inclusion of “licences” in the section of open access to benchmarks. The new proposals mandate that CCPs and trading venues are granted access to licenses on “a reasonable commercial basis within three a price no higher than the lowest price at which access to the benchmark is grated or the intellectual property rights are licensed to another CCP, trading venue or any related person for clearing and trading purposes”.

If passed in current form, exchanges will not be able to exclusively own licences to derivative contracts. This, in addition to the open access to clearing, could revolutionise the market.

Mifir does seemingly create fungibility that means that the market is far more open to new entrants than ever before and that fees will inevitably fall and margins on derivatives trading and clearing will inevitably narrow.

A key variable on how that revolution will play out is the ongoing merger of NYSE Euronext, operator of London-based Liffe, and Deutsche Boerse, which operates Europe’s largest derivatives exchange Eurex. Currently in the hands of regulators, the merger has the potential to create a massively dominant player in the options space.

Between them Liffe and Eurex control more than 90% of the European equity derivatives business, with trading dominated by options on the Euro Stoxx 50, the second most active index option in the world after contract on Korea’s Kospi 200, according to the World Federation of Exchanges.

Whereas the same single name options can be traded across the various options exchanges, European index options products, which account for a large share of the market, are bespoke to individual trading venues. The Euro Stoxx 50, for example, must be traded on Eurex, whereas FTSE options are traded on Liffe.

In some places there has been limited competition. For example, European investors can trade Euronext single-name NL options such as TNT or Arcelor Mittal in Amsterdam, and also the same names through Eurex Dutch options in Germany.

NYSE Liffe runs futures and options markets in Amsterdam, Brussels, Lisbon, London and Paris, trading between them around €2tr of derivatives daily, while Eurex offers options on Dutch, Scandinavian, French, German, Italian, Russian, Spanish, Swiss, and U.S. equities, and an array of global indexes.

Proponents of the merger point to the likely benefits in liquidity, cross-margining and netting, in a vertical clearing silo that will likely decimate the over-the-counter business, that currently accounts for some 74% of the single-stock options market. Opponents worry about the predictable dangers of a virtual monopoly.

NYSE and Deutsche Borse went some way to assuaging those fears in recent weeks, announcing new plans in single equity derivatives to divest some parts of their businesses and in index equity derivatives to grant limited third party access to Eurex Clearing.

Still, not everybody was convinced that the announced changes would make a huge amount of difference.

“I don’t think it will do the market much good,” says Willem Meijer, chief executive of TOM, a new Dutch provider of equity options, that launched in the autumn. “They are only opening clearing to products they are not already trading in.”

The vertical silos seen in Europe are in sharp contrast to the US, where there is fungibility across contracts and a single clearing house, the Options Clearing Corp.

European regulation has set out in no uncertain terms the conditions it expects for a competitive landscape when it comes into force in 2013. A standout example is new rules relating to options on index products, requiring under Article 30 of Mifir that owners must grant non-discriminatory access to licensed benchmarks following a request from a central clearing counterparty. Article 28 of the regulations meanwhile, allows for fungibility in clearing, a move that will have been noted with relish at newly launched CME Clearing Europe.

The new rules should help operators such as Turquoise Derivatives, the pan-European market launched over the summer by the London Stock Exchange Group, compete on a level playing field. Liffe Clearing, for example, would be required to clear Turquoise’s FTSE 100 index options, launched in September. In the future it may benefit the new merged BATS-Chi-X entity which earlier in the year signed a deal to create new regional indexes with Russell Investments.

As exchanges battle over clearing and fungibility, one industry group that looks set to offer an alternative to the exchange model is inter-dealer brokers, which are ideally positioned to take advantage of the Mifid legislation and turn themselves into OTFs, offering dealer-to-dealer trading, often on existing electronic platforms.

A key challenge for brokers as they seek buyside order flow is how to move forward without alienating their traditional customer base the dealers, who are likely to see themselves as being dis-intermediated from the execution process. The challenge for dealers will be to reinvent themselves as facilitators and matchers of trades.

While e-trading is nothing new in the equity options marketplace (single-dealer and multi-dealer platforms have operated for years) the rise of the OTF moves the business away from the discretionary request-for-quote model, to a system closely resembling the continuous bids and offers seen in the cash markets. Unlike in the US, it seems likely there will not be ownership restrictions for dealers, though that will be offset by a ban on OTF owners using their proprietary capital to fund trades.

As the price discovery process moves onto electronic platforms, Europe for the first time may see high frequency traders enter the market.

“Whether execution occurs on dealer platforms, MTFS, OTFs or exchanges it is safe to say the days of manual domination for equity options are coming to an end,” said Tabb Group’s Will Rhode. “With more electronic liquidity will come more participants like high frequency providers with the power to make Europe’s equity option markets deeper, more competitive, more tightly priced and far, far faster.”

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