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 As Mareen Goebel discovers, the prophesies of doom have gone – but they’ve been replaced by knowledge that reform is going to involve an enormous amount of work and adjustment.

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 derivative markets.

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 trading derivatives.

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 22.

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 competition.

Besides Emir and Mifid 2, the Market Abuse Directive or Mad deals with market abuse and short selling.

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.

Mifid’s focus squeezed

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 mind.

“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 London.

He 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 subject.

“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,” says McDonald.

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. “ 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 business.

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 1.

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 concerns.

“While it’s expected that people from CESR will likely carry over 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, chairman 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 come.”

Central clearing – preventing the next shock?

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 data.

Yet in the EU, this round of regulatory change reaches further and deeper.

“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 also defines rules for CCPs clearing equities and bonds. Many people are confused by the scope of this.”

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 venue.

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 Börse.

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 clearing house.

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 clients.”

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 companies.”

The industry is carefully watching the liquidity requirements. According to the rules, CCPs are required to have ‘adequate liquidity’.

“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 cost implications.”

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 capability.”

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 EU.

In the top-down approach, Esma and its macro-prudential counterpart, the European Systemic Risk Board, decide which contracts should be subject to mandatory clearing.

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 clearing mandate.”

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,” outlines McDonald.

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 proceed.

“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 ago.

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 restriction.

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 west.

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 original Mifid!”

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 points out.

The City under siege?

Some are worried about the complexity of the new supervisory arrangements and their effect on competition with non-EU players.

“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 market.”

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 some:

“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 Belchambers.

Others fear that the regulation may be missing the original goals set during the G20 meetings, as lobbying has derailed the process.

“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.”