Derivatives Users Shocked at MiFID II Clearing U-Turn

Terry Flanagan

The watering down by the European parliament late last month over clearing competition in derivatives has shocked some market participants.

When a review of the Markets in Financial Instruments Directive, or MiFID II, was proposed by the European Commission in October last year there was a provision in it to boost competition in the clearing of derivatives, which would have attacked the so-called ‘vertical silo’ clearing model. An interoperable model, where clearing houses are able to interconnect, would allow market participants to reduce their costs from the netting and cross-margining of trades between venues.

However, the parliament’s Economic and Monetary Affairs Committee (Econ) on September 26 voted overwhelmingly in favor of diluting the draft law’s “open access” articles intended to increase competition in processing derivatives trades, as part of sweeping reforms of Europe’s financial markets.

In Europe, two venues—NYSE Euronext’s Liffe and Deutsche Börse’s Eurex—continue to have a near duopoly on the exchange-traded derivatives scene, as between them they currently control over 90% of trades in some contracts. They either operate a vertical silo model, like Deutsche Börse, where the exchange owns its own clearing house in one integrated business, or will operate a similar model like NYSE Euronext, which is planning to open its own derivatives clearing house some time next year.

“Do we wish to legally mandate in MiFID that one or two monopolies govern our market infrastructure with all the inefficiencies that this brings?” said Greg Clark, the U.K. financial services minister, in a speech in Brussels last week.

“Expensive services for consumers, no incentives to improve services and the risk of setting up mini-monopolies that represent a single point of failure.

“I would urge the European parliament to reflect again whether it is sensible to delete these provisions. This loophole must be closed in the current MiFID negotiations.”

Competitors have struggled to draw market share away from the incumbents as the big venues also own the intellectual property of their benchmark index products as well as control the open interest in their listed products through the vertical-siloed clearing approach. Econ also ditched a provision making it easier for rivals to buy licenses for popular traded benchmarks such as Deutsche Börse’s Stoxx.

Rivals such as Turquoise, a pan-European multilateral trading facility owned by the London Stock Exchange, have recently tried to break the vice-like grip that the two venues have on the exchange-trade derivatives space in Europe but Turquoise has struggled to make any real impression. Nasdaq OMX is also going to try, with its new offering, likely to make its bow early next year. Called NLX, Nasdaq says it will provide similar products to Liffe and Eurex but will offer lower fees and reduced margin requirements.

David FitzGerald, management consultant, Baringa Partners

David FitzGerald, management consultant, Baringa Partners

“The apparent lack of will to allow strong competition between clearing houses seems counterintuitive,” said David FitzGerald a management consultant at Baringa Partners, a financial services consultancy. “It would seem that the regulatory agenda seeks to favor a low-competition, high cost model.”

Bringing more competition to derivatives clearing would have attacked the power-base of these two exchange operators in European derivatives but the two exchanges argue that greater access would increase financial instability and systemic risk. However, a vertical clearing model appears to run counter to the aims of MiFID, which has tried to boost competition across European Union markets.

In February, the European Commission also opposed the $7.4 billion super-exchange merger between NYSE Euronext and Deutsche Börse over competition fears that the new entity would wield too much power in the exchange-traded derivatives market.

“The European parliament has recognized that clearing competition in derivatives is not what they support—they do not like competition in the clearing space,” Mark Spanbroek, secretary-general of Brussels-based FIA European Principal Traders Association, a proprietary trading group which represents firms that trade their own capital on European exchange-traded markets, told Markets Media.

With legislation known as the European Market Infrastructure Regulation (Emir), part of the G20 commitments to reduce systemic risk in financial markets following the global financial crisis, set to become law some time next year, clearing house are being pushed to the forefront of these reforms.

Any bilaterally-traded OTC derivatives instrument that can be standardized to trade on an exchange will be forced on to electronic venues—to be called organized trading facilities—and pushed through centralized clearing by the Emir ruling, bringing a swathe of new business to clearing houses across Europe. The OTC market is over 10 times as large as the exchange-traded derivatives market.

Politicians believe that by pushing a lot of the OTC derivatives market through centralized clearing it will reduce systemic risk. U.S. investment bank Lehman Brothers was a big user of derivatives and its demise in 2008—with much of the trouble revolving around its OTC derivatives contracts—caused the onset of the global financial crisis.

Some buy-side institutions, though, are against centralized clearing as they see it as potentially riskier than the current over-the-counter model as margins could get mixed up with that of other firms who may or may not be equally creditworthy. While others are unsure as to how the more esoteric products with little liquidity will fare on exchange-like venues.

LCH.Clearnet, the Anglo-French clearer that the London Stock Exchange is in the process of acquiring, has also said, in a statement released last week, that it estimates that it would have to increase “its regulatory capital by approximately €300-€375 million which it intends to have in place during the first half of 2013 in order to comply with the new [Emir] regulations in advance of applicable regulatory deadlines”.

Meanwhile, the Centre for the Study of Financial Innovation, a London-based think-tank, issued a report last week on Europe’s post-trade space arguing that the EU must speedily complete plans to safeguard its economy against a clearing house failure—and then add those plans to its existing program for regulating the post-trade infrastructures that provide clearing and settlement services in financial markets. It also urges the European Commission to launch a competition policy investigation to ensure that efficiency and competition are not sidelined in EU post-trade legislation.

There is, however, still some way to go in the political process in Brussels before MiFID II becomes binding. Econ’s draft of MiFID II will soon be voted on by all MEPs, although this is thought to be a mere formality. Then the Council of Ministers will table its own version, likely around the end of November, with input from the European Commission before the three institutions of Europe sit round a table and thrash out the final law, in a process called trialogue. Formal implementation is not expected until 2015.

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