Derivatives Users Wary As OTC Rules Clear Final Hurdle in Europe

Terry Flanagan

The European Union’s legislature has now officially adopted regulation to increase transparency in the over-the-counter derivatives markets.

As Europe begins to catch up with the progress made in the U.S. with the Dodd-Frank Act over similar measures that are being introduced in accordance with the G20 group of nations’ diktat to introduce far-reaching reforms to the $700 trillion global OTC derivatives market, the European Market Infrastructure Regulation (Emir) is now, like rules in others jurisdictions, set to become law by the end of this year.

Emir aims to drive all standardized OTC derivatives trades through central clearing with the view to reducing counterparty risk, as well as the reporting of all derivative contracts to trade repositories, which will offer market participants a clearer view of the derivatives markets.

“It’s a great initiative and positive that the industry is moving down this path,” Joe Nash, managing director, Asia-Pacific, of Dion Global, a technology firm, told Markets Media.

“Taking it at the tail end, the post-trade, we are really encouraged but there is a lot of work still to be done at the pre-trade providing more transparency at the point of trade.”

Nash believes that improvements need to be made on bid and offer spreads, market depth and transparency so that derivatives markets “can enjoy all the great things from the cash equities markets”.

The previously unregulated OTC derivatives sector, which accounts for roughly 95% of all derivatives trades, has been blamed, in some quarters, for the 2008 collapse of Lehman Brothers, a heavy user of derivatives trades, and also the subsequent global financial crisis. The U.S. and Europe are home to the main derivatives markets with Asia, which is also adopting similar G20-style legislation, accounting for approximately 8% of global volume.

However, there are some in the industry who think that leaving some things as they were may not have been such a bad idea.

“The idea of trying to make sure more OTC derivatives are cleared centrally and reported is based upon two assumptions,” Steve Grob, director of group strategy at Fidessa, a trading and technology company, told Markets Media.

“The first is that centralized clearing is safer than bilateral clearing and there are some that argue that if I am a very large buy-side institution that only trades with similar large risk-averse buy-side institutions then, actually, bilateral trading and clearing is safer as I don’t have to worry about who my collateral and margin are mixed up with out there on a CCP [central counterparty].

“And the second assumption is that CCPs never actually go bust. While that has been evident up to now, it was interesting at the IDX [International Derivatives Expo] conference in London the other week that [Deutsche Börse’s] Eurex was asked if Eurex Clearing [its derivatives clearing house] has a living will and it does, so that proves that people are thinking about these sort of things. And if a CCP were to get into trouble that would be much more of an issue systemically than if just one party had a problem.”

The Council of the European Union adopted all amendments of the Emir regulation agreed by the European parliament in March and the European Securities and Markets Authority (Esma), the pan-European regulator, has been busy in recent months trying to write the technical standards for Emir.

The industry has just one month to voice any concerns to Esma over its consultation text that was published in late June, before the final draft standards are submitted to the European Commission for endorsement by September 30.

“The devil is always in the detail in the legislation and the regulation of how it will be managed,” said Nash at Dion Global.

Last month, Kay Swinburne, a UK center-right MEP, who is also a member of the influential Economics and Monetary Affairs Committee at the European parliament, told Markets Media that Esma would meet most of its deadlines over the technical standards but that there were likely to be delays in moving trading on to an electronic format by the end of the year.

Some market participants, though, have cast doubt on the ability of Esma to handle their burgeoning workload. Esma has also had to write technical standards for a host of other financial regulations, including MiFID II and new market abuse rules.

“Esma is doing a valiant job,” said Grob at Fidessa. “But they are being hit by wave after wave of regulation; it is probably getting harder for them.

“It is not when one bit of regulation is implemented that they are done with it. They have to sit and look for all the unintended consequences and fix those. So every bit of regulation they produce causes more work for them, not less.”

Esma, which will also be responsible under Emir for the surveillance of trade repositories as well as the identification of contracts subject to their clearing obligation, says its staffing levels are adequate for the tasks in hand.

The Emir regulation, as agreed by the EU legislature, also provides for venues of execution, such as multilateral trading platforms or exchanges, to have access to any CCP to clear OTC derivatives transactions and vice versa, subject to technical and safety requirements.

All standardized OTC derivative contracts will have to be cleared through CCPs by the end of 2012, while non-centrally cleared contracts will be subject to higher capital requirements.

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