EU Becomes Bolder Over Regulation

Terry Flanagan

As expected, the European parliament today gave its final seal of approval to regulate the region’s opaque over-the-counter derivatives market.

The draft regulations for the European Market Infrastructure Regulation (Emir), which were previously agreed upon last month by parliament, the European Commission and the Council of Ministers, are now expected to become law by the end of this year as planned, in line with the G20 timeline to introduce far-reaching reforms to the $700 trillion global OTC market.

And the decision has clearly emboldened the Commission to push through this and other financial regulation, such as the revised Markets in Financial Instruments Directive (MiFID), in double quick time.

“I congratulate the European Parliament on its vote approving a regulation for more stability, transparency and efficiency in derivatives markets,” said Michel Barnier, the European Union’s financial services commissioner.

“It is a key step in our effort to establish a safer and sounder regulatory framework for European financial markets. With this new regulation, we are taking a big step towards financial stability.

“The EU has now also fulfilled its G20 commitments in this field, and on time. I call on all other jurisdictions around the globe, which have not yet done so, to take the appropriate steps to meet our shared G20 commitments.

“I also call on the co-legislators to now focus on complementary European rules that we need to agree on quickly to continue strengthening financial markets; in particular a swift revision of rules on the Markets in Financial Instruments [Directive].”

Although the final text of Emir has not been published by parliament, it released a set of ‘frequently asked questions’ on the matter. In it, it says that “each derivatives contract traded by a financial or a non-financial firm will have to be reported to trade repositories”. It goes on to say that “trade repositories will have to publish aggregate positions by class of derivatives, providing market participants with a clearer view of the derivatives market; however, trade repositories will not publish data at trade level as the type of information is commercially sensitive”.

Derivatives trades, which have been blamed for the global financial crisis and the collapse of Lehman Brothers in 2008, will also have to be cleared through central counterparties (CCPs), thus reducing the risk of default, although pension funds have gained a ‘light touch’ obligation in terms of clearing. For these schemes, the obligation would not apply for three years, extendable by another two years plus one, subject to proper justification.

“Once the industry has developed the appropriate technical solutions for the provision of non-cash collateral as variation margins by pension funds they will be subject to central clearing,” the EU report said. “In the interim, pension funds will have to exchange collateral for their OTC derivatives.”

As the amount of collateral held in the system will increase markedly, the European Securities and Markets Authority (Esma), the pan-European regulator, will have greater powers over the clearing houses who will hold this cash to prevent central counterparties themselves becoming a source of risk to the financial system. Esma will also be responsible for monitoring trade repositories and be able to grant or withdraw their registrations.

Clearing houses from third countries will also be recognized in the EU only if the legal regime of the third country in question provides for an effective equivalent system for recognition.

The report also muddies the waters somewhat over interoperability, or the use of multiple clearers at the same exchange.

“Interoperability may expose CCPs to additional risks,” the report stated. “For this reason, regulatory approval is required before entering into an interoperable arrangement.”

The EU member states still have to formally sign off the set of regulations parliament passed. The Commission is then expected to decide on the technical recommendations from Esma in September. While it is widely expected that the Commission will agree with most of its recommendations for Emir, it does have the authority to go further. The new standards are now expected to be fully adopted by the year’s end.

However, Esma is under immense pressure from the industry over the technical recommendations. Many believe that there just isn’t enough time to frame the rules with the financial services industry worried about potential unintended consequences.

“We would like to stress that the proposed technical standards will not easily be implemented within a short timeframe—this particularly applies to buy-side clients, such as pension funds,” the Federation of Dutch Pension Funds, which speaks for 350 pension funds, told Esma in a letter last week.

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