MiFID to Overhaul Derivatives Trading

Terry Flanagan

Draft of proposed legislation would direct OTC trading to regulated venues.

The review of Markets in Financial Instruments Directive (MiFID) will include new requirements for derivatives to be traded on organized trading facilities and will also require vertically-siloed exchange/clearinghouses to provide non-discriminatory access to their services.

The MiFID review, known as MiFID II, is scheduled to be introduced at the end of October by the European Commission, but copies of the draft have been circulated and reviewed by news organizations.

According to a version of the draft, MiFID II will “ensure that all organized trading is conducted on regulated venues and is fully transparent. The proposed revision will shift trading o of the suitably developed derivatives to such platforms.”

In the U.S., exchange-traded options and futures are traded on a regulated exchange and cleared by a regulated clearing house.  Under Dodd-Frank, OTC derivatives that become subject to new clearing requirements will also need to be traded on a SEF–swap execution facility.

Under the EU approach, European Market Infrastructure Regulation (EMIR) covers clearing requirements and trade repositories.   As proposed, EMIR would apply to OTC derivatives which would be defined as derivatives not executed on a regulated market as defined under MIFID.  Therefore, derivatives transacted on trading platforms governed by MIFID would not be covered by EMIR and would not be subject to mandatory clearing.

Under MIFID II, a greater portion of the derivatives market in Europe will move to regulated markets going forward.  Therefore, based on the current EMIR OTC derivatives definition, those derivatives moving to these regulated markets would escape the EMIR clearing requirement.

“The idea is that OTC transactions are pushed onto regulated markets. EMIR and capital resources requirements penalizing those entering into OTC trades based on the counterparty risk requirement are designed to do this,” Jacqui Hatfield, partner
in the financial services regulation practice at Reed Smith, told Markets Media.

“If the transactions are on regulated markets, the transactions will then be subject to MiFID,” said Hatfield.  “Traders, including non-financial companies such as energy trading companies, are likely to need to be authorized, as a result of the narrowing of the MiFID exemptions under MiFID II.”

MiFID II will also require exchanges that also operate clearinghouses to provide access to their services on a non-discriminatory basis.

“Members states shall not prevent investment firms and market operators operating a multilateral trading facility from entering into appropriate arrangements with a central counterparty or clearing house and a settlement system of another member state with a view to providing for the clearing and/or settlement of some or all trades concluded by market participants under their systems,” the MiFID II draft states.

In the U.S., FinReg requires OTC derivative clearinghouses to “provide for non-discriminatory clearing of a swap … executed bilaterally or on or through the rules of an unaffiliated designated contract market or swap execution facility.”

Firms that provide both execution and clearing services for OTC derivatives could price services in such a way that huge cost savings would be had if a trade was both executed and cleared via their platforms, or could limit direct electronic access to all but their own SEF, forcing outside SEFs to send trade details manually rather than via a more automated method.

The extension of European derivatives legislation to cover listed contracts holds major implications for the competitive structure of exchanges. In particular, it could swing the pendulum away from vertically-siloed exchange/clearing organizations toward horizontally-focused CCPs that clear multiple products traded on multiple exchanges.

Vertical integration, in the form of an integrated group bringing post-trade infrastructure providers under common ownership with providers in other parts of the value chain, such as exchanges or central securities repositories, would clearly create efficiencies.

At the same time, however, a vertical entity might acquire greater market power and thwart competitors from entry, such as by negotiating exclusive access to the trade flow from an exchange in the vertical group, excluding trading platforms outside the group from accessing the CCP, disallowing positions from different exchanges’ as being fungible, and preventing interoperability with other CCPs.

Indeed, the primary driver behind exchange consolidation is the opportunity to own the infrastructure that handles post-trade services for equities and derivatives. Exchanges want to be consolidators of settlement and clearance data and offer an array of new services such as risk and collateral management, financing and lending.

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