Vortex of Change

Terry Flanagan

Capital markets are being subjected to crosscurrents of regulations on both sides of the Atlantic.

Capital markets participants are finding themselves caught within a vortex of regulatory change on both sides if the Atlantic.

Each of the major regulatory regimes—such as derivatives reform, equity market structure change, investor protection—is like a spinning top, and the faster each spins, the greater the uncertainty.

The mega-regulations, such as the Dodd-Frank Act in the U.S. and the MiFID and EMIR regulations in Europe, are each capable of generating tremendous complexity, but when they’re all intertwined, the complexity becomes nearly unfathomable.

“Regulatory reform will be pervasive over the next 3-5 years,” said Dr. Anthony Kirby, chair of the regulatory committee at ISITC Europe. “Reform will impact all players from the front through to back offices for all constituencies in all G20 countries, although the pace of change could well differ.”

Although the U.S. and Europe are on the same page insofar as achieving the G20 reforms via centralized clearing and execution of OTC products, transaction reporting, and removing barriers to entry for competition, there are some significant differences, according to a report by Kirby.

Dodd-Frank Title VII requires standardized swaps and security-based swap products deemed eligible for clearing to be centrally cleared through regulated clearinghouses, and traded on a designated contract market or swap execution facility (SEF).

“This approach is similar to the EMIR measures that propose mandatory CCP clearing for eligible products,” said Kirby.

There are also other commonalities: the transparency of OTC derivatives enhanced through recordkeeping and reporting requirements and provision of trade repositories; assets used top margin or guarantee swaps must be able for be centrally cleared, with rules providing for capital and margining requirements, and the provision of position limits and margin requirements for major OTC derivatives market participants.

Equally, there are important differences, according to Kirby.

One is the U.S. National Market System (NMS), which routes cash equity flow toward the most appropriate venues on the basis of the trade-through rule.

Under MIFID II, OTC derivatives can be traded on regulated markets, multilateral trading facilities (MTFs), or on a new category of trading venue–organized trading facilities (OTFs).

OTFs would include both bilateral and multilateral systems, capturing all types of organized execution and trading arrangements not captured by regulated markets or MTFs, including broker crossing systems and single-dealer platforms for trading OTC derivatives.

“There is reluctance by the U.S. to follow the Europeans in classifying dark pools and broker crossing networks as OTFs subject to volume thresholds,” said Kirby. “The Europeans meanwhile have shown a reluctance to follow the U.S. example by developing the equivalent to the Volcker Rule of the swaps push-out rule.”

There also differences of timing. Whereas the Dodd-Frank Act was signed into law this year, and rules for its implementation are in the advanced stage, MiFID (which consists of both a directive and a regulation, the latter known as MiFIR) was proposed by the European Commission in October, and EMIR is still undergoing trialogue discussions involving the European Parliament, the European Commission, and the Council of the European Union.

“Europe also consists of several countries, so trying to apply directives to produce a consistent legal effect across every Member State is not the same process as in America,” Kirby aid. “The whole process must be driven by the national laws in each country.”

Looking at comparisons with the U.S., it is unsurprising that business models differ, as do the market infrastructures that support them.

“Just compare the DTCC in the U.S. against the 33 central securities depositories and 22 CCPs in Europe, not to mention the differences in principal versus agency models, or the differences in solvency regimes as applied to OTC derivatives such as interest rate swaps, FX swaps, and credit default swaps,” Kirby said.

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