Regulators in Europe and the US are still dealing with a backlog of cross-border problems in the over-the-counter derivatives market. Are these issues resolvable, and what is at stake if they are not? By Michael Watt.

Laufenburg, a small, non-descript town of some 2000 people, straddling the Swiss-German border, is not likely to be familiar to the average derivatives market regulator, but it offers a cautionary tale that could have proved useful over the past few years.

In 2003, the authorities in Laufenburg decided to build a bridge over the river Rhine, which bisects the town. Construction was started on both banks, but as the structure neared completion, it became clear that someone had blundered – the two sections of the bridge did not neatly meet in the middle. In fact, one was a full half-metre higher than the other, forcing an embarrassing rebuild on the German side.

Derivatives market supervisors have found themselves in a similar fix. The years since the financial crisis have seen the construction of perhaps the most extensive and intensive set of regulatory changes in the history of financial markets. Given the scale of the change, it is remarkable that so many new rules, which encompass dozens of different jurisdictions, have been brought into force with a minimum of fuss. Regulators have introduced massive changes to capital and liquidity standards without serious geographic schisms.

There are, however, significant cross-border issues within derivatives market reforms. Regulatory agencies, such as the Commodity Futures Trading Commission (CFTC) in the US, and the European Securities and Markets Authority (ESMA), have worked to different timetables and have focused on mending their own fences, leaving cross-border co-operation a little further down the list of priorities. As a result, the derivatives market risks becoming regionalised, rather than globalised, and saddled with higher costs and lower liquidity.

In November 2014, Timothy Massad, the chairman of the CFTC, indicated that his organisation would make special effort to work with other regulators to resolve any outstanding issues. It is perhaps fitting that the call for co-operation came from the CFTC. It has been accused of constructing needlessly strict compliance rules for non-US firms operating within the US, and of throwing its weight about beyond its own borders, resulting in non-US firms becoming reluctant to deal with US counterparts anywhere in the world for fear of being caught in the CFTC’s dragnet. One year on, how successful have those co-operation efforts been?

Equivocation on equivalence

Most of the cross-border problems have arisen from difficulties in securing ‘equivalence’ between the standards used by different regulatory regimes to approve and monitor firms or processes that can loosely be described as ‘market infrastructure’ – central counterparties (CCPs), the collateralisation of uncleared swaps, and trading platforms, be they swap execution facilities (SEFs) in the US or multilateral trading facilities (MTFs) in the EU.

Clearing is an absolutely indispensable part of the post-crisis derivatives market landscape. The requirement for all standardised over-the-counter (OTC) derivatives to be cleared through CCPs was set at the meeting of the G20 countries in Pittsburgh in late-2009, but, as always, what is easy to say is not always easy to do. Moving the market away from bilateral trading and onto CCPs has proved harder than many expected. Over the past few years, the US has finalised its approach through the Dodd-Frank Act, and pushed through clearing mandates for a number of products. The EU is somewhat further behind, and is still working on aspects of its European Markets Infrastructure Regulation (EMIR). To maintain the unity of the global market, the EU, through ESMA, must now recognise US clearing houses as equivalent to its own, or else EU market participants will bit hit with massive capital charges if they attempt to clear trades through US CCPs. This has proved a difficult process.

“Arguably the highest profile example of the problems that can occur through a lack of harmonisation is in the clearing space,” says Eric Litvack, head of regulatory strategy at Société Générale in London. "Negotiations between US and European regulators over whether US clearing houses should be recognised by ESMA have been stalled over technical differences in margin methodologies, raising the spectre of punitive capital charges.”

Though the European Commission has delayed the deadline by which capital charges would be aimed against participants clearing with non-recognised CCPs, it will soon be crunch time for this issue. The first clearing obligations for some derivative instruments will come into force in Europe in April 2016. If the equivalence issue is not sorted by then, European firms will not be able to clear through non-recognised CCPs, resulting in a balkanised clearing market and a fractured liquidity pool for the global derivatives market.

Breaking the deadlock 

At first glance, the ‘technical differences’ do not seem too vast. Indeed, in May 2015, Mr Massad and Jonathan Hill, the European commissioner for financial services, announced that an equivalence deal would be settled "by the summer". The matter was obviously more complicated than expected, as the settlement is still to be completed close to the end of the year. As Mr Litvack notes, much of the rift has been created by different margining requirements. Under EMIR, members of European CCPs are required to post enough netted initial margin to cover two days of risk as soon as a trade is executed, whereas in the US, clearing members post margin on a gross basis for only one day of risk, and must post this by T+1 (i.e. by the end of the trading day after the day of execution). 

Analysis shows that two-day margining requires an average 41% more margin than the one-day approach, leading to fears from European CCPs that business will flow to the US if an equivalence regime kept this difference intact. However, the CFTC claims that its insistence on gross margining, rather than netted, flips these estimates the other way around, leaving the European system lagging in terms of the amount of margin posted. Even if this matter is resolved, the Europeans are unhappy that the CFTC will still require non-US CCPs to register as designated clearing organisations, while EU regulators are happy to defer to offshore regulators if their regimes are granted equivalence.

To break this deadlock, the dealer community, led by the International Swaps and Derivatives Association (ISDA), has pushed for automatic equivalence to be given to any CCP that meets the principles for financial market infrastructures set down by the Committee on Payment and Settlement Systems and the International Organisation of Securities Commissions (Iosco), two regulatory bodies associated with the Bank for International Settlements.

The impasse remains, but David Weisbrod, chief executive of the US subsidiary of London-based clearer LCH.Clearnet, is confident that all will be right on the night. “We’ve taken the view that the risk management standards for CCPs have to be the most carefully constructed part of the whole equation. We haven’t seen many updates on the equivalence situation recently, but these things take time because they are so complicated. They will get there, though. Everyone agrees that we need equivalence,” he says.

Unclear, undecided 

Another area where industry participants hope regulators will soon be grinding their way towards an agreement is the posting of margin for uncleared derivatives. Though much of the market will be pushed through CCPs, regulators recognise that some swaps are too bespoke and too complex to be executed in this fashion. These trades will still have to be collateralised, however, and, as with CCP equivalence, years of work has gone into finding a solution that works in all jurisdictions.

“Of all the issues that remain on the table, margining for non-cleared trades is probably the area where we’re going to see the most fruitful cross-border co-operation. There has been a global effort to produce a consistent regime, and though it has taken some time, I think we’re on the verge of a solution,” says Scott O’Malia, chief executive at ISDA.

The Basel Committee and Iosco published a global margining framework in September 2013, leaving national authorities to fill in the fine detail. This is where the disparities began to crop up. European proposals were first published in April 2014. In the US, differing national-level proposals were published by the CFTC and prudential agencies, including the Federal Deposit Insurance Corporation in September and October 2014. European supervisory agencies then initiated a consultation period in June 2015. 

The main difference between the proposed US and EU rules is the treatment of non-cleared inter-affiliate trades. In the European (and Japanese) approach, margin is not required for these, but initial US proposals took the opposite view. Recent final rules from the US prudential regulators have altered this position slightly so that margin need only be posted by one side of the trade rather than both. The CFTC is expected to release its final ruling in the coming months. Though the US regulators have moderated their inter-affiliate stance somewhat, it is still at odds with the European proposals, and if a common approach is not found by September next year, when margining for non-cleared swaps is phased in, it will mean higher costs for US participants.

“Looking at it in the round, there isn’t really much difference between the EU and US rules in this area. They are pretty well aligned. Regulators should be looking for outcomes-based equivalence. Anyone who expects these things to always be symmetrical and perfectly in sync isn’t being realistic,” says Michael Beaton, managing partner of London-based advisory firm Derivatives Risk Solutions.

Different approaches

The importance of an outcomes-based approach to cross-border regulation was emphasised by the SEF equivalency saga that cropped up in the first half of 2014. Alongside the commitment to central clearing, the G20 Pittsburgh communique in 2009 also stated that all OTC derivatives should be traded on-exchange or on electronic platforms to improve market transparency. In the US, this aim was translated, via the Dodd-Frank Act, into the establishment of SEFs, which market participants can access to make or take prices on derivatives trades. The equivalent platform in Europe will be the MTF, as established through the second Markets in Financial Instruments Directive (MiFID II).

So far, so simple. Dig any deeper, however, and the whole thing gets a lot more complicated. Dodd-Frank was passed in 2010, and by the back end of 2013, with a few hiccups along the way, US platforms had begun registering as SEFs with the CFTC. Meanwhile, in Europe, MiFID II was not even close to readiness. While the CFTC’s standards governing SEFs were precise, detailed and rule-driven, the proposals laid out in MiFID II for MTFs were principles-based. So, when European platforms hoping to be both MTFs in Europe and SEFs in the US tried to register as SEFs, they found it almost impossible to keep the CFTC happy.

The differences between an MTF and a SEF are nuanced, but important. SEFs are designed for swaps only, whereas MTFs can accept trades from any asset class. Both use central-limit order books, which stream prices in any given instrument to a participant’s screen which can then be selected and executed. However, an MTF must display prices on a non-discretionary basis, whereas a SEF can display them on a discretionary basis and can offer a ‘request for quote’ model, where participants can hit up other participants for a price on a particular instrument, rather than passively wait for it to be streamed. There are also other more minor differences in pre- and post-trade transparency.

Dragging on  

In an attempt to prevent a geographical fragmentation of swap liquidity, the CFTC put together ‘qualifying MTF’ (QMTF) proposals in early 2014, after engaging in a dialogue with the UK Financial Conduct Authority and other European regulators. However, market participants found this so slanted towards the CFTC’s existing SEF rules, that compliance was impossible. In their final form, the QMTF proposals effectively required European platforms to convert their entire business, not just a segment of it, to a SEF footing. That would have led to the decay of any other non-SEF services, be they MTF compliant or not, a prospect that was unpalatable to European firms.

As a consequence, the QMTF effort fell apart in May 2014, and swaps liquidity did indeed fracture, with US participants staying within their own borders. “The change in trading behaviour coincided with the introduction of US SEF rules, which prevented US persons from trading on any platform that hadn’t registered as a SEF,” says Mr Litvack at Société Générale. “Historically, end users of OTC derivatives have been able to access the global liquidity pool with few barriers. Faced with the higher cost and complexity of meeting conflicting cross-border rules, derivatives users are increasingly retreating to their home jurisdictions, creating a fragmentation of liquidity along geographic lines. That results in reduced choice and higher costs, and could make it more challenging for end users to properly manage their risks, particularly in stressed markets.” 

According to research conducted by ISDA, 88.6% of inter-dealer volume in euro interest rate swaps within Europe was traded between European dealers in the second quarter of 2015, compared with 73.4% in the third quarter of 2013.  

It is unlikely that a solution to this problem will be reached before the full MTF rules are introduced with MiFID II. “It’s all over. There won’t be any cross-border substitution or sorting out until MiFID II is ready. The regulators have been miles away from the QMTF process for about 18 months. There has been no movement at all, and all the while the fragmentation problem has gotten worse and worse,” says a senior manager at one European trading platform.

Mifid II was initially due for implementation in 2012, but now will not be ready until early 2017. It may even be later than that, as the European Commission is pressing for a year-long delay to deal with the many kinks in the framework.

The devil is in the data

The third pillar in the new derivatives regulation regime, alongside clearing and platform execution, is data reporting. To make the market more transparent and prevent an extreme build-up of dangerous positions in particular instruments, regulators wanted participants to report the details of their trades to designated data repositories.

The implementation of trade reporting has been less than stellar. In the US, the CFTC went down a relatively simple route, requiring that only sell-side counterparties send trade data to a repository. It also kept the number of designated repositories to a minimum.

In Europe, where trade reporting comes under the auspices of EMIR, the approach was a little more complex. Both sides to a trade, sell side and buy side, have a responsibility to report, bringing in thousands of firms that had never been subject to this sort of supervision before. ESMA largely left the industry to its own devices in designing the nuts and bolts of the reporting procedures – what data fields were required, which counterparty would generate the 'unique trade identifier', which must be attached to each trade. It also approved six different data houses as designated trade repositories, meaning that in many cases counterparties on the same trade were reporting its details to two different places. 

All this resulted in mass confusion when reporting became mandatory for all derivative trades in Europe in January 2014. The number of correctly reported trades was much less than 50%, and has not improved much in the time since. Worse still, the different trade repositories to do not yet have an easy way to talk to one another and clear up any inconsistencies in the reporting, and regulators have no way of seeing the data across all the repositories. As things stand, the reporting system does not fulfil its objective of allowing regulators a clear view of global derivatives market activity.

A great deal of effort is being put into remedying this situation. On the industry side, ISDA is leading a consortium of market participants to construct a common product identification methodology, and Rodrigo Buenaventura, head of markets as ESMA, believes progress is being made. “We have issued guidance on inter-trade repository reconciliation, and we have made big improvements in how the industry submits its data. Ninety-nine percent of all trades now arrive with fully completed data fields,” he says.

Completed, yes, but correct? No. “We are not where we want to be with regard to the quality of the data. It is very challenging. Though the data fields are now being filled in, in many cases they are not filled with accurate information because there is not enough consistency in standards. We have launched a data quality plan to tackle this problem, and we are looking into data validation process at the trade repository level, too,” says Mr Buenaventura.

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