As regulators seek to push more business onto exchanges and into central clearing, and to make derivatives and other markets more transparent and more resilient, the reform of the securities industry is well under way. What will regulations mean for businesses in practice?

When the Markets in Financial Instruments Directive (MiFID) came into effect on November 1, 2007, its major aim was to increase competition and consumer protection in investment services. The review of MiFID currently under way – part of a continued push for further consumer reform – extends the MiFID framework for equities to all asset classes and into markets in which centralised bid-offer markets and pre- and post-trade transparency have never existed.

At the same time, the European Market Infrastructure Regulation (EMIR) will reshape the over-the-counter (OTC) markets beyond recognition. The ramifications of this will be widespread – not least because the measures will add requirements in terms of initial and variation margining as well as electronic execution, price publication and centralised clearing.

Does the move towards exchange trading and central clearing for over-the-counter derivatives create any opportunity for the industry?

All change

“The whole notion of netting trades and presenting trades to a clearing house is going to mean that the way business is currently conducted will have to change,” says Dr Anthony Kirby, director of regulatory reform for asset management, Europe, the Middle East, India and Africa, at Ernst & Young.

“Currently, brokers put up initial and variation margins on behalf of fund managers but in the new world to come this will be much more explicit," he adds. “In Europe, non-financial end-user corporates that are currently using OTC derivatives for speculation will face proportionality tests and may be called upon to put up margin in the form of cash collateral or appoint third parties that will offer collateral transformation services at a price.”

While yet to be finalised, both MiFID and EMIR – and other regulations that are also in the pipeline – will have a huge effect on the securities value chain. But because of the scale of the changes, market participants cannot afford to wait for draft legislation to go through the final review and ratification processes before they act.

Mr Kirby estimates that some 70% of the final legislative text is already settled by the time the European Commission issues its first draft. This means that market participants have to seize the opportunity to set out their first steps towards implementation.

Need for urgency

Not all banks have a head start and some of the mid-tier and especially regional players in Europe are indeed waiting for the final rulebook. They should start looking at the collective impacts as early as possible.

There are four fundamental areas which banks must address. The first is the correct specification of the bank’s legal entities. The location of business is driven by a variety of considerations such as local tax and legal issues, as well as broader macro-economic trends and local infrastructure. Given the huge changes that are emerging, the regulatory environment will be a major driver in ensuring legal entities are sited for optimum effect.

The process of on-boarding clients is also under the spotlight. Banks and investment firms need to look very carefully at how their clients are classified. In Europe in particular, regulators are increasingly sensitive to the characteristics of individual products and their suitability for different categories of clients. For example, OTC derivatives are regarded as complex products, which are only suitable for sophisticated investors (under MiFID II, none of the 'simple' products listed are derivatives).

Third, market participants need to look at how they can re-engineer the processing model for securities trades: from the information provided to clients through to settlements, complaints and failures. There are multiple ways that trades can be routed to the appropriate execution venues; this means a lot of choice but also a huge amount of complexity that has to be managed under higher volumes. With incoming regulation, banks need to ensure that these trading routes remain as efficient as possible.

Finally, banks must address increased reporting and disclosure requirements. They must improve the quality of the disclosure and be able report to regulators and to clients on a far more frequent and consistent basis.

Mr Kirby says: “For this reason, banks are going to need much more standardised, better quality data and they will need to accommodate how each client and regulator wishes to receive this information. There is going to have to be a step-up in the quality and quantity of reporting that is carried out. Good quality data and the ready availability and 'processability' of the data will differentiate the winners from the losers.”

EMIR impact

While the European Commission's draft of MiFID II is still a work in progress, there is already a basic framework in place for EMIR, says Stephen Wolff, managing director and head of strategic investments at Deutsche Bank.
 
“A lot of work has been done to prepare both ourselves and our clients for some of the core changes coming with EMIR. Although we don’t know the exact product set or exact client set that will be affected by central clearing, we know that core flows of derivatives products and our financial services clients will be impacted and there is a lot we can do now to build infrastructural capabilities."
 
Furthermore, this shake-up means that banks are starting to look at opportunities to standardise the synergies between asset classes, transactions and market practice across centrally cleared interest rate swaps, foreign exchange swaps and options. It is clear that banks will need to take intelligent bets about which products are likely to be centrally cleared and which ones will not, in order to streamline their operations.

Deutsche Bank has recently merged its existing over-the-counter and listed derivatives clearing businesses, creating a new group dedicated to providing execution and prime clearing services across all asset classes. Other banks such as JPMorgan and the Royal Bank of Scotland have taken similar actions. This new model is a direct impact of the regulations for mandatory central clearing, as well as the new Tier 1 capital requirements of Basel III. By offering these ‘one-stop shops’ for exchange-traded and OTC products, both cleared and non-cleared, banks are able to consolidate across asset classes and offer cross-margining and risk attribution value added services.

Disclosure and transparency

MiFID II is aimed at further improving transparency, which all markets will benefit from. But Mr Wolff argues that transparency is a means to an end rather than an end in itself, and says there is a clear distinction between the issues around pre-trade transparency and post-trade transparency.

“All markets accept that post-trade transparency needs to be improved, and will be improved, it is just a matter of agreeing how this is calibrated on a market-by-market basis, as each market is different,” he says.
 
However, Mr Wolff adds that the impact of pre-trade transparency on price formation and liquidity, particularly in the bond market under the current draft of MiFID II, is another matter and is still being discussed.

Part of the problem is that applying an infrastructure built for the equities market to the bond markets – and bringing the same level of transparency to pre- and post-trade bond prices in the current economic environment – could severely impact market-makers’ appetite for providing liquidity. “The only outcome there can be from these proposals is that there will be less liquidity,” says Mr Wolff, “and this will greatly impact the end-consumer”.

On the plus side, most believe there will be more transparency, innovative business models, better counterparty risk management and more choice in the market. But the price for this will be greater pre- and post-trade complexity and an additional processing burden. Just as trading fragmented under MiFID, clearing could fragment once EMIR takes effect.

Lessons from mark one

However, there are some quick lessons to be learnt from the implementation of MiFID I which could significantly ease the pain of the transition to MiFID II. A UK-based IT consultancy, BJSS, recently published a white paper based on an analysis of transaction reporting under MiFID I. The paper analyses all the incidences of banks being fined by regulators for non-compliance with MiFID I – such as incorrect market details, inconsistent reference data and business process failings – in order to identify patterns that can be used to improve systems and processes for the implementation of MiFID II.

One of the clearest patterns identified arose from the complexity of merged entities that have not consolidated their infrastructure. In such cases, banks have ended up with a variety of systems carrying out the same operation and have multiple copies of reference data or more than one interface with regulators. “Regardless of what comes out of MiFID II, banks should be consolidating their systems to make compliance easier and reducing this degree of risk,” says Paul Everson, a programme manager at BJSS.

The upshot of the growing complexity arising out of regulation in the front office is an increasing appetite, particularly from the buy-side, for the outsourcing of selective front-office components, says Mr Kirby. “If there are going to be a lot more [trading and clearing] venues, growing cross-asset class trading, and cross-collateralisation, the question is which banks have the scale, capital and agility to offer the next generation of new services to asset managers looking to take fixed costs out of their models,” he says.

Accordingly, reporting and data management – relating to order and execution channels, smart order routing, managing client service agreements, treasury management and facilitating transaction cost analysis tools – are all candidates for outsourcing in the years to come.

And this means that the new regulatory environment will bring opportunities as well as challenges.

PLEASE ENTER YOUR DETAILS TO WATCH THIS VIDEO

All fields are mandatory

The Banker is a service from the Financial Times. The Financial Times Ltd takes your privacy seriously.

Choose how you want us to contact you.

Invites and Offers from The Banker

Receive exclusive personalised event invitations, carefully curated offers and promotions from The Banker



For more information about how we use your data, please refer to our privacy and cookie policies.

Terms and conditions

Join our community

The Banker on Twitter