DOUBLE VISION.

Jannah Patchay, partner at Agora Global Consulting outlines some of the inconsistencies and incompatibilities of US versus European regulation and the potential impact on derivatives markets trading.

The relentless onslaught of new financial regulation, conjured up by an army of legislators and regulators with varying degrees of insight and expertise, continues its inexorable march across the global financial markets landscape.

In Europe, the traditionally relaxed northern hemisphere summer, customarily the preserve of month-long holidays, has been punctuated over the past couple of years by a fast-dawning realisation that the regulatory timeline most certainly does not take such niceties into account. Many in the industry expected to spend this summer poring over the Level 2 texts for the second iteration of the Markets in Financial Instruments Directive (MiFID II).

However, the European Securities and Markets Authority’s (ESMA’s) decision to postpone publication of these texts pending an early legal review by the European Commission led, this year, to something more approaching collective torture than a brief respite.

As the industry continued to agonise over the potential interpretation and impacts of the MiFID II Level 1 provisions on such arcane matters as the future of OTC trading versus systematic internalisation, the meaning of “liquidity” as applied to different asset classes and product sets, the nature and composition of prices to be published to clients versus the market, and what exactly constitutes a “commercial policy”, some of the key cross-border regulatory issues remain lurking in the shadows.

There is ample good reason for this: the US’ Commodity Futures Exchange Commission (CFTC) and the European Commission (EC) have yet to reach an agreement on substituted compliance for derivatives margining and clearing requirements, or on equivalence for central counterparties (CCPs), let alone considering the potential cross-impacts of MiFID II and Dodd-Frank on EU and US market participants.

Furthermore, these are not issues that have gone completely unrecognised by both sides; in July 2013, the CFTC and the EC agreed their “Path Forward” on harmonisation of their approaches to derivatives regulation, just in time to agree substituted compliance between the Dodd-Frank and European Market Infrastructure Regulation (EMIR) provisions on Risk Mitigation.

MiFID II creates new complexities in terms of both its scope and its potential impact on the efficient and effective functioning of global financial markets. For example, all multilateral platforms, including ECNs and brokers, must become authorised as MiFID trading venues – either regulated markets (RMs), multilateral or organised trading facilities (MTFs or OTFs) – by the regulatory deadline of 3rd January 2017, in order to continue their operations in the EU.

Furthermore, certain derivatives, deemed by ESMA to be subject to the Derivative Trading Obligation (DTO), may only be traded by clearing-eligible counterparties on a MiFID trading venue, with OTC trading in these cases no longer allowed.

If this is all sounding familiar, that is because it is roughly analogous to the concepts of permitted and mandated trading, respectively, on Swap Execution Facilities (SEFs), introduced by the CFTC in June 2013.

Before we get ourselves too comfortable though, it is worth bearing in mind that both the CFTC’s SEF requirements and MiFID II’s DTO have differing jurisdictions. The DTO applies to authorised European investment firms, and to all eligible transactions into which such entities enter. SEF requirements, on the other hand, apply to any eligible transaction, anywhere in the world, entered into by a US Person.

Take for example a European bank entering into a trade in a highly liquid derivative with a US Person. Suppose the derivative is subject to both the DTO in the EU, and has been Made Available to Trade (i.e. is subject to MAT determination) by a US SEF. The trade therefore falls under the jurisdiction of both sets of regulation, and must be executed on both a SEF and a MiFID trading venue, in order to fulfil both sets of requirements.

Currently, the US and the EU have not managed to come to an agreement on an equivalence determination for SEFs and MTFs (OTFs are a new introduction, and do not even appear to have been considered in discussions between the two sets of regulators to date). Therefore, if the trade is executed on a platform that is authorised in the US as a SEF, it will meet US requirements, but not those of MiFID II. And if it is executed on an MTF / OTF in the EU, it will not meet the US obligations. This problem already exists, as many interest rate derivatives have already become MAT on SEFs. It has been temporarily remedied by the granting of time-limited no-action relief, in which the CFTC essentially promises not to enforce a specific rule for a set period of time.

However, the conditions imposed by the CFTC have proven so onerous – both qualifying MTFs and participants trading on them must meet a number of CFTC reporting requirements – that only one MTF has taken advantage of this relief. Instead, European market participants have reluctantly accepted that, in order to carry on doing business with US Persons in MAT derivatives, they must trade on a SEF, with all the accompanying issues of liquidity fragmentation that have been so well-documented elsewhere.

All right, you may be thinking at the moment, but surely some platforms can become authorised as both SEFs and MTFs / OTFs, and that would solve the problem? Except, they can’t really. SEFs impose a number of requirements on the trade execution model that are completely at odds with existing platform trading models, as well as creating conflicts with MiFID II’s provisions around pre-trade transparency.

There is no Plan B, no contingency, in the event that the regulators do not reach a mutually agreeable compromise. In the very worst case scenario, a near-complete split between US and European liquidity could take place, necessitating the use of complex corporate structures, back to back trades and potentially new derivatives instruments for participants in one market to gain exposure to another. The only solution, then, is to continue in hope that one will be reached. With the hurdles of clearing and margining equivalence still in the process of negotiation, this is only likely to come late in the day.

Regulators on both sides of the Atlantic are tasked with improving the regulatory framework in order to achieve more stability and transparency. It is ironic, then, that so often, new regulation has the potential to create in itself new and dangerous sources of systemic risk.

[divider_line]©BestExecution 2015

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