European Regulatory Authority finally moving forward

The new framework – described by ESMA as “practically applicable rules” for market participants and national supervisors – is intended to ensure that secondary markets are fair, transparent and safe and that the interests of investors are protected when investors are sold investment products. According to ESMA Chairman Steven Majoor, the regulations will “bring greater transparency and improve the overall functioning of markets, thus strengthening investors’ trust in the financial sector.”

The regulations are scheduled to go into effect on January 3, 2017.

While the new regulations are intended to bring in tougher rules on investor protection, manage systemic risks, and improve transparency and competition, there is some question as to their ultimate impact on the markets. Many fear the regulations will add unnecessary complexity to financial instruments, while others are concerned about certain ambiguities contained in the rules.

One of the most contentious issues is the treatment of forward contracts. Under the new regulations, forward contracts as currently defined will be considered financial instruments. This is raising significant concerns for commodity derivatives market participants, as these securities were not previously subject to the regulation. Specifically, they are concerned about the implications of a failure to accurately separate financial and commercial commodity contracts, which could lead to significant expansion of ESMA’s remit and impose an unnecessary burden on non-financial products and suppliers.

Putting all that aside for a moment, the recently published consultation paper, technical standards and upcoming open meeting represent significant steps forward in ESMA’s efforts to reform the financial markets. The paper and standards focus on commodity derivatives, data publication, investor protection, market data reporting and post-trading issues, micro-structural issues, requirements applying on and to trading venues, portfolio compression, and transparency.

As it pertains to derivatives, the key proposals contained in the new regulations focus on:

• Algorithmic and High Frequency Trading
• Commodity Derivatives
• Data Publication and Access
• Indirect Clearing
• Open Access by a Central Counterparty (CCP) or Trading Venue
• Post-Trading Issues
• Safeguarding Client Assets
• Trading Obligations
• Transaction Reporting
• Transparency

Algorithmic and High Frequency Trading (HFT)

The new rules clearly define the characteristics of algorithmic trading and its subset, HFT trading. Firms that meet those will have to become authorized to continue trading in that format.

Commodity Derivatives

The new regulations introduce position limits and reporting requirements on commodity derivatives. They also provide technical advice on the characteristics of wholesale energy products that must be physically settled. Pursuant to the rules, a contract must be physically settled if: it contains provisions which ensure that parties to the contract have proportionate arrangements in place to be able to make or take delivery of the underlying commodity; it establishes unconditional, unrestricted and enforceable obligations of the parties to the contract to deliver and to take delivery of the underlying commodity; it is not possible for either party to replace physical delivery with cash settlement; and the obligations under the contract cannot be offset against other obligations.

Data Publication and Access

ESMA’s new regulations lay out the authorization and organizational requirements for DSRPs (data reporting services providers), which include APAs (approved publication arrangements),

CTPs (consolidated tape providers), and ARMs (approved reporting mechanisms). The rules also address issues related to the publication chain of post-trade transparency information from investment firms and trading venues to the CTP through an APA. The content of that published information is addressed as well.

Indirect Clearing

Under the new rules, indirect clearing of exchange-traded derivatives is permissible, provided that the arrangements do not increase counterparty risk and provided that they ensure that the assets and positions of the counterparty benefit from suitable protection. The specific types of indirect clearing service arrangements that meet these conditions are defined in the rules.

Open Access by a CCP or Trading Venue

In an effort to increase competition in the EU, the new regulations lay out provisions for regulating access to CCPs, trading venues, and benchmarks. According to ESMA, an access request may be denied by a CCP due to the anticipated volume of transactions, arrangements for managing operational risk and complexity, or other factors creating significant undue risks. ESMA also indicated that an access request may be denied by a trading venue due to certain operational risks and complexities, or other factors creating significant undue risks. A number of other issues are also addressed, including:

• Non-discriminatory and transparent fees charged by CCPs and trading venues;
• The conditions for the non-discriminatory treatment of con- tracts (including how to determine whether two contracts are economically equivalent);
• The conditions under which access must be permitted;
• Transitional arrangements for CCPs and trading venues;
• Non-discriminatory access to and licensing of benchmarks; and
• The standards guiding how a benchmark may be proven to be new.

Post-Trading Issues

With regard to straight-through-processing for CCPs, trading venues, and investment firms acting as clearing members, the new regulations extend the scope of the clearing obligation to all derivative transactions concluded on a regulated market. They also require clearing members to ensure that derivatives are submitted for clearing as quickly as practicable. The minimum requirements for systems, procedures, and arrangements are specified by ESMA, which took into account the need to ensure proper management of operational or other risks. When finalized, these rules will apply to all OTC and exchange-traded derivatives, regardless of whether or not they are subject to the clearing obligation.

Safeguarding Client Assets

In the realm of safeguarding client assets, ESMA offered advice on the following topics:

• The governance and organization of such arrangements and the prevention of the unintended use of client financial instruments;
• Measures to ensure an appropriate use of TTCA (Title Transfer Collateral Arrangements) when dealing with non-retail clients;
• Arrangements to be adopted with respect to securities financing transactions;
• Strengthening the due diligence requirements, including diversification for firms depositing client funds;
• Recording and disclosure requirements with respect to inappropriate custody lines or similar rights, to the extent possible, over client assets; and
• Measures aiming to increase the effectiveness of segregation requirements.

Trading Obligations

Much like the trading mandate for swaps that is included in Dodd Frank, ESMA will for the first time require certain derivatives contracts to trade on a trading venue, such as a Regulated Market, Multilateral Trading Facility, Organized Trading Facility (which is essentially a European version of an SEF), or a third country trading venue deemed equivalent by the European Commission. The types of derivatives contracts that would be subject the new requirement include those which are cleared through a CCP and deemed sufficiently liquid.

Unlike Dodd-Frank, however, the provisions of the new trading obligation are somewhat vague. As a result, ESMA must develop specific technical standards to clear up any ambiguity.

Transaction Reporting

The new Transaction Reporting and Reference data regime provides for a number of reporting requirements in relation to the disclosure of transaction data and reference data on financial instruments covered by the regulations. ESMA is currently carrying out a thorough analysis and examination of the current regime, in order to evaluate the suitability of the existing formats. This examination will assist ESMA in selecting the most appropriate format for transaction reporting and reference data to be used along with their respective standard schema. The analysis is expected to be completed by March 2015.

Transparency

The new rules introduce transparency requirements for bonds, structured finance products, emission allowances, and derivatives.

National regulators have the power to waive the obligation for market operators and investment firms operating a trading venue to make public pre-trade information for certain non-equity instruments for which there is not a liquid market. On the post-trade side, they may also authorize market operators and investment firms to provide for deferred publication in respect of transactions that are related to non-equity instruments for which there is not a liquid market.

In order to determine the liquidity of all the various non-equity financial instruments, ESMA advises using the COFIA (classes of financial instrument approach). To establish a framework for the transparency regime, this approach provides for the segmentation of non-equity financial instruments into specific classes and subclasses. These are defined by ESMA on the basis of a set of criteria (such as maturity, currency, or underlying instrument) which varies from one asset class to another.

ESMA also describes the analysis carried out across different asset classes, for the purpose of segmenting non-equity financial instruments, in order to define the sub-set of liquid classes. And it defines what constitutes a “liquid market” for non-equity financial instruments.

This article was first published in edition 3 of Rocket, our magazine. Download your copy here, or save your address in your profile to receive a printed copy.