In the eight years since the financial crisis, the derivatives industry has been playing a game of slow motion table tennis as it reacts to the swathe of new rules that regulators and politicians around the world have been batting its way in a bid to prevent a recurrence.
Even though many of these new rules have not yet been fully implemented, there is growing recognition that some of the rules may need to be redesigned. Asset managers, commodity firms and other market users are warning that there are elements of the new regulatory framework that are at best disproportionately burdensome and at worst counterproductive to the main goals of the post-crisis reforms.
European legislators are now listening, though, and have actively called for comment on whether their steps have been effective. This gear change was flagged following Jonathan Hill’s appointment in 2014 as Commissioner for Financial Stability, Financial Services and Capital Markets Union. Last September Hill issued a "call for evidence" to assess the effectiveness of the EU regulatory framework for financial services. Hill explained that the time had come to consider the cumulative impact of the post-crisis reforms on financial markets and the economy as a whole.
“Over the past five or six years, we had to legislate at speed and we introduced a whole battery of measures,” he said. “That overall architecture has made the system safer, and it has made the system more resilient. That is not in question at all. But now, as we work to create an environment that supports investment, we need to check that the cumulative impact of these rules hasn't had any unintended consequences. And that is something, incidentally, that the European Parliament has been calling for.”
****Photo caption: EU Commissioner Jonathan Hill asks market participants to weigh the effectiveness of EU regulatory framework.
The specific objective of the consultation was to look for empirical evidence and concrete feedback in four areas:
- Rules affecting the ability of the economy to finance itself and grow.
- Unnecessary regulatory burdens.
- Interactions, inconsistencies and gaps.
- Rules giving rise to unintended consequences.
The responses, which were submitted at the end of January, came from a range of stakeholders, including financial institutions, market infrastructures and end-users of financial markets and services. Given the aim of ensuring that financial markets are fit for purpose and support investment in jobs and growth—a focus, therefore, on the real economy—the responses from end-users are likely to prove of particular interest to the Commission.
Challenges to Hedging
While each sector has its own particular concerns, the responses reveal several areas of common concern regarding the impact of new regulation on the listed and cleared derivatives markets. These concerns include:
- The impact on and threat to liquidity.
- The impact on the ability of end-users to hedge.
- The burden of overlapping and in some cases conflicting regulations.
- The impact on commodities.
For end-users, an overall theme has been that while regulatory change aims to address shortcomings within financial institutions (particularly banks), they have, in the process, affected non-financial, non-systemically important institutions that rely on financial markets.
As the European Association of Corporate Treasurers explained: “The significant wave of financial regulation has concentrated on ensuring financial stability and on reducing the likelihood of a similar crisis reoccurring. Whilst this was certainly necessary, the EACT is concerned that the measures adopted might have had some serious adverse consequences on non-financial companies’ ability to fund themselves, manage their risks and handle their liquidity, and have resulted in putting excessive administrative burden on corporates generally.”
According to EACT, “banks are generally becoming much more selective with their clients” as a result of capital regulations CRD IV and CRR, leading to unequal access to banking services. Adding to this is the growing burden inherent in EMIR, the European Markets Infrastructure Regulation.
To meet the Commission's request for empirical evidence, EACT conducted a survey regarding the impact on the use of derivatives by corporate treasurers. The survey identified several developments that the association called "detrimental" to the ability of non-financial companies to mitigate their risk. These developments include:
- The pricing of OTC derivatives has increased, "sometimes substantially," and has become less transparent than before.
- Hedging long-term exposures has become "very difficult or impossible."
- There is increased pressure by banks to demand collateralization even when this is a not a legal requirement.”
As one respondent to EACT’s survey stated: “We have reduced our hedging activities dramatically. Our current decisions are more driven by the question ‘Can we meet the EMIR requirements?’ instead of the question ‘Will the hedging reduce our risks?’ This is fatal.”
The Investment Association, which represents the U.K.-based investment management industry, echoed these views. For example, as a result of the leverage ratio rules, many banks are restricting over-the-counter derivatives trades to those that are collateralized with cash variation margin only, the IA said. This trend is expected to continue and creates significant concerns for the association's members.
“Not all end-users hold cash and these users may not be able to access the OTC derivatives market in the future," the IA said. "We are already seeing evidence of reduced liquidity being made available to such end-users (e.g. pension funds).” A further concern for the IA is that this move will increase demand for cash in times of stress, when large mark-to-market moves occur. The result will be an increase in liquidity risk and a reduction in financial stability.
Impact on Commodities
Several groups raised concerns about the cumulative impact of restrictions under EMIR and MiFID II on the ability of non-financial companies to trade commodity derivatives.
“This will impact liquidity and participation in commodity derivatives markets as many firms will decide to limit their activity accordingly,” EACT said. “This will have knock-on consequences on the ability of all companies to access commodity derivatives markets at a reasonable cost to efficiently hedge their risks.”
This view was echoed by the European Federation of Energy Traders. In its response to the call for evidence, EFET urged the Commission to understand the interaction of financial market reforms with a separate set of initiatives designed to improve European markets for physical energy.
“Financial (and underlying physical) commodity markets have been particularly affected by the development of this comprehensive and overlapping regulatory framework,” EFET stated in its response. “This has come at a time when liquidity and participation in commodity markets has been falling.”
The overall result has been a contraction in the size of the OTC commodity derivatives market and the creation of barriers to entry, EFET said.
“Financial market regulation is beginning to create a three-way squeeze on firms. There are now high costs of entry to markets which are incurred regardless of the level of activity undertaken. There are increasingly high ongoing costs of doing business (which increase with the amount of activity) and can distort firms’ decisions and ability to efficiently and effectively hedge their risks. And [there are] restrictions on the amount of activity before significant additional obligations (and costs) are incurred, which limit the ability of firms to establish sustainable commercial platforms in light of the rising regulatory costs,” EFET said.
Among those costs has been the investment required to meet reporting requirements. There has been widespread criticism of the new regulatory reporting requirements in Europe since their introduction under EMIR (under which reporting obligations went live in February 2014). This problem has been compounded by the introduction of specific requirements for energy firms under the Regulation for Energy Market Integrity and Transparency (REMIT), which started last fall. To complicate things further, MiFID II brings its own reporting rules.
Costs of implementing and meeting regulatory requirements on reporting can be high, as high as 1.5 million euros (USD$1.7 million) for implementation and 200,000 euros (USD$226,000) in annual maintenance, according to EACT.
This cost is fundamentally ineffective as it does not contribute to greater financial stability, EACT said. The association therefore recommended that EMIR should be amended to remove the obligation for dual-sided reporting and reporting of intragroup transactions. Energy firms are also particularly hit because of the double requirements of EMIR and REMIT reporting. Because of a lack of harmonization in reporting requirements, EACT warned that firms will have to submit multiple reports to satisfy reporting requirements.
The Investment Association suggested there is merit in reviewing and streamlining the various reporting requirements that attach to asset managers. While the association said it is not opposed to reporting requirements, the association warned, “There is a clear obstacle to efficiency in the continuing proliferation of requirements…especially when these are meant to address the same data.”
The overriding message from the end-user community is that the volume of regulatory change, which was designed to improve financial market stability, could prove a disincentive to managing risks by increasing costs and reducing the opportunities for access to the services of financial institutions.
It is clear that end-users feel disproportionately impacted by regulatory change designed for financial institutions. It remains to be seen whether their concerns will find a sympathetic ear in Brussels.
On 29 January, FIA submitted its response to the European Commission Consultation - FIA Response - CMU Call for Evidence 29.01.2016.pdfCall for Evidence: EU Regulatory Framework for Financial Services. FIA's response covers key recommendations from members on, among other areas: the leverage ratio; indirect clearing; equivalence determinations; commodities firms - including capital issues as well as position reporting; trading and e-trading; reporting; definitions; and global solutions. With regard to concerns about the leverage ratio, FIA members recommended that the Basel Committee and European Commission should amend the leverage ratio in the area of exposure value calculation for client-cleared derivatives to recognize the exposure-reducing effect of segregated margin. The response called for an amendment to the leverage ratio methodology to move from CEM to SA-CCR (without modifications) so that it is not punitive to client clearing of derivatives and end retail investors (e.g. through pension funds) or market participants with off-setting positions, including amending weightings and other add-ons.
On the topic of indirect clearing, the FIA response calls for ESMA to publish final Regulatory Technical Standards (RTS) that enable a scalable model for indirect clearing of OTC and exchange-traded derivatives which addresses insolvency and property law issues contained in earlier RTS proposals under EMIR and MiFIR. It also suggests a limit in the scope of requirements to EU CCPs, to EU indirect clients' and to the first four parties in a clearing chain. Clearing members should also have discretion over to whom they offer indirect clearing.
Additionally, FIA suggests that there should be greater collaboration and coordination among legislators and regulators across the globe with regard to consistency in global timelines for implementation of high-level political commitments. For example, the European Commission should wait for the completion of the CPMI-IOSCO paper on CCP recovery and the FSB paper on resolution prior to formulating its own CCP Recovery and Resolution implementation work.
European Market Infrastructure Regulation, EMIR, came into force on 16 August 2012 and introduced requirements aimed at improving the transparency of Over-The-Counter (OTC) derivatives markets and to reduce the risks associated with those markets.
EMIR requires that OTC derivatives meeting certain requirements are subject to the clearing obligation and for all OTC derivatives that are not centrally cleared that risk mitigation techniques apply. In addition, all derivatives transactions (both OTC and ETD) need to be reported to trade repositories (TRs). Finally, EMIR establishes organizational conduct of business and prudential standards for both trade repositories (TRs) and central counterparties (CCPs).
KEY EMIR PROVISIONS
- Reporting obligation for derivatives contracts (which began in February 2014).
- Requirements for trade repositories (TRs).
- Clearing obligation for OTC derivatives and risk mitigation techniques for non-cleared OTC derivatives including non-financial counterparties (NFC) obligations. Mandatory clearing starts in June 2016.
- Requirements for clearing houses/central counterparties (CCPs).
MiFID is the Markets in Financial Instruments Directive, which has been applicable across the European Union since November 2007. It is a cornerstone of the EU's regulation of financial markets seeking to improve the competitiveness of EU financial markets by creating a single market for investment services and activities and to ensure a high degree of harmonized protection for investors in financial instruments.
On 20 October 2011, the European Commission adopted a legislative proposal for the revision of MiFID which took the form of a revised Directive (MiFID II) and a new Regulation (MiFIR). MiFID II and MiFIR were adopted by the European Parliament on 15 April 2014, by the Council of the European Union on 13 May 2014 and published in the EU Official Journal on 12 June 2014. Last month, it was confirmed that the directive and regulation, both originally due for implementation in January 2017, have been delayed by a year to January 2018.
The Market Abuse Directive (MAD) is intended to guarantee the integrity of European financial markets and increase investor confidence. Any unlawful behavior in the financial markets is prohibited. MAD was published in the Official Journal and entered into force on 12 April 2003. Its objective is to create a level playing field for all economic operators in the Member States as part of the effort to combat market abuse by:
- reinforcing market integrity.
- contributing to the harmonization of the rules for market abuse throughout Europe.
- establishing a strong commitment to transparency and equal treatment of market participants.
- requiring closer co-operation and a higher degree of exchange of information between national authorities, thus ensuring the same framework for enforcement throughout the EU and reducing potential inconsistencies, confusion and loopholes.
The Market Abuse Regulation MAR will apply as of 3 July 2016.
The regulation on wholesale energy market integrity and transparency (REMIT) is overseen by the Agency for the Cooperation of Energy Regulators (ACER). It introduces a sector-specific legal framework for the monitoring of wholesale energy markets. The objective is to detect and to deter market manipulation. For the first time, energy trading will be screened at EU level to uncover abuses.
Reporting of energy transactions began in October 2015, in a phased approach, which concludes with the final stage of data collection from April 2016.