It is one of those tasks that is conceptually simple but needs enormous effort to implement in practice. The G20 summit in Pittsburgh in September 2009 declared the need for a safer and more transparent financial system. The official leaders’ statement singled out the over the counter (OTC) derivatives market as one of the key areas where excessive risk-taking needed to be curbed.
Yet, five years later, the process of reforming financial regulation is far from complete – the task involves negotiating formidable operational, technological and legal obstacles. Unlike under the US’s Dodd-Frank Act, which only covers sell-side institutions, the process under Europe’s new rules will eventually bring tens of thousands of players in scope – including accountants, asset managers, custodian banks, investment banks, lawyers, pension funds and non-financial corporates – and numerous financial instruments.
Two centerpieces of the new regulatory framework within the European Union are the European Market Infrastructure Regulation (EMIR, which governs derivatives, central counterparties and trade repositories) and the updated Markets in Financial Instruments Directive (MiFID II).
EMIR covers all derivatives transactions but the changes are more far-reaching for OTC instruments, owing to the lack of a pre-existing regulatory framework. It involves the introduction of three new elements to the market: a central clearing system, margin and capital requirements, and trade reporting. MiFID II, along with the associated Markets in Financial Instruments Regulation (MIFIR), covers a wide range of activities, including transaction reporting, and also contains provisions related to OTC derivatives trading.
At present, EMIR is the priority for market participants simply because they are in the midst of implementing many of its measures, particularly in relation to trade reporting, this year. In contrast, transaction reporting under the new MIFIR will not be implemented until early 2017.
Two related requirements under EMIR have already been introduced in 2014; the reporting of trades themselves became mandatory in February and the reporting of prices was introduced in August. Reporting involves each counterparty submitting up to 85 data fields. This compares with only 26 fields under MiFID I.
Price reporting has posed a challenge since there is room for debate about exactly what value to report.
“We have many difficulties on what is fair pricing,” says Etienne Deniau, head of business development focused on asset managers and owners at Société Générale Securities Services. “Is it the counterparty price or the pricing made independently? And how do you make sure both parties are reporting the same price?”
Trades made under EMIR have to be reported to repositories whose role is to collect and maintain records of transactions. ESMA (the European Securities and Markets Authority), an independent EU regulatory body for financial markets, has registered several repositories for this purpose.
Establishing the system has involved assigning unique identifiers to every entity and every trade. The first step was to introduce the LEI (Legal Entity Identifier) for identifying counterparties. Deniau says this seems to be working pretty well. The next stage was the introduction of a UTI (Unique Trade Identifier) for every trade.
Both processes have revealed teething problems in the implementation of EMIR. At present, there are said to be more parties with a reporting obligation than there are LEIs – suggesting that some parties are simply not reporting. Judging by the experience of MiFID I, it might take the levying of significant fines before everyone is willing to comply. There are also evidently instances where different parties to a transaction are using different UTIs for the same trade. This is despite the fact that the ESMA guidelines for implementing UTIs are said to be clear – although they are not yet mandatory.
It is important to note that under EMIR every counterparty has the responsibility to report trades but it is possible to delegate the action to another party. For example, an asset manager or pension fund could delegate reporting to the banking counterparty – although both sides would retain regulatory responsibility for the transaction.
Legal & General Investment Management (LGIM) has decided it would be simpler to report its own trades rather than relying on investment banking counterparties. If it had chosen to rely on the sell side, it says it might find some who were not willing to report. Many other asset managers have reportedly taken a similar view.
“You’ve got to get an awful lot of ducks in a row to ensure that all your stuff is being reported accurately”, says Simon Thompson, LGIM’s chief operating officer.
LGIM will also report trades on behalf of its pension fund clients. However, in line with the EMIR framework, these segregated funds will maintain responsibility for ensuring the action is carried out.
Opinions are mixed as to how well the implementation process is going overall. Mark Higgins, a managing director for global collateral services at BNY Mellon, says that many investors and their bank counterparties are having the discussions they need to get on top of EMIR reporting processes and their respective responsibilities. In his view, the existence of well-defined standards is easing the process.
Kieran Mullaley, a director in financial services at Ernst & Young, is more guarded on the reconciliation processes and technology. “There are still improvements needed in terms of standardised reference data and the way different people have interpreted rules,” he says. “If you look across multiple repositories there is certainly more work to be done there.”
A perhaps under-appreciated result of these changes is that new legal documentation needs to be drafted. ISDA (the International Swaps and Derivatives Association) has worked hard to produce documentation everyone can use but this goal has yet to be achieved.
“The idea is for it to be standardised but everyone’s lawyers have to sign off on it,” says LGIM’s Thompson. “Rather unhelpfully, there hasn’t been as much clarity in terms of the details of the provisions of EMIR as there might be. A number of things have been left open to interpretation.”
One area where there appears to be universal agreement is that the new layers of EU financial regulation come at a price. Enhanced regulation might achieve its goal of improving global financial stability but the immense amount of time and effort involved incurs financial costs.
Despite the complexities of introducing the new system of regulation within the EU, it should be remembered that it is not the end of the story. For example, an OTC derivatives transaction could have one counterparty in the EU and another in the US. Getting these two systems to work smoothly together could, in the words of someone involved in the process, involve “a whole wealth of pain”.
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