By Elizabeth Fraiser-Nelson – elizabethfnelson@internationalbanker.com
After the crisis that shook the world and reduced financial markets to chaos, watchdogs the world over rushed to start regulating a sector that was so far almost completely liberalized. First came the Dodd-Frank Act, which was passed in 2010, and which aimed to set strict rules for the whole financial system in view of avoiding another crisis. The Dodd-Frank Act led to the creation of new government agencies such as the Financial Stability Oversight Council, which monitors companies seen as “too big to fail” in order to prevent the occurrence of an event such as the collapse of Lehman Brothers, and the Orderly Liquidation Authority, responsible for making sure that companies with fatal financial troubles manage to be liquidated with the least possible fallout.
A key component of the Dodd-Frank Act is the Volcker Rule, which specifically concerns trade in derivatives and other financial instruments. Derivatives have been blamed for being one of the main drivers behind the financial crisis, seriously aggravating a situation that could have otherwise been resolved much more quickly and with a lesser impact. This is why derivatives have been a special target for regulators on both sides of the Atlantic. The Volcker Rule limits banks’ capacities to trade in derivatives and invest in certain asset classes using their own accounts, and also limits the scope of their relationships with private-equity and hedge funds.
Europe was a bit slower to come up with the relevant legislation, but in 2012 the European Parliament passed and the Council approved the European Market Infrastructure Regulation, which sets ground rules and procedures for the operation of central counterparties (CCPs) and trade repositories (TRs), and regulates trade in derivatives, with a special focus on instruments that were previously traded over the counter. Aiming to bring greater transparency and accountability in a sector so far seen as rather opaque, the EU requires that some classes of OTC derivatives are now centrally cleared, and for those that are not, it prescribes that stakeholders apply rigorous risk-mitigation measures. EMIR formally came into effect in August 2012, but putting into practice its provisions has only taken off recently.
Among other things, EMIR has been advertised as a piece of legislation that will encourage greater competition among clearers as it moves more asset classes to clearing. It was devised with greater safety in financial markets in mind, reducing systemic and other risks inherent in the sector. However, it has been criticized for being much too complex and burdening financial-market players with requirements that could eventually lead to higher prices for services stemming from increased investments in data management, made necessary by the trade-reporting provision.
Under the regulation, any business that conducts trade in derivative instruments, regardless of sector, has to report it to a trade repository, which, like central counterparties, needs to get authorization from the European Securities and Markets Authority, the body in charge of implementing EMIR. So far ESMA has authorized six trade repositories whose job it is to reconcile trades that are reported by all parties taking part in them. To do this efficiently, the watchdog has come up with unique trade identifiers (UTIs) and legal entity identifiers (LEIs), helping TRs match reports on a trade. According to TRs themselves, however, things are far from working properly, months after the official launch of trade reporting on 12 February.
One of the TRs approved by ESMA, ICE Trade Vault Europe, said recently that on the first day of trade reporting alone, it processed some 4.5 million trades involving more than 300 participants from a wide range of industries. Such numbers are certainly impressive and illustrate the problems repositories and clearers face. The situation is made worse by imperfections in the workings of the UTIs and LEIs. At a recent event organized by the Association of Corporate Treasurers in the UK, trade-repository representatives complained that the level of trade reconciliation was very low due to significant confusion over UTIs, resulting in trade counterparties sending their reports to different repositories than the ones to which they were meant to be sent. Part of the problem, say TRs, is that they did not have enough time to arrange their operations in a way that would include non-financial entities. ESMA informed them that the regulation would concern all business enterprises, not just financial ones, only in the middle of 2013. Another part is the overall lack of readiness among businesses themselves, particularly non-financial enterprises that have so far left it all to their banks and the trade repositories. In other words, ESMA has poured a flood of requirements on all market participants without giving them sufficient time to adjust to the new situation. According to critics, it has also failed to provide them with usable practical guidelines on how these requirements should be complied with.
It seems that under the smooth surface, EMIR is ridden with serious problems. To stay on the subject of identifiers, ESMA stipulates in the regulation that all trade counterparties need first a LEI and then a UTI. Though they should have registered for LEIs long before 12 February, many of the financial-market participants failed to do so, unaware that they had to. It is still unclear how many enterprises need such an identification number. As of mid-March, 200,000 legal entities had registered for LEIs, and the total number could reach a six-digit figure. Further complicating matters, ESMA did not make clear which counterparty will be the one to generate the UTI, leaving it to market participants themselves. This led to a lot of confusion, making it impossible for repositories to match trades. Currently, TRs are working with ESMA to find a solution to the problem.
The inclusion of non-financial entities in the derivative trade-reporting regime is also a complicating factor, simply because it considerably raises the number of market participants. Compared with the number of TRs so far authorized, which is six, a picture emerges of tonnes of data that needs to be matched and reconciled on a daily basis. At the same time, however, having more than one trade repository opens the door to a whole new kind of problem, and it has to do with the communication and collaboration among trade repositories themselves. This is especially problematic in view of the requirement that both counterparties in a deal have to report it. More data to process, more data to match. Although EMIR allows for delegated reporting, where one counterparty delegates its reporting responsibility to the other, it still remains with the responsibility for the accuracy of this reporting.
Data is at the heart of the regulation. Watchdogs around Europe want to keep a close eye on trade data in order to be able to track developments in the derivatives market, identify trends and potential risks, and be able to act in a timely manner to prevent a recurrence of the crisis. However, analysts widely share the opinion that quite a bit of time will pass before things settle down, and the data is in such a form and quantity as to make actual sense for regulators. After all, if one trade repository registers millions of trades a day, then for all six of them the figure will be tens of millions, potentially even more. This is an enormous amount of data that has to be as reliable as possible and harmonized with the technical standards that ESMA has compiled. Then it has to make sense of it, and how it will do this is still vague. Based on the time it took for Dodd-Frank trade reporting to bed down, which was around a year, for Europe a longer period will be necessary in view of the greater complexity of requirements and the larger number of trade repositories.
There are headaches related to CCPs, too. Perhaps the major issue market-players are facing is collateral management. It is one thing to only post collateral with one clearing house, and quite another to have to manage it across different ones, which have different margin requirements. This has prompted suggestions that as a whole, the need for collateral will increase across the market, and firms will have to juggle with different initial margins and lower-threshold variation margins. What’s more, not all CCPs clear all sorts of trades, i.e., not all trades are fungible from CCP to CCP. This raises the question of to what extent the competition among clearers that ESMA says EMIR will encourage will be effective.
One thing that critics and defenders agree on is that the legislation will bring greater transparency in a market that was until now unregulated. Transparency should reduce systemic risk and help watchdogs identify any early signs of such risk arising. At the same time, however, operational risk is prone to increase, according to some critics. There also remains the question of how the data that regulators receive from the derivatives market will be put to actual use, but the answer lies in the future. Suspicion and doubt are a normal reaction to a change that aims to completely transform how a certain activity is carried out, in this case trade in financial instruments. Finding the balance between compliance and optimal resource use is bound to take time, but hopefully the market will emerge from the initial chaos more solid and safer for all parties concerned.
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