WRITTEN BY KATERINA CHRISTO

This year’s Annual General Meeting of the International Swaps and Derivatives Association (ISDA) in Tokyo discussed a number of topics around future challenges in the financial services industry. One of the concerns identified was the possible divide between the European and U.S. derivatives market, following a revision of the Markets in Financial Instruments Directive (MiFID II). The new provision requires a sub-section of over-the-counter (OTC) contracts to be traded exclusively on EU trading platforms, similar to the Swap Execution Facility (SEF) regime rolled out in the U.S. in 2013 requiring the sole use of U.S. trading platforms.[1]  By drawing parallels to the U.S. regime, the EU’s intention is to achieve an elevated level of global harmonisation. However, if this is not attained, there is a risk of reduced trading activity in markets where regulations have made doing business less profitable and more complicated than in others, invariably leading to a fragmented derivatives market and less transparency overall. With MiFID II expected to be implemented in 2018, two years later than intended, what can we expect to occur in the short and long-term?

Case Study – MiFID II how does this apply?

It is well documented that a major contributing factor to the 2008 crash was the lack of transparency surrounding trading agreements. One of the main objectives of the new MiFID II regulation requirement is to increase market transparency to avoid a repeat of the 2008 financial crisis.

The new directive stipulates for, among other things:

- Thresholds for the pre-trade and post-trade transparency regimes extended to equity-like instruments, bonds, derivatives, structured finance products and emission allowances;

- Trading obligations for certain derivatives to be traded only on regulated platforms instead of over-the-counter; a double volume cap mechanism to limit dark trading and reshape the use of waivers for shares and equity-like instruments;

- New reporting requirements for commodity derivatives.[2]

Having a greater degree of transparency in the market is key for managing and identifying risk, preventing market perversion, and ensuring there is accountability for market corruption. In theory, transparency within the market is required to minimise risk, but the worry is whether the regulation will manage to effectively achieve this objective and do so within a reasonable time frame.

Regulatory action – it’s not all good news

The application and embedding of regulations such as MiFID II, EMIR and Dodd-Frank will initially prove problematic for financial institutions as they impose new requirements, for example, trade reporting. As banks adjust to these new requirements, trading volumes are expected to temporarily decrease as capacity is siphoned from the business into implementing programs to comply with regulations. Despite the long-term benefits of these regulations, such as increased transparency, the disrupted trading activity will hinder commercial activity and, in turn, profitability.

Another concern is the cost incurred by the banks as a result of implementing these requirements. By way of example, the Financial Services Authority (FSA) found that MiFID cost financial institutions a total of more than £75 million to implement.[3] These costs, combined with reduced trading activity, will cut into banks’ profitability in the short term. If the U.S. and the EU fail to closely align their laws, financial institutions will engage in regulatory arbitrage to ensure the impact to their profits are as minimal as possible. It is clear, therefore, that a common standard should be established to maintain fluidity in the derivatives market and healthy trading activity.

Although in the short-term implementing these changes may be costly, in the long-term markets will be more transparent and efficient. If the EU and the U.S. can agree on a set of Regulatory Technical Standards (RTS’s) acknowledging the similarities in their policies then, there is hope for trading platform harmonization. Subsequently, the industry will benefit from enhanced trade liquidity, increased market transparency and reduced risk.

Conclusion – So what does mean for the banks?

What is the future for cross-border regulation? According to ISDA, the CFTC should consider a jurisdiction by-jurisdiction approach to determining comparability of the regulation of foreign trading venues.[4]  If the U.S and EU recognise each other’s trading platforms, we can expect trading activity to be restricted in the short-term, and to operate more efficiently in the long run.

Although it may be a protracted process, the regulations’ successful employment will result in a greater degree of market transparency and consequently in a reduction of risk to the banks. Regulators should cooperate effectively to develop trading rules and establish clear and comprehensive regimes to facilitate mutual recognition.[5] As the MiFID II directive is still subject to change, the banks should look to the SEF as a guideline for determining best practices.

There will be provisions to comply with, processes to be completed and a greater need for consultancy firms to help with the implementation and remediation. What is certain is that we still have a long way to go before the directive comes into full effect.

[1] http://www2.isda.org/news/isda-publishes-principles-for-useu-trading-platform-recognition

[2] https://www.esma.europa.eu/policy-rules/mifid-ii-and-mifir

[3] http://www.fsa.gov.uk/pubs/international/mifid_cost_survey.pdf

[4] Principles for US-EU Trading Platform Recognition, www.isda.org (February: 2016)

[5] Principles for US-EU Trading Platform Recognition, www.isda.org (February: 2016)