MiFID moves

European CDS regulations scrutinised

The extension of the Markets in Financial Instruments Directive (MiFID) to OTC products has sparked concern over transparency and reporting in the European CDS market. At the same time, other regulatory moves – including the implications of organised trading facilities (OTFs) – are under scrutiny by the end-user community.

The key issues in organised derivatives trading focus on the split between European and US approaches and models, according to Adam Jacobs, assistant director of European policy at ISDA. “Whereas Europe’s new category has been introduced in the form of organised trading facility, US policymakers are grappling with the concept of swap execution facilities. In both cases, there are questions of scope and design, as well as the matter of what the requirements mean for existing trading models,” he explains.

He adds: “If you’re going to talk about trading venues, you also need to take into account what’s happening in the post-trade environment. In Europe, the European Market Infrastructure Regulation (EMIR) will greatly enhance the role of CCPs and trade repositories. On all these issues, it is worth considering the differences between the US and the EU – both in terms of how markets work and the rules that have been proposed.”

Both the US and the European authorities started from the common position of the G20 commitments. But, so far, they have taken a divergent approach in how they implement the arrangements.In the US, the CFTC and the SEC have detailed exactly what the trading model should be. Roger Barton, founder of Financial Reform Consultants, explains that the two agencies have virtually stipulated that for any trades other than block trades execution is required to be electronic.

“In Europe, the situation is less clear and a lot will depend on what the definition of an OTF is. The European Commission has clearly indicated that it does not intend to prescribe the precise trading model that must be followed – provided it meets requirements, such as transparency and multilaterality,” he continues.

But Scott Fitzpatrick, global head of sales at GFI Group, argues that the EC is attempting to preserve the current diversity of the existing. “If we take the definition of OTF as it stands in the Commission’s MiFID Consultation Paper, then I think it’s fair to say that – whereas the intention is to bring more regulatory control to the execution of OTC derivatives – there has been a concerted effort under this definition to enable all execution methods to be preserved, with the caveat that where possible electronic execution should be encouraged. Is this feasible? I and the other WMBA member firms would argue: yes, it is.”

Increasing post-trade transparency, meanwhile, is another regulatory goal in both the US and Europe. The US requirements indicate that trade details will be made public within very short periods, aside from block trades, which will have a fifteen-minute delay.

While Barton believes post-trade transparency will increase in Europe, he doubts it will be as demanding as in the US, however. “The big question in Europe at present seems to be whether EMIR should apply not just to OTC derivatives, but listed derivatives too. If so, the effects could be very far reaching.”

John Wilson, former global head of OTC clearing at RBS, suggests that national interests are being keenly fought over in the discussions about widening the scope of EMIR. “What we’re being shaped by is not necessarily a pragmatic sensible approach; it’s about horse trading between countries. So don’t be surprised to see some odd rules coming out of all of this – after all, the rules of the road are being written by people who’ve not necessarily sat in a car or been on the road,” he says.

The pre- and post-trade transparency requirements are also expected to dramatically change risk appetites, as banks will be reluctant to take on inventory risk for large positions as they will quickly have to make public the trade they’ve taken on their book. This could result in banks refraining to trade in size and instead offering to work the orders for their client, who can no longer get immediacy and has to bear the inventory/market impact risk.

Indeed, bank business models are fundamentally changing, driven by the division of sales and trading functions. “Today, the sales and trading teams are working together. But going forward it won’t be like that, as the sales guys will have to show the trade to a SEF/MTF; as a result, traders will become price makers or price takers versus the SEF,” Wilson notes.

He suspects that many SEFs will launch in the coming months, whose number will inevitably dwindle over the years. But, in the meantime, the fragmentation of liquidity will have a devastating effect on many end-users and on transparency. “The only person who succeeds in the fragmentation of liquidity is the dealer.”

Clearing is ultimately anticipated to act as a leveller of these competing interests, albeit some interesting nuances are already kicking in. Wilson cites as an example SwapClear, where – providing it is possible to map out the cashflows – trades can be cleared without needing standardised items like start and end dates. “Clearing does not necessarily demand homogeneous products, but this is almost essential for a trading venue,” he adds.

Benjamin Schiessle, head of CDS risk management at LCH.Clearnet, points out that market discipline around illiquid off-the-run names should improve, thanks to CCP users having to agree on valuations on which margin calls are based. A separate benefit is that CCPs protect against possible P&L impacts and ensure the continuity of users’ risk profiles.

Another advantage that CCPs bring is that the gap between gross and net notional CDS outstandings will decrease, notes Michael Hampden-Turner, director in Citi’s credit strategy group. This would create significant efficiencies in terms of netting.

Hampden-Turner adds that the effect of commoditisation and standardisation that CCPs have on CDS contracts is already being seen in terms of a shift in trading patterns and a greater number of participants entering the market. But he points out that a bifurcation between liquid and non-liquid contracts is likely as a result.

“A small number of contracts will become more liquid based on their simplicity and cheapness, which in turn will encourage a greater number of participants to enter the market. Market makers will in turn benefit from the increase in trades, albeit at a lower margin,” Hampden-Turner explains.

He adds: “The less liquid names will be harder to trade, but most of them are a legacy of the synthetic CDO market so it makes sense. By 2013 the sector is expected to shrink to half of its size at the peak of the market.”

Nevertheless, BlueMountain Europe ceo Jeffrey Kushner says he’d like to see more off-the-run names being cleared by CCPs, as well as CDX tranches. “The CDX and iTraxx indices in the US and Europe account for approximately 500 names, but restricting clearing to just these names will significantly decrease liquidity in a large universe of names that would not be cleared. This is largely due to the fact that we anticipate that non-cleared transactions will attract materially higher capital charges.”

A number of other issues also need to be resolved in respect of CCPs. Governance is one such issue, according to Kushner.

“I’m concerned about what say buy-side participants will have in the running of CCPs,” he explains. “The buy-side is represented in bilateral CDS contracts; for example, in the constitution of ISDA’s Determinations Committees. It would be an unacceptable step backwards for investors to not have similar input to a CCP around credit events, including restructuring and succession.”

Another issue is segregation of client accounts, Kushner adds. “It’s unclear whether CCPs are offering true segregation or omnibus segregation, which could make client assets subject to the failing of others. It’s important to define what rights non-contributors to a CCP’s guarantee fund will have.”

Josh Danziger, founding principal of Valere Capital Partners, concurs that many CCP-related issues still need to be ironed out by the industry. For example, during the crisis access to cash was critical, so any increase in initial margins during times of stress is pro-cyclical. The need to fund initial margin could exacerbate other pressures in the market, such as the increased concern over rehypothecation and the Basel 3 rules on liquidity.

In addition, Danziger suggests that CCPs carry their own counterparty risk. “CCPs aren’t immune from failure and so I wouldn’t be surprised to see, for example, ‘CCP A’ ultimately listing CDS on ‘CCP B’,” he concludes.


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