The 2,000 page Dodd-Frank Act is the US government’s response to the financial crisis. While it was signed into law well over a year ago, the finer points are still being negotiated, clarified by lawyers, and challenged by Wall Street players.
For energy and commodity firms operating in Europe, this is a cautionary tale – the European Union (EU) is introducing an alphabet soup of directives and legislation affecting the financial and commodity markets including the Regulation of Energy Market Integrity and Transparency (REMIT), the Market Abuse Directive (MAD), the second Market in Financial Instruments Directive (MiFID II), the European Market Infrastructure Regulation (EMIR), and the Capital Requirements Directive (CRD).
The EU’s objective is to have all legislation in force by the end of 2013. The exact provisions aren’t fully baked, but it’s clear that all companies trading over-the-counter derivatives will be impacted across the whole value chain from front office sales through to back office reporting and all points in between.
Not sure how to prepare your company for the impending regulatory avalanche? Mike Zadoroznyj, Triple Point’s Vice President, Treasury and Regulatory Compliance, has written an article for FX-MM magazine about what you need to do in order to ensure that your systems are compliant. Read it now
Research and consultancy firm, Finadium, published an interesting report last week on the challenges that new regulations (MiFID and Dodd-Frank) are set to bring collateral management for OTC trading. The report highlights how dramatic the changes are going to be, and according to the market participants they interviewed, how technology is the only viable solution to effectively manage collateral in a post regulation world.
MiFID and Dodd-Frank central clearing mandates are going to change OTC trading forever. The increase in cash collateral requirements and daily margin calls will have a large impact. According to a recent Bloomberg article the cost of central clearing could setback Europe’s electricity market by up to $93bn.
While decreasing counterparty credit risk, central clearing will bring huge operational risk. Daily margin calls will make position and liquidity management impossible on a manual basis. Additionally, firms with non-standard trades that cannot be centrally cleared, or who are exempt from clearing, need to manage a ‘mixed’ collateral environment which only adds to the complexity and need for automation.
Effective collateral management needs to become a key feature in pre-trade decision making, where costs of collateral may affect where, whether and how to engage in a trade. So, not only is effective collateral management required from an operational point of view but it will be vital to drive the best trading decisions.
In its conclusion the report highlights that the majority of participants have started to look for collateral management solutions now, rather than wait until the regulations have taken effect. Have you started to think about this? With changes this far reaching can you afford not to?
The full report can be downloaded from here: www.omgeo.com/reportswhitepapers
The sweeping Dodd-Frank Act changes in the US for market participant classification, clearing, and margining are being closely watched and emulated internationally. The dangers/opportunities between national regulations, adoption, and timelines can be significant.
In September of last year, the European Commission proposed a framework to regulate OTC derivatives, central clearing counterparties, and trade repositories. In December, the Commission also published a consultation paper on the Markets in Financial Instruments Directive (MiFID) to “improve the regulation, functioning and transparency of the financial and commodity markets to address excessive commodity price volatility.” In a joint statement from EU Commissioner, Michel Barnier and CFTC Chairman, Gary Gensler, Barnier stated, “It’s essential –across the board on all financial regulation–that the United States and Europe move in parallel and that we don’t create new space for regulatory arbitrage.”
It still remains to be seen how significant the differences will evolve, and which countries and companies will be most affected or take the most advantage (China stands out as a likely recipient of business fleeing costly or time-consuming regulations.) Below is a table with some of the key similarities/differences. Also of note is that some of the regulations at the bottom that are US-centric may be applied to US-listed companies or those operating in the US (e.g. Canada.)
|Clearing||Mandatory for standardised OTC contracts (unless end-user exempted)||X||X|
|Hedging for non-financial entities||X||X|
|Uncleared swaps to SDR (US) or trade repository (EU)||All|| Specified
|Volker Rule||Prohibiting bank proprietary trading||X|
|Swap Push Out||Banks to establish separate trading entity (“too big to fail”)||X|
|Timeline||Deadlines for most major provisions to be published||9/2011||12/2012|
|Regulatory bodies that are responsible for enforcement|| Many
|Reporting on payments to non-US governments (provinces and municipalities)||X|
|Executive compensation drawbacks||X|
|Companies operating mines in the US||X|
|Up to 30% >$1M in damages||X|
|Independent review of minerals being conflict free (e.g. Congo)||X|
Although in its early stages, European Financial Reform is rapidly developing. There are challenges unique to the European Union in terms of jurisdictional complexity that make Dodd-Frank look like a stroll in the park. Providing regulatory oversight without stepping on nationalist toes will be some trick indeed.
In spite of the obvious obstacles, the EU is moving forward. In December the European Parliament moved legislation that created the European Systemic Risk Board. The ESRB is part of the European System of Financial Supervision (ESFS), the purpose of which is to ensure the supervision of the Union’s financial system. The ESRB closely resembles the Financial Stability Oversight Council, which was created by the Dodd-Frank Act. It will be responsible for the macro-prudential oversight of the financial system within the EU in order to assist in the prevention or mitigation of systemic risks to financial stability in the EU.
This month, the European Parliament established three new European Supervisory Authorities: the European Banking Authority, the European Securities and Markets Authority, and the European Insurance and Occupational Pensions Authority. These are the guys that will be setting the technical standards for financial institutions. They will work very closely with the ESRB in laying the groundwork for the new regulatory policies. One key stipulation that the ESAs must abide by is that they must ensure that no decision impinges on the fiscal responsibilities of EU member states. I can see situations arising where a national interest and a rule issued by an ESA may be at odds. One wonders what the reconciliation process will be like.
In order for these newly established entities to be effective the EU will need to come up with joint data standards. Data standards across national supervisory bodies have long been considered a kind of Achilles’ heel for the EU. With 27 member states, it will be interesting to see how the data standards develop – I can’t get my family to agree on lunch.
What About Derivatives?
Regarding the regulation of derivatives we see the European Commission proposing rules similar to those seen in Title VII of Dodd-Frank. Through the MiFID (Markets in Financial Instruments Directive) revision proposals we see the central themes of greater transparency, central clearing and reduced operational risk clearly taking shape.
European entities will be subject to mandatory reporting of OTC derivative trades to central data centers. Very much like its US counterpart, the Swap Data Repository, the trade repository will collect position information by derivative class and publicly disseminate the information. It will be the responsibility of the European Securities and Markets Authority to govern these repositories.
Very much like in Dodd-Frank, over-the-counter derivatives that can be cleared must be cleared through central counterparties. Eligible transactions will include those that are standardized or that possess a high level of liquidity.
The European Commission’s proposal strongly promotes the use of electronic means for the timely confirmation of the terms of OTC derivatives contracts as a means of reducing operational risk. Entities should develop and maintain an organizational structure, internal controls and a reporting system suitable for the identification, assessment, control and monitoring of operational risks in market-related activities.
Prompted by the 2009 G-20 agreement that stated – “all standard OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end-2012 at the latest”, the European Commission has made it clear that it intends to stick to that time frame.
We will be watching these developments very closely.