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With the imminent announcement of new MiFID II rules, Cleartrade Exchange CEO, Richard Baker, gives his view on how best to prepare and what role exchanges can play in adapting to the new trading landscape.
The last 2 years have seen a flurry of drafts and technical specs on MiFID II and MiFIR being put together by the ESMA colleges and various consultations by the industry. At the time of writing, I personally think that we are now at that ‘tipping point’ where the final drafts and specifications are going to be made public as we go into the final quarter of 2015. Whenever the results are published (which of course may well have happened by the time you read this), the fact remains that there are still important details which market participants and exchanges need to consider, and I have taken the opportunity to analyse some of these fundamentals as the industry embarks into a new MiFID II landscape.
So, within the short-term, what do we as an exchange and, most importantly, should our clients expect from MiFID II during the next 12 to 18 months? Soon we are going to be asked by the European regulators to begin our preparations for implementation, currently earmarked for January 2017. The primary question we need to ask ourselves now is “at what stage of readiness is the market for this change?” Personally, I think our market is about 85% ready. Whilst that is good progress, there is uncertainty in areas such as non-MTFs evolving to become new OTF venues, price transparency rules, pre-trade risk, hedging exemptions and trade reporting rules to name but a few hot topics. These, together with other issues, still remain to be addressed.
One of the most frequently discussed areas in the last few months has been hedging exemptions under MiFID II – particularly so, among large commodity houses or proprietary trading firms. This relates to how they can speculate or hedge, and has a large bearing on whether they are participating in a physically settled or cash settled contract. For example, if I’m trading a physically settled contract in energy, then most of the new MiFIR (MiFID II + EMIR) rules may not apply to me. This is because, within power and gas especially, REMIT regulations have had more of an influence in this market. A consequence of this carve-out is that under MiFID II, this will prompt the introduction of the OTF style of trading venue and a different way of capturing and reporting trades. With the introduction of OTF, the role of MTFs in Europe is seemingly under threat, because contracts listed on MTFs will be classified as OTC Derivatives and will indirectly generate a risk for traders under EMIR Clearing Threshold rules. In this regard, we anticipate challenges regarding how trading thresholds are calculated and asset classes defined which could potentially run the risk of lowering volumes instead of helping markets grow. Naturally, we all believe in managing systemic risk, but we certainly don’t believe in removing liquidity.
Let’s look at the blanket approach MiFID II has taken to trade reporting and mandatory clearing. As a result of the impending rules, most firms will have to become registered financial trading entities. From a CLTX perspective, the vast majority of our asset classes are not physically settled, but cash settled. Our customer base therefore will need to abide by the new rules. Our market will have to prepare itself by making sure firms are registered correctly and take steps to ensure they have clearing accounts at ESMA-approved clearing houses. Furthermore, they need to be in a position with trade identifiers (LEI’s) to report to Trade Repositories and ensure compliance.
New technology and processes are needed in order to meet these additional challenges. I believe this highlights customers’ needs for enhanced systems and reliable providers to ensure that they meet the incoming new rules. Having spoken with our own clients, I have found that it isn’t a case of them being scared or intimidated by the prospect of moving towards clearing and trade reporting. It is simply a matter of implementing the correct infrastructure and adapting to new situations.
It’s important to note that the effects of MiFID II are not just confined to Europe. There is also strong impact and consequence at a global level. It is no secret that there is a degree of speculation in Europe that MiFID II rules are harsh and that it will impact the status quo for firms wishing to continue trading. As a result, we are seeing a number of commodity houses and proprietary trading firms moving a large percentage – if not all – of their operations to Asia in an effort to avoid the constraints of the new regulation. Therefore, the issue of regulatory arbitrage remains.
The question is: how long does the issue of regulatory arbitrage exist from a geographical point of view? The main regulators in Asia have been tracking the implementation of MiFID II and the US’s CFTC rules with interest and have made a deliberate choice to trail it by no more than a year in order to see how Europe and the US harmonise this and work to find a common blueprint.
I think Asia has made a good decision by waiting, by allowing the new rules to ‘bed in’, following which it will make the task of providing harmony to the Asian markets much easier to implement.
We’ve seen this happen with the Monetary Authority of Singapore (MAS) in the first quarter of 2015. They created MiFID I equivalence between Singapore and Europe in the understanding and naming of exchanges and venues which will have equal status across the two territories. The degree of uncertainly and doubt in the market as a whole surrounding MiFID II is clear. Many will search for a safe haven through so-called regulatory arbitrage. However, I believe this could be a false jump as the arbitrage may well not exist for too long.
For technology providers and compliance consultants there should be new business ahead, I expect to see a number of new venue types to appear in Europe in the form of OTFs from 2016 onwards with mid to large size broker firms registering themselves as OTFs. The old days of being very casual about how you report on your voice trading is also changing, already implemented in the US, voice systems will be subject to stricter voice recording and surveillance rules and pre-trade transparency may be therefore better fulfilled in combination with electronic trading. This will introduce a level of formality and structure into the market and therefore provides certainty and security for customers where increased levels of regulator scrutiny will play a major part.
In addition, there are new rules coming under MiFID II including sponsored Direct Market Access (DMA). This is how a trading firm in one country can enter via a trading system and gain access to an overseas exchange. There are some significant implications for exchanges in terms of supporting the sponsored DMA rules. Off the back of recent flash-crashes and concerns around High Frequency Trading (HFT), the obligations through sponsored DMA are robust and have increased the liability of the trading venues quite significantly. These obligations include; having to run a parallel system 24/7 so those using DMA can test their order routing; order access; test robustness of systems and test order types to make sure they know how it will work.
Whilst we have focused on MiFID II so far, we cannot ignore EMIR. The role of futures contracts has become more important in light of new clearing house thresholds under EMIR. Let’s expand on the example I made earlier. In Europe, if I’m trading an on-exchange future, there is a strong benefit for me as a client because a future will keep me out of clearing threshold rules. However, if I’m trading on an OTF or MTF, the contract is deemed an OTC Derivative and therefore subject to EMIR clearing threshold rules. To be clear, in Energy commodities there is a 5bn euro notional value and if my overall book value (all products) exceeds that, I am mandated to clear my entire book at a clearing house within 30 days. Quite simply, the margin call on that mandate would bankrupt most businesses.
In conclusion, I firmly believe that the outlook is not all ‘doom and gloom’. To reiterate, despite a widely held perception (to the contrary), market participants are in fact more prepared than they probably realise. This is as a direct result of the steps taken by many to move towards clearing cash settled products and away from OTC instruments back in 2007-9. Our market participants have already taken some very big steps, and now it’s about becoming registered and understanding some of the technical specifications. But ultimately, there is an onus on us, as an exchange, to help clients navigate the next 12–18 months and make sure that their transition into this new phase is as easy and seamless as possible. This is a responsibility that we are fully committed to.
