Wednesday, December 08, 2010

European Commission Proposes Changes to MiFID to Require Exchange or Electronic Platform Trading of OTC Derivatives

As part of an overall reform of the Markets in Financial Instruments Directive, the European Commission proposes to require the trading of standardized and liquid OTC derivatives on exchanges or electronic trading platforms, or on a specific sub-regime of organized trading facilities to be defined by MiFID. This effort is part of a global initiative vetted by the G-20 to ensure that trading in standardized derivatives moves to exchanges or electronic trading platforms. The SEC and CFTC are currently setting up a similar regime for OTC derivatives in the US pursuant to the Dodd-Frank Act. These initiatives are designed to increase transparency, mitigate systemic risk, and protect against market abuse. The Commission envisions adopting the proposals in the first half of 2011.

In announcing the proposed revisions, Commissioner for the Internal Market Michel Barnier said that the original aim of this key piece of European legislation, MiFID, was to create a robust common regulatory framework for EU securities markets. In many ways, it has been a success. The goal of the proposed revision is to adapt the MiFID regulatory framework to the new trends and players on financial markets to provide greater market transparency and more investor protection.

The Commission said that exchange trading of OTC derivatives will bring additional benefits of competition, market oversight and price formation. While it is important to consider which different kinds of trading venues correspond to the G-20 characterization of exchanges and electronic trading platforms, noted the Commission, this focus on the outcome renders the issue slightly less relevant. Therefore, it is anticipated that,while different jurisdictions will continue to have diverging execution arrangements and requirements, they will make regulatory choices in favor of certain venues in accordance with internationally agreed upon principles, thereby minimizing the risk of regulatory arbitrage.

In addition, a recent European Parliament resolution on derivatives markets calls for as many eligible derivative products as possible to be traded on organized markets and for the provision of incentives that encourage the trading of eligible derivative products on trading venues regulated by MiFID, such as on regulated markets and multilateral trading facilities. The Resolution goes on to state that all financial derivatives that concern public finances in the EU, including sovereign debt of Members States, must be standardized and traded on an exchange or other regulated trading platforms in order to promote transparency of derivatives markets for the public.

The Commission specifically proposes that an OTC derivative can trade on an exchange, a multilateral trading facility, or a sub-regime of organized trading facilities. In order for a venue to qualify as a sub-regime for trading of OTC derivatives it would have to satisfy the general criteria for organized trading facilities. In addition, the venue would have to provide non-discriminatory multilateral access to its facility, support the application of pre- and post-trade transparency, report transaction data to trade repositories, and have dedicated systems or facilities in place for the execution of trades.

The Commission envisions a critical role in the derivatives regulatory regime for the new European Securities and Markets Authority (ESMA). The Commission proposes to allow ESMA to decide when a derivative which is eligible for clearing is sufficiently liquid to be traded exclusively on one of the organized venues. ESMA could base its decision on, for example, the frequency of trades in a given derivative and the average size of transactions.

As part of this process, ESMA would systematically also consider in which cases trading on exchanges or electronic trading platforms furthers the G-20 commitment to transparency and mitigation of systemic risk. This could be the case when, for example, there is an over-concentration of dealers in a specific derivative, a large-scale presence of buy-side investors in relation to sell-side participants in a given derivative, or when market oversight is shown to be hampered. The criteria for assessing sufficient liquidity and these other parameters would need to be specified at a subsequent stage.

With regard to transparency, the Commission proposes a new pre- and post-trade transparency regime for structured products and derivatives. Pre-trade transparency refers to the obligation to publish in real-time current orders and quotes, while post trade transparency refers to the obligation to publish a trade report every time a transaction in a share has been concluded.

The transparency regime would be properly calibrated to the class of financial instruments, such as bonds, structured finance products, or derivatives, and to the type of instrument, such as an option, swap, or forward. The transparency regime would be predicated on a system of thresholds and delays based on transaction size.

In order to minimize information asymmetries and improve pricing, the post-trade
transparency regime would be transaction-based. It would provide data on transactions in terms of price, volume, time of trade, and the main reference characteristics of the traded instrument rather than aggregate data.

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