Monday, October 24, 2011

European Commission Proposes Derivatives Regulatory Regime by Revising MiFID and Adopting EMIR

The European Commission has proposed a regulatory regime for derivatives under which all trading of derivatives which are eligible for clearing and which are sufficiently liquid will move to either regulated markets, multilateral trading facilities, or to new organized trading facilities. The Commission also proposes to give harmonized and comprehensive powers to financial regulators to monitor and intervene at any stage in trading activity in all commodity derivatives, including in the shape of position limits if there are concerns in terms of market integrity or orderly functioning of markets. Venues offering trading in commodity derivatives will also be required to adopt suitable limits on trading activity by traders active on their platform, to safeguard market integrity and efficiency, to be harmonized in implementing measures. The proposals applicable to other derivatives regarding increasing pre- and post-trade transparency and mandatory trading on organized venues will also apply to commodity derivatives.

The proposals will be effected through revision of the Markets in Financial Instruments Directive MiFID and adoption of a new European Markets Infrastructure Regulation (EMIR). The proposals now go to the European Parliament and the Council for negotiation and adoption. Once adopted, the Regulation and the Directive will apply together as of the same date.

Under the proposals, fewer commodity firms will be exempt from MiFID when they deal on their own account in financial instruments or provide investment services in commodity derivatives on an ancillary basis as part of their main business and when they are not subsidiaries of financial groups. It is proposed to narrow down existing exemptions in the interests of greater regulatory oversight and transparency, taking into account the need for continued exemptions for commercial firms and the risks posed by these players.

The Commission is acting through a Directive and a Regulation due to the need to achieve a uniform set of rules in some areas, while allowing for national specificities in others. The De Larosière report highlighted that one of the problems leading to the financial crisis was an inconsistent implementation of financial services rules leading to a fragmented internal market. The Commission believes that the harmonized approach embodied in the proposed Regulation will help avoid confusion in the daily functioning of markets, and minimize opportunities for harmful regulatory arbitrage between Member States.

The proposed Regulation sets out requirements on the disclosure of data on trading activity to the public and transaction data to regulators, the mandatory trading of derivatives on organized venues; removing barriers between trading venues and providers of clearing services to ensure more competition, and specific regulatory actions regarding financial instruments and positions in derivatives.

The Directive would amend existing provisions on authorization and organizational requirements for providers of investment services, and all rules regarding investor protection, including for firms located in third countries but actively engaged in EU markets. Also included in the Directive are the authorization and organizational rules applicable to different types of trading venue, providers of market data and other reporting services, as well as the complete powers to be granted by Member States to national authorities, including the framework of sanctions for breaches of the rules. These provisions are best situated in a Directive to account for differences in national markets and legal structures as well as the profile of local investors.

Like the Dodd-Frank Act, the revision of MiFID would both amend provisions already in force and add to them in light of the financial crisis and other market developments. The most visible area of common ground concerns the overhaul of the regulation of derivative markets, including commodity derivatives. In many areas, such as comprehensive regulation for professional participants in derivative markets and the regulation of alternative electronic exchanges, the changes in MiFID are less significant than those in the US, as similar provisions did not yet exist before the Dodd-Frank Act. In other areas, such as the regulation of commodity derivative markets, US regulation was more developed and the revision of MiFID allows Europe to catch up.

Currently the access of third country firms to the EU markets is not harmonized under MiFID. Each Member State can introduce its own third country regime, provided that national provisions do not result in treatment more favorable than that given to EU firms. In order to overcome the existing fragmentation and to ensure a level playing field in the EU for third country players, the Commission proposes to introduce a harmonized third country equivalence regime in MiFID for the access of third country investment firms and market operators to the EU.
A firm which is authorized in a third country will be able to provide services directly to professional investors on condition that the country where it is based is deemed by the Commission to have equivalent rules and supervision. Also, equivalence will be granted only if the third country provides access to EU-based firms on a reciprocal basis.

In order to be allowed to provide services to retail investors, the establishment of a branch is required. A third country firm will be able to provide services to investors in other European countries from its branch, provided that it notifies the regulators in those countries.

The proposals envision a significant role in the new regime for the European Securities and Markets Authority (ESMA). For example, ESMA will decide when a derivative which is eligible for clearing is sufficiently liquid to be traded exclusively on the various organized venues, such as regulated markets, MTFs or organized trading facilities. Appropriate criteria for such assessment will need to be taken into consideration by ESMA. Moreover, in coordination with ESMA and under defined circumstances, regulators will be able to ban specific products or services in case of threats to investor protection, financial stability or the orderly functioning of markets.

The proposals also foresee stronger regulation of commodity derivatives markets. It introduces a position reporting obligation by category of trader. This will help regulators and market participants to better assess the role of speculation in these markets. In addition, the Commission proposes to empower financial regulators to monitor and intervene at any stage in trading activity in all commodity derivatives, including in the shape of position limits if there are concerns about disorderly markets. The G-20 Summit in Cannes in early November will also address the issue of commodity derivatives

Building on a comprehensive set of rules already in place, the revised MiFID sets stricter requirements for portfolio management, investment advice and the offer of complex financial products such as structured products. In order to prevent potential conflicts of interest, independent advisors and portfolio managers will be prohibited from making or receiving third-party payments or other monetary gains. Finally, rules on corporate governance and managers' responsibility are introduced for all investment firms.

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