ESMA Wants to Hear From You
By George Bollenbacher, Capital Markets Advisors
Originally published on TABB Forum
The European Securities and Markets Authority laid out its views on the future of the European markets in two papers totaling more than 800 pages. But the regulator has more questions than answers. Here are some of the key points on critical derivatives issues, including safeguarding client assets, best execution, and sponsored access.
On May 22, ESMA published two documents, totaling more than 800 pages, on the next steps in the MiFID journey. One is the Consultation Paper on MiFID/MiFIR Technical Advice; the other is a Discussion Paper on MiFID/MiFIR draft RTS/ITS. Together, they lay out ESMA’s views on the future of markets in Europe, so they are pretty much required summer reading. In addition, ESMA specifically solicits comments on the both papers by Aug. 1. That deadline has already caused some public comment.
According to the introduction, the discussion paper “seeks stakeholders’ views on key elements of future ESMA technical standards. On the basis of responses and feedback received, ESMA will prepare a subsequent Consultation Paper that will include the draft technical standards for submission to the Commission.” Meanwhile, the purpose of the consultation paper is “to consult interested parties for the purpose of producing its technical advice to the Commission.” Perhaps the regulator could have served both purposes in one document, but it chose to issue two.
Given my particular interest in derivatives reform, I’ll be concentrating on that aspect of the two documents. There is, however, much more to them, including subjects such as HFT, research conflicts of interest and something ESMA calls microstructure. But let’s dig into the derivatives aspects of these documents.
Safeguarding Client Assets
In light of the recent collapse of two clearing firms in the US, we can start with the consultation paper’s section on safeguarding of client assets (p.52). According to the paper:
“ESMA proposes introducing additional requirements in respect of both client instruments and client funds. ESMA is proposing that firms should have proper and specific governance in place to ensure the safeguarding of client assets. More specifically, ESMA proposes addressing concerns around inappropriate lending of, and liens over client assets; and restricting any inappropriate activity in this area; increasing disclosure to clients; and addressing, through diversification, the contagion risk to client funds that occurs when held exclusively in group banks.”
One area of concentration is title transfer collateral arrangements (TTCA), which is the ESMA language for rehypothecation. It says:
“In order to mitigate the risk of blanket use of TTCA that amounts to bypassing the safeguarding requirements required by MiFID II, one measure could be to require investment firms to consider and to be able to demonstrate the appropriateness of any TTCA …; they should not be able to rely on TTCA as a means of bypassing MiFID safeguarding requirements. Under such a measure, firms may still make use of TTCA, provided that they have considered and are able to demonstrate the appropriateness of TTCA.”
Thus it looks like ESMA may be contemplating a more active role in administering the segregation of client assets, much like the CFTC has done. (By the way, safeguarding customer assets was also a major subject of discussion in the recent meeting of the CFTC’s Global Markets Advisory Committee.)
The consultation document has an entire section on best execution, starting with the MiFID II blanket statement:
“Member States shall require that investment firms take all sufficient steps to obtain, when executing orders, the best possible result for their clients taking into account price, costs, speed, likelihood of execution and settlement, size, nature or any other consideration relevant to the execution of the order.”(p.150)
That statement either assumes that every transaction is being done as agent, or it requires that principal transactions be done at the “best possible result” for the customer. If the latter, that will be a significant change in the markets, assuming one could determine the “best possible result” for the customer at any point in time.
In its discussion, the consultation document says:
“Adequate disclosure of appropriate information, both prior to the provision of services and on request by a client, is a key element of the best execution obligation. … This principle applies equally to firms that execute orders directly and to those that receive and transmit or place orders for execution by another entity.”
So this looks somewhat similar to the notorious midmark requirement in the CFTC’s external business conduct rule. In addition, ESMA appears to be planning to require disclosure of “third party payments” – i.e., rebates from trading venues to executing brokers.
Exchange Trading for Derivatives
The discussion paper is much more specific about derivatives than the consultation document; for example, in the section on “The Trading Obligation for Derivatives” (p.185). In describing the process of mandating exchange trading for swap classes, the document says:
“The trading obligation process will not require the generation of general technical standards. Instead, ESMA will mostly respond to decisions taken under the clearing obligation. In effect, ESMA will have gained a new, long term task to be conducted on a routine basis.”
The process of requiring exchange trading of derivatives is set out in Section 32 of MiFIR, and the discussion document specifies that:
“Whether or not a class (or sub-class) of derivatives should be made subject to the trading obligation will be determined by two main factors:
- The Venue Test. Whether a class or sub-class is admitted to trading on a venue.
- The Liquidity Test. Whether they are also ‘sufficiently liquid’ and there is sufficient third party buying and selling interest (in ESMA’s view, any ‘sufficiently liquid’ class or sub-class will also have sufficient third party buying and selling interest, and this would be taken into account as part of any liquidity assessment).
“This means that before being considered for the trading obligation, any class (or sub-class) must not only be subject to the clearing obligation but must be traded on at least one trading venue and be considered sufficiently liquid to trade only ‘on venue.’ ”
Perhaps the most relevant implication of this section is the possibility that the trading obligation criteria may be different between the US and the EU. In particular, will the US liquidity test be more or less stringent that the EU one? And if they are, and it results in a product being MAT in the US but not obligated in the EU (or vice versa), is the same arrangement as in clearing (strictest rule applies) in effect here? Do you want to comment on that?
Direct/Sponsored Market Access
The consultation paper has a section on direct electronic access (DEA), which appears to be equivalent to sponsored access in the US (p.235). MiFID II defines DEA as an “arrangement where a member or participant or client of a trading venue permits a person to use its trading code so the person can electronically transmit orders relating to a financial instrument directly to the trading venue.” Although DEA may not be much of an issue currently, it is likely to become one as listed trading of swaps expands and matures. In particular, as we see the CFTC’s rule on recordkeeping by exchange members evolving, SEF membership may not be attractive for large end users, as many have already said.
Here ESMA provides more questions than answers in the document. Such as:
“Given that [automated order routing] AOR arrangements and DEA might pose the same risks to the markets ESMA requests the views of market participants on whether it would be appropriate to consider AOR as falling within the DEA definition.
“Additionally, ESMA requests the views of market participants about how to further clarify the definition of DEA (and as a consequence, those of DMA and SA) to capture all types of arrangements that might meet this definition.
“ESMA is interested to know the views of market participants on whether it may be possible to use [electronic order transmission] interfaces to perform algorithmic or high frequency trading strategies.”
So ESMA has lots of questions, and most of them are substantive. Anyone who trades, or plans to trade, in EU markets needs to read and respond. So pour a fresh cup of coffee, find a comfy chair, and get to it.