News analysis: Will MiFID II breakdown the silos that survived EMIR?

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18 October 2011

The European markets infrastructure regulation (EMIR) has failed to introduce price-based competition between derivatives clearing houses. But all is not lost. MiFID II may offer a second chance, finds Dan Barnes.

The victory that George Osborne claimed for the UK in negotiating details of the European markets infrastructure regulation (EMIR) on 4 October, was a partial victory.

EMIR contains the proposed legislative guidelines for central clearing and risk mitigation for OTC derivatives, the framework for central counterparty (CCP) operation and rules on post-trade interoperability, reporting obligations and the requirements for trade repositories.

It was conceived to support the objectives that the G20 countries set out in 2009 at their Pittsburgh summit; “All standardised 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. OTC derivative contracts should be reported to trade repositories. Non-centrally cleared contracts should be subject to higher capital requirements.”

The scope of derivatives that would be dealt with by EMIR has been the subject of furious debate, with the UK supporting its application to all derivatives and Germany arguing to restrict the scope to OTC derivatives as mandated by the G20. Behind this jousting is the issue of competition between exchanges and clearing firms.

Germany’s Deutsche Boerse is a dominant force in European derivatives; its Eurex platform is estimated by the Futures Industry Association to account for 58% of European exchange-traded derivatives contracts traded by volume in the period January to October. NYSE Euronext’s market are the second largest with a 33% share by volume.

Eurex’s dominance relies on its success in producing derivatives over which it has complete control. Deutsche Boerse operates the Eurex Exchange and Eurex Clearing which function together within a silo; the exchange traded derivatives that Eurex originates, such as the market-leading blue-chip EURO STOXX 50 index are traded and cleared within its four walls, allowing Eurex to reap all of the benefits of its products’ success.

For proprietary exchange-traded derivatives, such as Eurex’s EURO STOXX 50, to be cleared by other CCPs would require the owner-exchange to provide its access to its feed for the derivatives trade data to other CCPs.

Other CCPs could potentially undercut an exchange’s own CCP on price, making ownership of a CCP less enticing as rivals could offer lower fees. Likewise if other venues had fair access to the exchange’s CCP at equal pricing levels to the exchange, there would arguably be less economic benefit in retaining the clearing house as rival venues could offer lower trading fees and the same clearing costs, while the exchange would be paying the CCP’s support costs.

Excess access

The German finance ministry has argued against open access claiming it presupposes interoperability between clearinghouses i.e. that if a trade were passed by a siloed exchange to its clearing house and another was preferred by the trading firm, the first CCP would have to pass the trade on to the second. That would require new margin and collateral provisions to be established and EMIR has specifically deferred the establishment of any such provisions until a study by ESMA on the subject has been completed in 2013.

Osborne has argued for open access to prevent the creation of a “market infrastructure that was not open to all market participants, contradictory to the principles of the single market.” Deutsche Boerse’s proposed merger with NYSE Euronext adds weight to his concerns over the dominance that such an infrastructure could have.

As it stands, EMIR will apply the obligation to give access to standardised OTC contracts such as interest rate swaps (IRSs) and credit default swaps (CDSs), but not exchange-traded derivatives. But this does not mean that open access is now off the cards.

Small victories

Osborne successfully made two amendments to the draft legislation. Firstly, that if the European Securities and Markets Authority (ESMA), the pan-European regulator, turned down the authorisation of a central counterparty (CCP), national regulators should able to ask for a review of the decision, giving more leeway to the process. Secondly, he successfully argued for the reinstatement of Article 8a.

Article 8a says that CCPs must be given free and fair access to trade data feeds from venues on which over-the-counter (OTC) derivatives trades are exchanged. It had been removed in earlier negotiations, under consideration of the German view on access presupposing interoperability. In theory it will allow independent CCPs to compete with CCPs that are tied to an exchange, but in practice this access provision is likely to be limited.

Under EMIR only derivatives not traded on a regulated market are defined as OTC; the rule therefore allows competition between CCPs clearing derivatives traded on organised trading facilities or multilateral trading facilities, but not those traded on exchanges.

In Europe the majority of IRSs are processed via SwapClear and the majority of CDSs through ICE Clear. Sources say that banks are unlikely to seek alternatives to their standing arrangements any time soon, so this is expected to have little direct effect.

But Article 8a’s inclusion is seen as potential leverage that can be used under the new MiFID regulation, or MiFIR, which includes a provision for venues to give access to CCPs in order to offer processing of their trades.

Now such a provision has been accepted within EMIR, there are those on the UK side of the debate who believe open access can be argued for more forcefully under MiFIR, which deals with all asset classes and will offer no distinction between one CCP or another.

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