Europe has been less direct in its approach to migrating over-the-counter (OTC) derivatives onto exchange than the US – much to the frustration of some market participants – but harmonisation between the two regions is essential to ensure new rules can be enforced effectively.
Earlier this year, the US Congress mandated the creation of swap execution facilities (SEFs) – trading platforms specifically designed to trade OTC contracts – and introduced new rules for centralised clearing, data collection and publication of OTC derivatives trades, as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act.
Europe has been slower off the mark and has split its plans to reform the OTC derivatives market into two legislative processes.
On 15 September 2010, the European Commission (EC) tabled draft legislation on the central clearing and reporting of OTC derivatives trades. The proposed directive is currently under consideration by the European Parliament and, via the European Council, the heads of EU member states. The final rules must be adopted by the end of 2012 to meet the timetable laid out by the Group of 20.
The concept of how OTC derivatives are to be migrated onto trading platforms will be dealt with separately in MiFID II, the revised version of the pan-European securities market legislation that came into force in November 2007.
The MiFID review began with a number of industry consultations by the Committee of European Securities Regulators (CESR), responsible for harmonising securities legislation across the continent, one of which related specifically to the exchange trading and standardisation of OTC derivatives instruments. This consultation was designed to shape both the OTC derivatives clearing and reporting directive as well as MiFID II.
Following CESR's recommendations, the EC is currently preparing a consultation document on MiFID II, the results of which will be used to inform the revised rules it will propose. The consultation is due to begin before the end of November, with draft legislation expected to start its passage through both the European Parliament and European Council in Q2 next year.
The lack of clarity in Europe – which is still undecided on how trading platforms for OTC derivatives will operate, which models are permitted and the instruments eligible for exchange trading – has irked investors, including UK buy-side trade body the Investment Management Association.
While Europe and the US have the same intentions – i.e. to rein in the risks associated with OTC derivatives – the different paths they are travelling are likely to cause some regulatory inconsistencies.
For example, in the US, the use of single bank platforms for obtaining quotes for OTC contracts, such as Barclays Capital's BARX, is likely to be outlawed to ensure counterparty risk is not concentrated and that investors have the ability to source competitive quotes. But a ban on single bank platforms is unlikely in Europe.
In addition, it is far from clear at this stage that the same products will be selected for exchange trading and central clearing in the US and Europe, responsibility for this process having been passed from legislators to regulators in both jurisdictions.
The issue of regulatory arbitrage has not been ignored. In early November, European single market commissioner Michel Barnier met with Gary Gensler, chairman of US derivatives regulator the Commodities and Futures Trading Commission, to reaffirm their commitment to a coordinated approach to OTC derivatives legislation, including exchange trading. But coordination will only be possible if Europe's politicians adopt a legislative framework broadly similar to that handed to Gensler and his fellow US regulators. This, of course, is far from a forgone conclusion.
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