Market participants have advised Europe’s securities watchdog to keep the specifications for deciding which OTC derivatives can be cleared as broad as possible to avoid circumvention of new regulations.
The issue of swap standardisation is a key facet of new rules that will transform bilateral OTC derivatives trading into an exchange-traded, centrally-cleared market.
Comments on how products should be standardised were part of responses to a consultation by the European Securities and Markets Authority (ESMA), which is in the process of devising technical standards to accompany the new rules.
Eurex Clearing, the central counterparty (CCP) owned by Deutsche Börse, thought a reasonably broad definition for deciding which products can be standardised should be applied.
“An excessively narrow description of legal frameworks and operational processes would encourage an evasion of the clearing obligation,” wrote Eurex in its reply to ESMA.
The European Association of Clearing Houses, the trade body which counts 23 CCPs as members, added “the risks of avoidance of the clearing obligation are more apparent than the risks of a CCP not being able to clear a particular class of standardised OTC derivative”.
Under EMIR, ESMA will facilitate a ‘bottom-up’ approach in deciding which derivatives are centrally cleared. The watchdog will first analyse the types of derivatives that can be cleared using the approach determined by the technical standards. In its consultation paper, ESMA said this would be determined by factors including whether the margins would be proportionate to the risk that the clearing obligation intends to mitigate, the historical stability of the liquidity through time, and whether there is enough relevant, accessible information on which to base prices for contracts. Central counterparties will then be required to apply to ESMA, via their home regulator, stipulating the classes of derivatives they wish to clear.
Inter-dealer broker ICAP added ESMA should also consider the potential for significant variation in economic terms within a particular class of derivatives.
“ESMA should consider additional factors such as the number of instruments per class of derivative, the trading interest per instrument, the value at risk, and the level of volatility,” wrote ICAP. “ESMA may also wish to take into account particular characteristics, such as whether the transaction is an outright or a spread trade, as well as the potential for liquidity in certain instruments to fluctuate.”
Other market participants stressed the need for derivatives standardisation to be considered in line with the trading venue categories for OTC derivatives that are defined in MiFID II. The latest version of the directive introduces the organised trading facility (OTF), a venue class giving operators discretion over access. A greater number of multilateral trading facilities (MTF) and systematic internalisers are also expected to emerge as the new derivatives rules reach the implementation phase.
“Liquidity is probably the most important and difficult to predict,” wrote Deutsche Bank. “It is important to consider how and where products are traded and whether this would be robust in a default situation. The OTF/MTF execution mandate as currently proposed will require a separate decision on products being ‘sufficiently liquid’, but clearable products will also overlap with the systematic internalisation regime which will impact liquidity and ability of participants to clear risk in a default scenario.”