Trade bodies urge ESMA to clarify EMIR fragmentation stance

Banking lobby groups are warning European policy makers that ambiguities in the drafting of new swaps rules risk may trigger monopolistic behaviour from trading venues and clearers.

Banking lobby groups are warning European policy makers that ambiguities in the drafting of new swaps rules risk may trigger monopolistic behaviour from trading venues and clearers.

The British Bankers Association, Association for Financial Markets in Europe, International Swaps and Derivatives Association and Italian banking trade body Assosim all raised concerns in a consultation held by the European Securities and Markets Authority (ESMA) which ended 5 August.

ESMA was seeking views on technical standards related to the European market infrastructure regulation (EMIR), the new rules for many derivatives currently traded bilaterally to move on exchange, clear centrally and be reported to newly-created data repositories.

The groups were particularly concerned by the possible unintended consequences of article 8.4 of EMIR, a clause which requires central counterparties (CCPs) and trading venues to grant access to each other only when “access would not require interoperability or threaten the smooth and orderly functioning of markets in particular due to liquidity fragmentation”.

The bodies argued that while 8.4 seemed to cast doubt on the benefits of liquidity fragmentation, they believed some fragmentation can facilitate competition to the benefit of the market. The groups warned that if a specific derivative contract could only be cleared by one CCP, anticompetitive behaviour in clearing costs could arise.

If, for example, a CCP owned by a trading venue only chose to clear swaps traded on its associated market, other markets would have to establish separate links with other clearing houses.

This would subsequently require market participants to have two pools of open interest for the same product, leading to major cost inefficiencies. The issue has already affected London Stock Exchange-owned multilateral trading facility (MTF) Turquoise, which was prohibited from sharing open interest in FTSE 100 options with NYSE Liffe, the dominant derivatives market for those products.

“We believe that it should be possible for two parties to trade the same product and agree in advance which CCP they will use to clear the transaction and that new parties should not be denied access to a CCP (and the same margin pool) that already clears an existing product,” read a joint submission from the trade bodies.

In need of redraft

The lobby groups urged ESMA to redraft article 8.4 so that it meets ESMA’s stated objectives in relation to fragmentation and interoperability more clearly. 

Other market participants have pointed out that fragmentation concerns would only arise if the owners of indices on which popular equity derivatives are based do not let other markets trade the same index-based instruments. This could force markets to replicate popular instruments based on different benchmarks and create a lack of fungibility between products that are essentially the same but traded on different markets.

In addition to its apparent confusion over fragmentation, other industry observers have noted ESMA’s silence on the ability of markets to route trades through different CCPs.

Alex McDonald, WMBA“ESMA only looked at the ability of CCPs to access trading venues, rather than the other half of the EMIR article which addresses fair and open venue access for sending matched trades into CCPs,” said Alex McDonald, CEO of the interdealer broker trade body the Wholesale Markets’ Brokers Association. "There are still a number of ways in which vertically-owned market infrastructures can make it economically or technologically more difficult to novate trades executed in outside venues relative to those done within the silo and it is a concern that ESMA has not ensured that access is consulted upon.”

There also appears to be a bias towards regulated markets in the ESMA paper. 

McDonald said the ESMA consultation paper uses a definition of OTC derivatives from EMIR, which states an OTC instrument is everything traded away from a regulated market. Such a definition would not include trades done on an MTF or an organised trading facility (OTF).

The paper suggests everything classed as an OTC derivative would be subject to more onerous risk requirements than those traded on regulated markets.

“This seems to put in a higher cost of margin barrier that makes it more beneficial to trade on an exchange, compared to an OTF or MTF,” said McDonald. “The biannual Bank for International Settlements data underline that OTC markets are typically much deeper and more liquid than the exchange, but in any case, these types of requirements should be aligned to the IOSCO principals of a level playing field and beyond those be left to a CCP’s risk committee to decide.”

The ESMA paper also included a framework for deciding when swaps should be deemed eligible for clearing, risk mitigation requirements for OTC derivatives that are not centrally cleared, and organisational conduct of business and prudential requirements for central counterparties.

After receiving the industry feedback, ESMA will now have until 20 September to finalise the technical standards and deliver them to the European Commission for approval, ahead of the expected implementation of EMIR at the start of next year.