The European Securities and Markets Authority (Esma) has attempted to clarify a pressing question surrounding over-the-counter (OTC) derivatives and the Markets in Financial Instruments Directive (Mifid) II - but left the market just as confused as it was before.
Trading venues had been concerned by a lack of clarity surrounding how European regulators will define certain instruments under the continent’s incoming regulatory framework. The issue arises out of reporting on certain types of financial instruments. The directive dictates that if the instrument is traded on a trading venue (TOTV), then reporting obligations apply.
But it's down to Esma to define exactly what TOTV means. This had not received much attention for some time as following the introduction of the organised trading facility (OTF) concept, the assumption was that most products would qualify as TOTV.
"It provides a starting point, but Esma seems well aware there are potential problems with this and that the guidance won't work for all purposes," said Ezra Zahabi, counsel in Akin Gump's London financial regulatory practice. "It doesn't seem sufficiently nuanced, given the nature of derivatives."
The Esma opinion says that where a derivative shares the same reference data as another which is traded on a trading venue, then reporting requirements will apply. From this it seems that all reference data - including maturity, which many were concerned about - is included, except for fields five to 12, which relate to the issuer.
It concludes that the opinion may need to be revisited in future, 'taking into account the evolution of markets...and to ensure this does not create incentives to move trading to the OTC space as this would run counter to the legislative goals of Mifid II'. Esma will continue to monitor the situation.
“In the absence of knowing how granular a definition of an instrument Esma is going to require, it’s very hard from a trading venue perspective to give consistent information as to what instruments are TOTV,” said Ben Pott, head of government affairs at Nex, before the Q&A was released. “Unless there is further clarity it could be confusing either way, with people either over or under-reporting.”
- Trading venues are concerned by a lack of clarity as to how European regulators define certain instruments under the incoming Mifid II;
- The rules say that if an instrument is traded on a trading venue then reporting requirements apply, but many in the market are still not clear as to what that means;
- For derivatives it’s particularly complex as some off-exchange trades are materially similar to others conducted on exchange;
- The risk is an inconsistent approach between venues and potential over or under-reporting;
- Clients will also be concerned about which of their trades will be made public.
For many instruments this is fairly clear cut, but in the derivatives and structured product space where there is a broader variety of products, some with few distinctions between, it gets more complex. For example, is a one-year euro swap traded today the same instrument as a one-year euro swap with a slightly different maturity date traded tomorrow?
This question remains largely unanswered, with fewer than 200 days to go until implementation.
Speaking before Esma's opinion was released in May, Pott explained that if the definition is too granular and is linked to maturity, all reference data may be published with a day’s delay. He would like to see the key attributes of an instrument defined as currency and tenor over maturity.
It was unclear whether OTC transactions that replicate transactions that are TOTV, and trades done outside of Europe where the underlying instrument is traded on a European trading venue, are in scope. But there’s also an issue around whether or not instruments that are admitted to a trading venue but not actually traded should be reported.
"Unless there is further clarity it could be confusing either way, with people either over or under-reporting"
“I would have thought that when we talk about a definition of a financial instrument then it would be relatively intuitive,” said Michael Thomas, partner at Hogan Lovells, before Esma released its opinion. “But the risk is that we could end up with an inconsistent approach between different firms and venues, and even national regulators as to what is reported.”
One suggestion is that the regulator uses regulatory technical standard (RTS) 23, which requires trading venues to submit reference data – but this links definitions to maturity dates, and was never intended to provide a distinction for derivatives in particular.
“It’s a starting point, but linking it to the exact maturity isn’t very helpful,” said Pott. “It means for the same derivative instrument, but with a different maturity, you’d have to rewrite and resubmit the entire reference data list every day.”
According to Clifford Chance partner Owen Lysak, this is a concern to clients too as it dictates which of their trades are subject to transparency requirements.
“For off-exchange trades, this will depend on whether the product is materially similar to anything traded on-venue,” he said.
“But there are complications around what attributes make two products materially similar or different, and this is a very techy discussion that hasn't been had a lot in the market. At the moment, I'm not sure there is a wide understanding of what it means.”
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