Most firms do not want to become a systematic internaliser (SI) for derivatives under the EU’s incoming Markets in Financial Instruments Directive (Mifid) II. And those institutions that have opted in – or plan to do so – have explained their reasons to IFLR.
Having SI status under Mifid II in other asset classes such as equities can be beneficial by routing extra trade flow, as shares must be traded on either a venue or SI. But according to industry sources, for derivatives it’s simply “more hassle than good”.
One of the key issues had been whether or not firms will be automatically deemed an SI and where the thresholds lie, though some clarification was provided by the European Securities and Markets Authority (Esma) in the form of a Q&A in early October.
While the revised SI regime doesn’t officially kick in until September 2018, there is an early opt-in process available. Sources are largely split on how many firms will choose to opt in ahead of the September deadline.
According to Sassan Danesh of ANNA DSB, the official Isin generator for OTC derivatives, some firms have made requests for an early opt-in. So far just Deutsche Bank, UBS and Nordea have officially registered. But Linklaters’ Rachel Knipe thinks it’s unlikely that a large number will follow: “because there’s no real economic gain to doing so”.
Kasper Folke, head of FX and algo quant at Nordea told IFLR that the firm has chosen to opt in to make life easier for its customers. "The move to become an SI is about providing clients with an improved service in the face of new regulation, rather than generating profit," he said. "It gives us an extra cost, but compared to the burden our clients are facing we find it a natural step for a bank of our size."
Johan Wijkstrom, fixed income business development at Swedbank, said that his firm will be opting in early purely because its competitors are. By opting in as an SI, a bank or other type of investment firm takes on its clients’ reporting obligations – so there’s anticipated pressure from the buyside. If firms don’t want to opt in they can provide clients with so-called assisted reporting instead.
“Do we want to opt in? No. But will we? Yes, because we want to keep a level playing field with our competitors,” said Wijkstrom. “It would not be smart to wait until September, as much as we would like to. We would lose too much business.”
Esma has taken a slightly different approach to other asset classes, opting for the most granular category of products as defined within the transparency framework: regulatory technical standard (RTS) two.
That could potentially mean thousands of categories: one firm may be an SI for a very particular type of interest rate swap, but not for another, for instance one with a different maturity date. “The definitions and level of granularity required are still very unclear,” said Wijkstrom.
"We've gone out with the product set we think is appropriate after having thoroughly examined our trading patterns and taking into account the concerns of our institutional clients," explained Nordea's Folke. "Right now we believe that these classes fulfil our clients' needs, but we are always open to further discussion."
Naturally, despite Esma’s clarification, questions remain. “I don’t think anything that has come out so far has made anyone less confused,” said Steve Grob, director of group strategy at Fidessa, a trading and investment systems provider. “Whether one firm is Mifid II-ready or not depends on whether everyone else in the ecosystem is Mifid II-ready. I expect there to be an awful lot of running around for the first half of next year.”
And despite the qualification thresholds now being set, the regulator won’t make the necessary data available to make an assessment until August 2018. Then firms have just a month, up to September 1, to crunch the numbers to determine whether or not they are an SI.
Many firms can glean at this point whether or not they will qualify as an SI based purely on their trading volumes today.
But pre-Esma guidance, some had argued that when two wholesale counterparties are dealing with each other there is no client. Historically the two firms would not have seen each other as clients – just two eligible counterparties conducting flow business. That would technically mean the trade does not need to be taken into account in the SI determination.
Esma insists that there is a client relationship in there somewhere, so counterparties must find it out. “That will potentially mean far more SIs than originally thought,” said Tim Cant, counsel at Ashurst.
And determining the client is not straightforward. According to Cant, for derivatives, generally the counterparty receiving, rather than paying performance would be the client – but technically both are providing an execution service.
“When we ask who the client is in a bilateral trade, what does that even mean? So many different types of legal entities exist inside a large bank or brokerage,” said Grob.
Either firm could be trading in its capacity as an SI, a multilateral trading facility, an organised trading facility or a swap execution facility: a term coined under the US’ Dodd-Frank that never quite caught on in the EU.
The early opt-in possibility poses huge reference data definition challenges, on top of Mifid II’s myriad other requirements.
The DSB is working to create so-called exotic templates that provide more flexibility for complex products in response to some firms’ desire for an early opt-in to the SI regime. They expect this to be an ongoing process, with requests for ever-more exotic products coming in well into 2017. The general anticipated timeline for a template request is between two to three weeks.
“Because every single derivative is in scope, we may cover 99% or even 99.9% of the market, but it’s almost certain that people are trading things we don’t know about,” said Danesh.
Those categories will determine a firms’ transparency obligations – so it’s important to get it right.
According to Danesh, the industry is frantically trying to make such huge decisions on a really quick basis – unheard-of timelines under normal conditions. “I wouldn’t be surprised if we have to revisit much of this at some point over the next few years. The rush means that general understanding of the transparency obligations is not very deep.”
The reporting obligations that fall to an SI are also keeping people up at night.
The scope of products that SIs need to provide data for tends to be more at the complex end of the business, according to Danesh, as venues generally deal with more standardised products that suit electronic trading – in the context of derivatives, something vanilla like benchmark interest rate swaps.
“Products traded by SIs are far more interesting – imagine a FTSE100 compared with some complex digital barrier option on that FTSE100. As the original security is traded on a trading venue, that hugely complex option has got to be reported too,” said Danesh. “You might be able to define the FTSE100 fairly easily, but this is a whole different beast.”
Linklaters’ Knipe agrees with this, saying that right across the market, there is a real lack of understanding on how the data fields will work with such complex products. “But the market is at its wits end, and is saying: ‘even though it makes no sense to me whatsoever, just tell me what you want me to do’,” she added.
The long term implications of the new regime are not yet clear, but one market participant expects higher volumes of on-venue trading, less liquidity in the market in general, and a much greater pressure on pricing.
“It’s so complicated because a lot of the derivatives obligations are premised on this traded on a trading venue concept, and that’s a mess,” said the source. “Esma’s opinion just doesn’t work, and even they have admitted that offline.”
This article is published by IFLR Insight, a new service launching soon. IFLR Insight will analyse how financial institutions are reacting to new rules.
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