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UK lawmakers will charge ahead with overhauling areas of pre-Brexit financial services legislation that are “ripe for reform,” the HM Treasury’s deputy director for securities, markets and banking signalled last week.
Talking at the International Swaps and Derivates Association (ISDA)’s European conference on Thursday, Tom Duggan confirmed high-level plans to amend several Mifid-related requirements and reshape the regulatory framework for the country’s financial sector in the new post-Brexit era.
“It is clear that some of the things in Mifid II have not worked effectively, and therefore are ripe for reform.
“This is a really good opportunity for us to look again at the evidence and think about what areas have not stood the test of time.”
Duggan said transparency rules in particular needed to be re-thought as they weren’t helping the goal of improving price formation as planned.
“On derivatives specifically, we thought quite heavily about transparency and whether the regime was working effectively.”
“In some areas, this clearly has not worked effectively,” he said. “In particular, things like pre-trade transparency just do not apply very well to many instruments.
Also aligning to post-2008 G20 commitments to enhance transparency over global securities trading and OTC markets, the EU’s 2014 Mifid II legislation significantly broadened the scope of pre- and post-trade transparency requirements for a large class of securities.
Among these, derivatives that are sufficiently liquid and eligible for clearing have been required to move from OTC arrangements to regulated trading venues, under the so-called Derivatives Trading Obligation (DTO).
Mifir implementation rules then set out a series of calculation methodologies to identify liquidity thresholds, waivers on transparency rules and the use cases for deferred trade data publication.
However, Duggan said pre-trade rules were missing the mark. “We see very high-burden complex waivers calculations that go into doing this, with little benefit for price formation or best execution.
“So, I think that’s an area that’s ripe for reform. I think we can better define the scope of transparency as it applies to derivatives.”
Post-trade rules, he added, also needed to be reviewed to improve information and market efficiency.
“Post-trade, we can improve the quality of the information. Information is sometimes provided too late [and] there are very complex deferral waiver systems,” he argued. “We think we can make that more efficient.”
Review of OTC and DTO rules fast approaching
Duggan’s comments echoed proposals put forward by the government in July under the Wholesale Markets Review, a consultation paper that laid the groundworks for upcoming changes to the Mifid II framework.
“Evidence shows that the Mifid II regime has achieved little meaningful transparency, and has had limited impact on price formation at a high cost to the industry,” the paper stated. “The government believes this is because the regime is not appropriately calibrated and does not account for the diverse nature of non-equity markets.”
“The government is therefore proposing to significantly reform the transparency regime for fixed income and derivatives markets.”
Duggan said the Treasury will publish a summary of the main findings in the next few weeks, with a view to “set out next steps for legislation, where it’s required, after that.”
Meanwhile, on October 15 the Financial Conduct Authority (FCA) amended the scope of DTO rules to reflect banchmark-rates changes due to the ongoing Libor transition.
“We recognise that the liquidity profile of the derivatives market will continue to evolve as the interest rate benchmark reform unfolds,” the FCA said in its statement.
“As a result, we may propose further amendments to the scope of the DTO in due course,” the FCA statement said, also citing the need for an “appropriately calibrated DTO.”
Changes to the calibration of OTC and DTO requirements could heavily impact future equivalence decisions between the UK and the EU, with important ramifications for the liquidity of OTC markets.
In September last year, ISDA urged the two blocs to mutually recognise each other’s derivatives trading venues to avoid aggravating the post-Brexit drop in OTC liquidity.
Systematic internalisers: reverting to Mifid I?
Another key area Duggan and other panellists picked up on was the Mifid II regime for so-called systematic internalisers (SIs) – firms that trade on own accounts on a systematic basis, outside of an external regulated venue.
Whereas under Mifid I SI rules applied solely to equities, under Mifid II they were extended to a much broader range of asset classes. An SI is required to take on post-trade regulatory reporting obligations on behalf of its clients.
However, because SIs are at present determined though quantitative thresholds, the government’s consultation paper noted that “for some transactions there is uncertainty about who should report the trade.”
Duggan said that the shift from a qualitative to a quantitative approach in Mifid II had resulted in “very complex, regular and expensive calculations done by firms to work out whether they are in SI or not.”
“I think this is a good illustration of where the EU approach for 28 members hasn’t worked so well,” he said, pointing out that the main rationale behind the shift to a quantitative approach – to ward off the risk of an uneven application across multiple jurisdictions – was no longer relevant.
Caroline Dawson, partner at Clifford Chance, held a similar opinion on moving back to a qualitative approach, arguing that the previous system “clearly did appear to have worked for the UK.”
Dawson said that current rules were based on the “assumption that [firms] will know whether [they] are a systematic internaliser or not,” using an entity-level standpoint, and other counterparties would do the same. “But clearly that leads to a number of mismatches and a number of difficulties.”
“Are you only a systematic internaliser for those assets for which you cross those quantitative tests, or is it a situation where, once you’re a systematic internaliser, you’re a systematic internaliser for everything?
“Does it really make sense that someone who’s only a systematic internaliser […] for a very small proportion of assets [to] then be treated as a systematic internaliser for everything else?
To counter this, she proposed to have an “asset class-based definition of systematic internaliser.”
Quashing doubts about whether a firm or counterparty qualifies as an SI would be essential for a correct application of reporting obligations, Dawson and Duggan said.
Mathew Coupe, director of market structure EMEA at Barclays, added that clarity on definitions would help the transparency regime work as intended.
“It’s really important to have [an] SI registry so we understand who is an SI, so we don’t have duplicate reporting.”
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