AIMA BRIEFING NOTE. The interplay between European and US derivatives trading rules. July 2015 (version 2)

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AIMA BRIEFING NOTE

The interplay between European and US derivatives trading rules

July 2015 (version 2)

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Disclaimer

This document is provided to and for AIMA members only. It is intended as indicative guidance only and is not to be taken or treated as a substitute for specific advice, whether legal advice or otherwise.

All copyright in this document belongs to AIMA and reproduction of part or all of the contents is strictly prohibited unless prior permission is given in writing by AIMA.

The interplay between European and US derivatives trading rules

While derivatives reforms in the US and EU stem from the same G20 commitment1, implementation has taken a very different path, at times leading to divergence between the content and timelines for the new rules in the US and EU. Plenty has been written about the differences between the clearing regimes in the US and EU – highlighting key differences in terms of segregation standards – but derivatives execution requirements have received less attention. This note offers a perspective on the relationship between US and EU derivatives execution rules.

Europe: A staggered approach to delivering the G20 package

The US tackled the G20 derivatives reform package with a single legislative act, the Dodd Frank Act. In Europe, reform measures were split across two packages of legislation: EMIR2 and MiFID23. EMIR, for which primary legislation was finalised in 2012, tackled clearing, reporting and margin standards. MiFID2, for which primary legislation was finalised in 2014, covers the derivatives execution requirement and associated transparency rules.

Secondary rules under both EMIR and MiFID2 are still being written.

It is at this point worth a brief digression to explain in brief some of the key aspects of the European legislative process that have shaped the legislation:

The split between primary and secondary legislation: European financial services regulation is typically delivered through a process that distinguishes between primary legislation (Level 1) that sets the broad policy intent and secondary legislation (Level 2) that sets out the detailed parameters needed to support the primary legislation.

A confusing cast of actors: A simple characterisation of the European policy process goes as follows: The European Commission – the EU’s civil service – proposes primary legislation. European Member States – represented through ‘the Council’ – and the European Parliament – the directly-elected representatives of

1 “All standardised OTC derivative contracts should be traded on exchanges or electronic trading platforms, where appropriate, and cleared through central counterparties by end- 2012 at the latest. OTC derivative contracts should be reported to trade repositories. Noncentrally cleared contracts should be subject to higher capital requirements.” Pittsburgh, 2009

2 Regulation (EU) No 648/2012 on OTC derivatives, central counterparties and trade repositories. Also known as the ‘European Market Infrastructure Regulation’, hence the acronym EMIR.

3 References in this note to MiFID2 cover the package of two legislative instruments, the updated Markets in Financial Instruments Directive text, i.e. MiFID2, and new companion regulation, MiFIR. Derivatives trading requirements are actually contained in the MiFIR part of the package. See http://eur-lex.europa.eu/legal-content/EN/TXT/HTML/?uri=CELEX:32014R0600&from=EN and http://eur-lex.europa.eu/legal- content/EN/TXT/HTML/?uri=CELEX:32014L0065&from=EN

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3 Europe’s citizens – each have a say over the text. The final primary legislation represents the outcome of the ‘trialogue’ negotiations between the three institutions.

 The elaboration of secondary legislation adds further procedural complexity. Without addressing this in full, it is worth noting the important role played by the European Supervisory Authorities (ESAs; the EU umbrella bodies for national securities, banking and insurance regulators). The European Securities and Markets Authority (ESMA), plays the most prominent role in the context of derivatives reform implementation. The European Commission remains responsible for the formal adoption of rules and can overrule ESMA if it does not agree with its approach.

Tension between the national and regional level: European law distinguishes between Directives (which Member States must write into their own law) and Regulations, which are directly applicable across the EU. The scope for Member States to ‘gold-plate’, i.e. to go above and beyond EU requirements, is therefore greatest where a Directive is involved.

From MiFID to MiFID2

In order to understand the way in which MiFID2 regulates derivatives trading, it is important to understand how the original MiFID legislation, in force since 2007, has been updated to implement the G20 obligation.

The original MiFID harmonised the regulation of trading venues in the EU, introducing the concepts of Regulated Market and Multilateral Trading Facility (MTF). The MTF concept is associated with less onerous governance requirements and was intended to facilitate competition between equities trading venues in the EU (noting that some Member States had until that point required trading in equities to take place on the main stock exchange, so-called ‘concentration rules’).

The original MiFID also set out transparency obligation for shares traded on venues, with requirements in respect of both pre- and post-trade transparency.

MiFID2 builds on the original MiFID by extending transparency requirements to non-equities instruments (including bonds and derivatives) and by adding a new category of trading venue, Organised Trading Facility (OTF). It also introduces a derivatives trading obligation requiring that the ‘sufficiently liquid’ subset of contracts that are subject to the EMIR clearing obligation must be traded on a venue – an OTF, MTF or regulated market.

In what follows, we discuss these requirements in further detail.

MiFID2 trading venues

As noted above, MTFs and regulated markets are established concepts. MiFIR recital 7 describes the key features of such venues as follows:

(7) The definitions of regulated market and multilateral trading facility (MTF) should be clarified and remain closely aligned with each other to reflect the fact that they represent effectively the same organised trading functionality. The definitions should exclude bilateral systems where an investment firm enters into every trade on own account, even as a riskless counterparty interposed between the buyer and seller. Regulated markets and MTFs should not be allowed to execute client orders against proprietary capital. The term ‘system’ encompasses all those markets that are composed of a set of rules and a trading platform as well as those that only function on the basis of a set of rules. Regulated markets and MTFs are not obliged to operate a ‘technical’ system for matching orders and should be able to operate other trading protocols including systems whereby users are able to trade against quotes they request from multiple providers. A market which is only composed of a set of rules that governs aspects

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related to membership, admission of instruments to trading, trading between members, reporting and, where applicable, transparency obligations is a regulated market or an MTF within the meaning of this Regulation and the transactions concluded under those rules are considered to be concluded under the systems of a regulated market or an MTF. The term ‘buying and selling interests’ is to be understood in a broad sense and includes orders, quotes and indications of interest.

One of the important requirements concerns the obligation that the interests be brought together in the system by means of non-discretionary rules set by the system operator. That requirement means that they are brought together under the system’s rules or by means of the system’s protocols or internal operating procedures, including procedures embodied in computer software. The term ‘non-discretionary rules’

means rules that leave the regulated market or the market operator or investment firm operating an MTF with no discretion as to how interests may interact. The definitions require that interests be brought together in such a way as to result in a contract which occurs where execution takes place under the system’s rules or by means of the system’s protocols or internal operating procedures.

It is worth noting the emphasis placed on ‘non-discretionary rules’ to govern the execution of orders. OTFs differ in that their operators do have discretion over order interaction:

MiFIR recital (8) In order to make Union financial markets more transparent and efficient and to level the playing field between various venues offering multilateral trading services it is necessary to introduce a new trading venue category of organised trading facility (OTF) for bonds, structured finance products, emissions allowances and derivatives and to ensure that it is appropriately regulated and applies non- discriminatory rules regarding access to the facility. That new category is broadly defined so that now and in the future it should be able to capture all types of organised execution and arranging of trading which do not correspond to the functionalities or regulatory specifications of existing venues. Consequently, appropriate organisational requirements and transparency rules which support efficient price discovery need to be applied. The new category encompasses systems eligible for trading clearing-eligible and sufficiently liquid derivatives.

It should not include facilities where there is no genuine trade execution or arranging taking place in the system, such as bulletin boards used for advertising buying and selling interests, other entities aggregating or pooling potential buying or selling interests, electronic post-trade confirmation services, or portfolio compression, which reduces non-market risks in existing derivatives portfolios without changing the market risk of the portfolios. Portfolio compression may be provided by a range of firms which are not regulated as such by this Regulation or by Directive 2014/65/EU, such as central counterparties (CCPs), trade repositories as well as by investment firms or market operators. It is appropriate to clarify that where investment firms and market operators carry out portfolio compression certain provisions of this Regulation and of Directive 2014/65/EU are not applicable in relation to portfolio compression. Since central securities depositories (CSDs) will be subject to the same requirements as investment firms when providing certain investment services or performing certain investment activities, the provisions of this Regulation and of Directive 2014/65/EU should not be applicable to firms that are not regulated thereby when carrying out portfolio compression.

(9) That new category OTF will complement the existing types of trading venues. While regulated markets and MTFs have non-discretionary rules for the execution of transactions, the operator of an OTF should carry out order execution on a discretionary basis subject, where applicable, to the pre-transparency requirements and best execution obligations. Consequently, conduct of business rules, best execution and client order handling obligations should apply to the transactions concluded on an OTF operated by an investment firm or a market operator. In addition, any market operator authorised to operate an OTF should comply with Chapter 1 of Directive 2014/65/EU regarding conditions and procedures for authorisation of investment firms. The investment firm or the market operator operating an OTF should

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5 be able to exercise discretion at two different levels: first when deciding to place an order on the OTF or to retract it again and second when deciding not to match a specific order with the orders available in the system at a given point in time, provided that that complies with specific instructions received from clients and with best execution obligations.

For the system that crosses client orders the operator should be able to decide if, when and how much of two or more orders it wants to match within the system. In accordance with Article 20(1), (2), (4) and (5) of Directive 2014/65/EU and without prejudice to Article 20(3) of Directive 2014/65/EU, the firm should be able to facilitate negotiation between clients as to bring together two or more potentially compatible trading interests in a transaction. At both discretionary levels the OTF operator must have regard to its obligations under Articles 18 and 27 of Directive 2014/65/EU. The market operator or investment firm operating an OTF should make clear to users of the venue how they will exercise discretion. Because an OTF constitutes a genuine trading platform, the platform operator should be neutral. Therefore, the investment firm or market operator operating the OTF should be subject to requirements in relation to non-discriminatory execution and neither the investment firm or market operator operating the OTF nor any entity that is part of the same group or legal person as the investment firm or market operator should be allowed to execute client orders in an OTF against its proprietary capital.

For the purpose of facilitating the execution of one or more client orders in bonds, structured finance products, emission allowances and derivatives that have not been declared subject to the clearing obligation in accordance with Article 5 of Regulation (EU) No 648/2012 of the European Parliament and of the Council (6), an OTF operator is permitted to use matched principal trading within the meaning of Directive 2014/65/EU provided the client has consented to that process. In relation to sovereign debt instruments for which there is not a liquid market, an investment firm or market operator operating an OTF should be able to engage in dealing on own account other than matched principal trading. When matched principal trading is used all pre-trade and post-trade transparency requirements as well as best execution obligations must be complied with. The OTF operator or any entity that is part of the same group or legal person as the investment firm or market operator should not act as systematic internaliser in the OTF operated by it. Furthermore, the operator of an OTF should be subject to the same obligations as an MTF in relation to the sound management of potential conflicts of interest.

As noted in the legislative language above, the creation of the OTF category was intended to support the move of derivatives contracts onto venues by creating a category of venue in which the venue operator would have greater discretion over how to match orders, something arguably more important in the context of contracts that are more heterogeneous and thinly-traded. Inter-dealer brokers were strong advocates of the OTF framework, which was seen as the means to accommodate their voice-broking services in the new derivatives trading construct.

That said, the relevance of the OTF category is at this point open to discussion. There was significant concern during the discussion of the primary legislation that giving too much discretion to OTF operators would create a less well regulated category of venue and the rules as they now stand are indicative of a concern about ‘going too far’; note:

 That the OTF framework cannot be used for equities trading.

 The ban on use by the OTF operator of its proprietary capital, something that would seem to bar single- dealer platforms operated by investment banks from becoming OTFs.

 A need for client consent to matched principal trading on the OTF.

 Concern that non-discriminatory access standards could be different to those associated with MTFs.

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Beyond this, however, there has been limited discussion about what the OTF, or indeed MTF, trading environment might look like for derivatives – in sharp contrast to the significant discussion in the US about swaps execution by

“any means of interstate commerce” and the design of SEFs. The definition of an OTF in MiFID Article 4(1)(23) describes an OTF as a “multilateral system which is not a regulated market or an MTF and in which multiple third- party buying and selling interests in bonds, structured finance products, emission allowances or derivatives are able to interact in the system in a way that results in a contract in accordance with Title II of this Directive”.

The reference to multilateral system has not been specified further and in practice is likely to accommodate a range of different trading functionality, whether pure order book trading or RFQ functionality. Indeed, the nature of the OTF (and MTF) trading environment will be determined to a large extent by pre- and post-trade transparency obligations which are common across all types of trading venue. At this stage, the debate about MiFID2 secondary legislation is heavily focused on the ‘calibration’ of these requirements for a range of different venue-types. In particular ESMA has discussed the implications for all of the following types of venue: continuous- auction-order-book; quote-driven; periodic-auction; RFQ (without discussing a minimum number of requests);

voice-trading; and systems not included in the other categories.

Given some of the restrictions on OTFs described above – and the cross-cutting nature of transparency obligation – is it highly likely that certain EU derivatives trading venues will instead fall within the MTF category, hence both OTFs and MTFs should be considered in any discussion about the interplay between the SEF environment and Europe’s trading structure.

Pre-trade transparency

The MiFID2 requirement for pre-trade transparency for non-equities instruments is reproduced below:

MiFIR Article 8

Pre-trade transparency requirements for trading venues in respect of bonds, structured finance products, emission allowances and derivatives

1. Market operators and investment firms operating a trading venue shall make public current bid and offer prices and the depth of trading interests at those prices which are advertised through their systems for bonds, and structured finance products, emission allowances and derivatives traded on a trading venue. That requirement shall also apply to actionable indication of interests. Market operators and investment firms operating a trading venue shall make that information available to the public on a continuous basis during normal trading hours. That publication obligation does not apply to those derivative transactions of non-financial counterparties which are objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty or of that group.

2. The transparency requirements referred to in paragraph 1 shall be calibrated for different types of trading systems, including order-book, quote-driven, hybrid, periodic auction trading and voice trading systems.

[…]

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7 As noted above, ESMA’s work to calibrate these requirements is ongoing. In practice, ‘calibration’ means defining the application of the transparency waivers that are also described in the text:

MiFIR Article 9

Waivers for non-equity instruments

1. Competent authorities shall be able to waive the obligation for market operators and investment firms operating a trading venue to make public the information referred to in Article 8(1) for:

(a) orders that are large in scale compared with normal market size and orders held in an order management facility of the trading venue pending disclosure;

(b) actionable indications of interest in request-for-quote and voice trading systems that are above a size specific to the financial instrument, which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors;

(c) derivatives which are not subject to the trading obligation specified in Article 28 and other financial instruments for which there is not a liquid market.

For ESMA, the task is undoubtedly a challenging one: ‘normal market size’ and ‘liquid market’ are open to a very wide spectrum of possible interpretations and a solution that might work for one segment of the market might be inappropriate in a different context. For these reasons, there are fairly fundamental concerns about the ability of policymakers to arrive at a workable calibration in the short time available to get the rules finalised (noting that they need to be in place ahead of the January 2017 go-live for MiFID2).

The outcome of ESMA’s work will have a significant bearing on what trading on derivatives venues in the EU ultimately look like. For example, would the requirement for publication of ‘current bid and offer prices and the depth of trading interests’ be compatible with RFQ-based trading systems? To a large degree the drafting does suppose electronic, order-book trading functionality.

There is a parallel between ESMA’s work and the US block trade threshold, which allows for trades to be negotiated off-SEF is they are above a certain size.

Post-trade transparency

When it comes to trading functionality, pre-trade transparency is likely to the key determinant for derivatives trading venues’ execution functionality, but it is worth noting that a similar calibration debate is ongoing for post-trade transparency rules:

MiFIR Article 10

Post-trade transparency requirements for trading venues in respect of bonds, structured finance products, emission allowances and derivatives

1. Market operators and investment firms operating a trading venue shall make public the price, volume and time of the transactions executed in respect of bonds, structured finance products, emission allowances and derivatives traded on a trading venue. Market operators and investment firms operating a trading venue shall make details of all such transactions public as close to real-time as is technically possible.

[…]

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Again, waivers provide for the possibility of calibrating of this requirement:

MiFIR Article 11

Authorisation of deferred publication

1. Competent authorities shall be able to authorise market operators and investment firms operating a trading venue to provide for deferred publication of the details of transactions based on the size or type of the transaction.

In particular, the competent authorities may authorise the deferred publication in respect of transactions that:

(a) are large in scale compared with the normal market size for that bond, structured finance product, emission allowance or derivative traded on a trading venue, or for that class of bond, structured finance product, emission allowance or derivative traded on a trading venue; or

(b) are related to a bond, structured finance product, emission allowance or derivative traded on a trading venue, or a class of bond, structured finance product, emission allowance or derivative traded on a trading venue for which there is not a liquid market;

(c) are above a size specific to that bond, structured finance product, emission allowance or derivative traded on a trading venue, or that class of bond, structured finance product, emission allowance or derivative traded on a trading venue, which would expose liquidity providers to undue risk and takes into account whether the relevant market participants are retail or wholesale investors.

As noted above, the relevant US comparison is the block trade framework, which provides for delays in post-trade reporting of transactions that meet the threshold.

Mandatory execution in the EU

The derivatives trading obligation requires entities that are within scope of EMIR clearing to execute those contracts on venue:

MiFIR Article 28

Obligation to trade on regulated markets, MTFs or OTFs

1. Financial counterparties as defined in Article 2(8) of Regulation (EU) No 648/2012 and non-financial counterparties that meet the conditions referred to in Article 10(1)(b) thereof shall conclude transactions which are neither intragroup transactions as defined in Article 3 of that Regulation nor transactions covered by the transitional provisions in Article 89 of that Regulation with other such financial counterparties or other such non-financial counterparties that meet the conditions referred to in Article 10(1)(b) of Regulation (EU) No 648/2012 in derivatives pertaining to a class of derivatives that has been declared subject to the trading obligation in accordance with the procedure set out in Article 32 and listed in the register referred to in Article 34 only on:

(a) regulated markets;

(b) MTFs;

(c) OTFs; or

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9 (d) third-country trading venues, provided that the Commission has adopted a decision in accordance with paragraph 4 and provided that the third country provides for an effective equivalent system for the recognition of trading venues authorised under Directive 2014/65/EU to admit to trading or trade derivatives declared subject to a trading obligation in that third country on a non-exclusive basis.

This only applies to the extent that the contract in question is ‘sufficiently liquid’, taking into account the following criteria (MiFIR Article 32(3)):

(a) the average frequency and size of trades over a range of market conditions, having regard to the nature and lifecycle of products within the class of derivatives;

(b) the number and type of active market participants including the ratio of market participants to products/contracts traded in a given product market;

(c) the average size of the spreads.

Again, it falls to ESMA to apply this test – in contrast to the Made Available to Trade (MAT) process, which makes SEFs responsible for assessing whether a contract meets one of the MAT factors. At this stage, it is not clear when ESMA’s will carry out its assessment. The MiFID2 primary legislation applies from January 2017, but secondary legislation will be required to subject specific contracts to the trading obligation. The experience under EMIR, where a similar approach was followed to apply the clearing obligation, suggests that the process for secondary rulemaking could be a protracted one and it is likely there will also be some sort of phase-in of the obligation.

As noted in the legislative language above, non-EU venues will be eligible for satisfying the derivatives trading obligation to the extent that the rules of the relevant third country have been deemed ‘equivalent’ by the European Commission. Note that there is a clear expectation of reciprocity on the part of the third-country jurisdiction in order for equivalence to be granted.

Another EMIR similarity is the mechanism to avoid overlap with third-country rules, allowing a transaction between one or more third-country entities to follow a third-country’s derivatives trading rules where that third country has been deemed equivalent.

Non-discriminatory access

The SEF construct has come under criticism from the buy-side in the US, in that regulatory reform has not yet managed to change historical trading patterns, leading to the persistence of a two-tier market:

A small group of dealers are able transact with each other on exclusive “dealer-only” trading platforms, commonly referred as the “inter-dealer” or “D2D” market. These platforms deny access to all other types of market participants, including investors (e.g., investment funds, insurance companies, corporations, etc.).

For investors, the only way to transact with that group of dealers is either bilaterally or on a limited number of

“dealer-to-customer” or “D2C” trading platforms.

This market structure is suboptimal in a number of respects, as it restricts the ability of investors to execute freely with any other counterparty, limits investors’ choice of trading protocols, compromises investors’ ability to execute the most favourable prices, inhibits new liquidity providers from entering the market, and engenders concentration of risk in the dealer community.

European authorities will be under pressure to use the implementation of MiFID2 as an opportunity to open up D2D trading venues to the client community, although it is not clear at this stage how the EU’s provisions on non- discriminatory access will be applied. Differences between the EU and US in this regard could have a bearing on equivalence discussions.

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Conclusion

Given the timelines and pronounced conceptual difference described above, the debate about the interplay between SEFs and MTFs/OTFs is likely to play out over an extended period of time. However, here are some initial observations in this regard:

 The CFTC has already sought to accommodate MTFs within the SEF regime to some extent with the Q-MTF relief. For a number of reasons, this was not seen as a success (challenges included the ability of MTFs to conform to all of the requirements of the relief, as well as migration of inter-dealer liquidity to entities that are not US Persons).

 While a significant focus under the SEF rules has been permitted types of trading functionality, far less time has been devoted in Europe to considering how the qualification of MTFs and OTFs as multilateral venues should be understood in terms of trading functionality (e.g. RFQ3 vs RFQ5). Rather, the focus in Europe has been on the transparency obligations for instruments traded on venue and the circumstances in which transparency obligations might be waived or deferred. Ultimately, however, transparency requirements are likely to guide what sort of trading functionality is possible.

 The precedent from discussions on clearing suggest that the European Commission could be slow to grant a positive equivalence determination in respect of US rules. This has parallels in the Q-MTF debate – should deference to other rules be based on detailed correspondence of requirements or a consideration of the overall outcomes that they achieve?

 Dual registration might also provide a solution for some entities (noting that IGDL already has dual registration as a SEF and MTF).

Contact: Adam Jacobs, AIMA ajacobs@aima.org

© The Alternative Investment Management Association Limited (AIMA) 2015

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