Europe’s regulatory jumble is still a puzzle to unfold

In our annual opening meeting at the Financial Services Club David Doyle, Policy Adviser on all matters to do with EU Regulations, gave us a swift canter through the key headlines in European financial markets focus for 2015.

These included the guiding principles that:

• All that is of systemic importance should be regulated and supervised
• To restore trust, investors and consumers should encounter clearer, more coherent and more effective safeguards
• Supervisory bodies should have the right tools to grasp the complex, interconnected and globalised financial nature of activities
• There is a need for a better capitalised finance industry with less leverage
• Perverse incentives in the financial sector should be tackled and reduced

2015 sees the EU Presidency pass to Riga, under the Latvian rule, who have created a key objective for European to become “competitive, digital and engaged”.  In this respect, they will oversee a number of regulations and directives through to their fruition including:

• Banking Union: ECB supervisory powers, Bank Recovery and Resolution Directive (BRRD), Deposit Guarantee Scheme
• Bank interchange fees
• Restructuring of EU banks
• Encouraging shareholder engagement (asset management)
• An agreement on the Savings Taxation Directive
• Fast-track at council on European Fund for Strategic Investments (EFSI)
• Resolution & Recovery plans for non-banks
• Revised Institutions for Occupational Retirement Provision (IORP) Directive (the Pensions Directive)
• European Market Infrastructure Regulation (EMIR): Rolling-out over-the-counter (OTC) derivatives clearing and margin rules
• Insurance Mediation Directive (IMD)
• Solvency II – agreeing on draft Implementing Technical Standards
• Packaged Retail Investment Products (PRIPs) Regulation
• UCITs V
• Shadow Banking - regulating money market funds (MMF) and securities lending
• Structural Reform of EU Banks
• MiFID II
• Market Abuse Directive (MAD)
• EU Mortgage Credit Directive (MCD)

Not much going on there then.

One of the key actions taken last year was the Asset Quality Review (AQR), as discussed yesterday.  This action was taken as the ECB (European Central Bank) becomes the new sheriff in town, as David calls them.  Under the Single Supervisory Mechanism, the ECB takes on new powers including:

• Monitors capital, liquidity and leverage requirements
• Authorises and revokes ban licence
• Enforces recovery plans
• Conducts stress tests
• Approves bank mergers & acquisitions (domestic and cross-border)
• Supervises early intervention in case of breaches of prudential rules (recovery plans, intra-group financial support arrangements, etc.)
• Empowered to request information directly from banks, conduct office visits, investigate.
• Impose restrictions on bank lending

In particular, the ECB has sole responsibility for determining whether a bank is “failing, or likely to fail…”  and no member state can bail out their banks anymore.  That is the responsibility and decision making of the ECB who, if so disposed, can let a member state’s bank fail if appropriate.

David focused his presentation mainly around the Markets in Financial Instruments Directive II, or MiFID II, as this will be the focus for the next two years in capital markets as its D-Day looms in early 2017.

MiFID II introduces a number of radical new changes to financial markets, including:

Market Structure

• Organised trading facility (OTF) reserved for non-equities only, i.e. bonds, derivatives, fixed-income, emissions allowances and structured products. But NOT equities
• OTF operators to face restrictions on the use of own capital. Including matched principal trading, except for illiquid sovereign bonds
• Limitation on trading away from regulated markets i.e., dark pools

High Frequency Trading (HFT):

• HFTs traders to be regulated. Must prove the existence of effective internal systems, controls and reporting. Need to impose ‘circuit breakers’ in the event of price volatility
• Commodity derivatives – imposition of position thresholds by category of trader set by ESMA, but enforced by National regulatory authorities
• Exemptions:
  • Non-financial firms using derivatives for hedging
  • Electricity and gas supply if physically settled and traded on OTFs
  • Oil and coal for four years with possible three year extension

Access

• Harmonised EU regime for non-discriminatory access to trading venues and CCPs – but five year transition period
• Access requirements for small derivative exchanges exempt for 30 months with possible 30 month extension if transactions are below a certain threshold
• CCPs clearing derivatives, securities and MMFs exempted for 30 months

Dark trading - pre-trade transparency rules

• Retention of pre-transparency disclosure exemptions for large-in-scale, price reference, order management and negotiated trade waivers for equities
• Exemptions for trading platforms to publish pre-trade quotes: a double volume cap mechanism set at 4% on the amount of trading that can be done per stock/per venue using the reference price waiver (RPW); and 8% global cap applied per stock on an EU-wide basis

Commodity Derivatives:

• Harmonised position thresholds for commodity derivatives
• National Competent Authorities (NCAs) will impose limits on traders positions in accordance with a methodology set by ESMA. This also introduces a “position reporting” requirement by category of trader

Regulatory structure:

• ESMA to conduct annual reviews of how national regulators implement these restrictions and whether these limits conform to ESMAs calculation methodology
• EC and ESMA to set parameters for these limits
• National regulators cannot exceed these thresholds, apart from in exceptional cases

Customer Protection:

• Strengthened conduct rules, i.e., appropriateness tests
• Reinforced and regular information to retail clients via “Statement of Suitability” and periodic assessment by firm of suitability, “containing updated statements of how the investment meets the clients preferences, objectives and other characteristics of the retail client”
• Firm to assess a “sufficient range of financial instruments available on the market which should be sufficiently diverse with regard to the type and issuers, or product providers, to ensure that the clients investment objectives can be suitably met”
• Products should not be limited to products issued or provided by the investment firm itself or by entities having close links with the investment firm….or other entities...with close legal/economic relationships…”
• Ban on commissions (inducements) paid to independent financial advisors and portfolio managers by third parties
• ESMA to prohibit or restrict the marketing and distribution of certain financial products, in well defined circumstances, with similar powers for the EBA in the case of structured statements

Third Country Access:

• Professional investors and eligible counterparties: Harmonised regime based on equivalence assessment of third country jurisdictions by the EC. If equivalence rejected, national regimes to continue
• Retail investors: National regimes remain in place. Member States can impose local branch structure, subject to EU minimum requirements regime

Finally, David finished with a cautionary note that the clearing changes for OTC Derivatives through the European Market Infrastructure Regulation (EMIR) could result in European investment firms being barred from using US CCP (Central Counterparty Clearing) firms.  Interesting.  Although I can’t see that happening, I can see territoriality in clearing becoming a problem as highlighted by Elliott Holley in two recent articles for Banking Technology:

• Extraterritoriality and volumes make future uncertain for CCPs
• CCP “contagion” fears spark derivatives debate

Anyways, it made for a fascinating and sobering meeting to kick off the New Year.  Now on to consider a few other issues, such as the Payment Services Directive III.