|MiFID II trading obligation for derivatives|
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MiFIR (Markets in Financial Instruments Regulation) will for the first time require certain derivatives contracts – those that are both cleared through a central counterparty (CCP) and deemed sufficiently liquid – to trade on a ‘trading venue’.
The trading obligation is probably the area where the important interdependencies between MiFIR and EMIR are most highlighted, given that it applies to non-intra group transactions in clearing eligible and sufficiently liquid contracts when traded by counterparties subject to clearing under EMIR.
The primary purpose of the MiFIR trading obligation is to determine which of those derivatives subject to the EMIR clearing obligation should also be required to trade on:
3) OTFs or
4) equivalent third country venues when traded by relevant counterparties (subject to the European Commission decision on equivalence and reciprocity).
Moreover, this link to the clearing obligation does mean that the trading obligation cannot apply to any derivatives contracts which are not traded OTC and already trade exclusively on venues, since such contracts will fall outside of the scope of EMIR and can never be said to be subject to the clearing obligation.
On the other side, not everything that becomes subject to the clearing obligation will necessarily pass the MiFIR venue and/or liquidity tests.
It appears that the EMIR and MiFIR classes will not be forced into alignment and it consequently means that there may be contracts that are mandatorily clearable but which do not become subject to the trading obligation, as is the position in the US (ISDA MiFID II Discussion Paper Submission of 31 July 2014).
The issue of trading obligation on regulated markets, MTFs or OTFs in principle relates to derivatives as a whole, emissions derivatives including (the relevant provisions of MiFIR are placed under the heading: “Derivatives”).
Implementation of the OTC derivatives markets reform
Trading obligation under MiFID II must be seen in the broader international context of the process run under the auspices of the Financial Stability Board (FSB).
At end-June 2017, six FSB member jurisdictions had determinations in force for specific products to be executed on organised trading platforms, up from three at end-June 2016 (OTC Derivatives Market Reforms Twelfth Progress Report on Implementation, Financial Stability Board, 29 June 2017, p. 31, 32).
MiFIR specifies that subject to the trading obligation will be transactions concluded between:
(2) non-financial counterparties that meet the conditions stipulated by EMIR to be covered by the clearing obligation (referred to in Article 10(1b) thereof) i.e. in brief, when the rolling average speculative positions (as opposed to hedging, that is “which are not objectively measurable as reducing risks directly relating to the commercial activity or treasury financing activity of the non-financial counterparty”) over 30 working days exceed the clearing threshold.
When it comes to the scope covered by point 2 above, i.e. non-financial counterparties above the clearing threshold, trading obligation goes beyond the traditional domain of financial legislation. However, such an extension can be seen as a landmark of a post-crisis era, where not purely financial, but systemically important entities, are put into the area of financial regulators' attention.
Trading obligation is thus among the points where MiFID II imposes legal requirements on entities not being classical financial institutions.
The consequence of such an approach is, however, that contracts concluded by the above entities with, for instance, NFCs- are clearly beyond the scope of the new requirement.
The substance of the trading obligation
The trading obligation as designed by MiFIR consists in the requirement placed on counterparties to conclude relevant transactions only on regulated markets, MTFs, OTFs or third country trading venues (subject to the European Commission decision on equivalence and reciprocity).
Covered transactions encompass the trades with other such financial counterparties or NFCs+ in derivatives pertaining to a class of derivatives that has been declared subject to the trading obligation by the European Commission in accordance with the special procedure and listed in the register established by the European Securities and Markets Authority (ESMA).
Hence, the focus is on regulatory technical standards (for this purpose ESMA has already published on 20 June 2016 the Discussion Paper (ESMA/2016/1389) and the Consultation Paper of 19 June 2017 (ESMA70-156-71).
The contracts potentially endangered in the first place are those subjected to EMIR clearing obligation.
The trading obligation may relate to classes of derivatives as well as individual derivative contracts.
Intra-group transactions and transactions referred to in the transitional provisions of EMIR (Article 89) are not covered.
MiFIR determines that the trading obligation applies to third-country entities, that would be subject to the clearing obligation if they were established in the Union, which enter into derivative transactions pertaining to a class of derivatives that has been declared subject to the trading obligation, provided that the contract has a direct, substantial and foreseeable effect within the Union or where such obligation is necessary or appropriate to prevent the evasion of any provision of the MiFIR.
What is covered by this enigmatic legal formula is specified in more concrete way in the level 2 legislation - Commission Delegated Regulation (EU) 2017/579 of 13 June 2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on the direct, substantial and foreseeable effect of derivative contracts within the Union and the prevention of the evasion of rules and obligations.
The said delegated Regulation (EU) 2017/579 of 13 June 2016 specifies the types of contracts with third country counterparties that are subject to the trading obligation, as well as the cases where the trading obligation is necessary and appropriate to prevent avoidance of the provisions in MiFIR.
These rules are mostly identical to the Commission Delegated Regulation (EU) No 285/2014 adopted under Article 4(4) of EMIR, which specifies the types of contracts with third country counterparties that are subject to the clearing obligation as well as the cases where the clearing obligation is necessary and appropriate in the cross-border application.
Given both regulations governing the clearing and the trading obligations, when it comes to cross-border effects, are in the intrinsic relationship, legislators saw no reasons to have in each area divergent premises and thresholds.
Also the technical terms necessary for a comprehensive understanding of the technical standards have the same meaning in both delegated regulations.
One thing is particularly important in the application of the said delegated Regulation (EU) 2017/579 of 13 June 2016.
Article 33(3) of the MiFIR states that the conditions laid down in Articles 28 and 29 of this Regulation (governing the trading and clearing obligations) are deemed to be fulfilled when at least one of the counterparties is established in a country for which the European Commission has adopted an implementing act declaring equivalence in accordance with Article 33(2) of MiFIR.
Therefore, the the said delegated Regulation of 13 June 2016 also applies to contracts where both counterparties are established in a third country whose legal, supervisory and enforcement arrangements have not yet been declared equivalent to the requirements laid down in that Regulation.
The said Commission Delegated Regulation of 13 June 2016 refers specifically to:
- guarantees provided on a cross-border basis by financial counterparties established in the European Union,
- OTC derivative contracts concluded between the European Union branches of financial counterparties established in third countries,
- indicators of the evasion of rules.
The pertinent provisions are quoted in the boxes below.
Register of the classes of derivatives declared subject to the trading obligation
The register for classes of derivatives declared subject to the trading obligation will be published and maintained by ESMA on its website.
The said register will specify the derivatives that are subject to the obligation to trade, the venues where they are admitted to trading or traded, and the dates from which the obligation takes effect.
Whenever the trading obligation is extended to other asset classes, ESMA may adjust the register to the specificities of that asset class.
The maintenance by ESMA of the list of "trading venues where the derivatives are admitted to trading or traded" occurs problematic.
Although this register resembles the clearing obligation register where ESMA has to include the CCPs that are authorised or recognised to clear the OTC derivative classes subject to the clearing obligation, however, contrary to EMIR which requires that competent authorities immediately notify ESMA when they authorise a CCP to clear a class of OTC derivatives (Article 5(1) of EMIR, which has been further specified in Article 6 of Commission Delegation (EU) No 149/2013), ESMA will not receive such granular information from competent authorities or trading venues with respect to the trading obligation for derivatives.
While Articles 18(10) and 56 of MiFID II require ESMA to maintain and keep an up-to-date list of MTFs, OTFs and regulated markets, this list will only include basic information on the trading venues, such as MIC, full name, country of establishment, competent authority, date of notification, and type of instruments that can be traded.
In the Consultation Paper of 19 June 2017 ESMA observed that the MiFID II does not contain the empowerment for ESMA to develop draft RTS further specifying the details to be included in the notification of regulated markets, MTFs and OTFs.
Hence, the information that ESMA will receive from competent authorities for the registers for regulated markets, MTFs and OTFs will not be granular enough to identify those trading venues that make derivatives subject to the trading obligation available for trading.
ESMA notes, moreover, that for the purposes of the Discussion Paper of 20 December 2016 and the said Consultation Paper of 19 June 2017 it obtained from competent authorities the information on the trading venues on which the classes of derivatives that are considered for the trading obligation are made available for trading, however, in MiFIR there are no provisions for the automatic transmission of the necessary information from third country trading venues as provided in Article 25 of EMIR for CCPs established in a third country.
MiFIR, furthermore, does not provide for a similar system of recognition of third country trading venues by ESMA following an equivalence decision of the European Commission.
ESMA therefore intends to maintain the register for third country trading venues only on a best effort basis, based on information received from third-country authorities and from third-country trading venues.
This seems to be an important shortcoming of the trading obligation register.
Another area of concern with respect to trading obligation register and the venue test is that ESMA intends to assess the trading obligation preconditions irrespective of whether actual trading takes place when a derivative is admitted to trading.
ESMA, moreover, does not see a need do be presented a proof of effective trading in order for a derivative to be considered traded on a trading venue for the purpose of the trading obligation (Consultation Paper of 19 June 2017, p. 11, 12).
Such suggestions are, in the ESMA's opinion, impossible to implement in practice.
ESMA argues that the trading venue test is to be applied, in accordance with Article 32(2)(a) of MiFIR, at a class of derivatives level (or a relevant subset thereof).
According to ESMA, in this context, it is difficult to establish whether there is actual trading for all the derivatives within a specific class.
In addition, Article 28(3) of MiFIR provides that “derivatives declared subject to the trading obligation [...] shall be eligible to be admitted to trading on a regulated market or to trade on any trading venue [...] on a non-exclusive and non-discriminatory basis”.
ESMA is of the view that the venue test should:
- be applied more broadly,
- focus on whether a specific class of derivatives is available for trading on a European trading venue and not on an assessment of actual trading of a specific derivative.
This would be the case where a trading venue offers to trade this class of derivatives to its members and participants or clients.
This approach was maintained in the ESMA’s Final Report of 28 September 2017, Draft RTS on the trading obligation for derivatives under MiFIR (ESMA70-156-227) were ESMA specified that with regard to trading venues where the relevant instruments are available for trading, ESMA will maintain a separate register with the list of trading venues that are trading interest rate derivatives and credit derivatives.
In the said Final Report ESMA stated that this register will not specify on which particular trading venue a given granular instrument is traded.
Another ESMA’s register will contain classes of derivatives subject to the trading obligation - see box.
Trading obligation procedure
General rules for identifying derivatives that will be subject to the trading obligation are stipulated in Article 32 of MiFIR (see text in the box).
As the Level 1 regulation is rather laconic with respect to specificities of the new framework, the details are further specified in secondary legislation.
The emphasis is placed on regulatory technical standards to determine the following:
(1) which of the class of derivatives declared subject to the clearing obligation must be traded on the venues referred to above;
(2) the date or dates from which the trading obligation takes effect, including any phase in and the categories of counterparties to which the obligation applies.
Public consultation is obligatory before ESMA’s submitting the draft regulatory technical standards to the European Commission for adoption.
The prerequisites for the trading obligation to take effect are:
(1) the class of derivatives or a relevant subset thereof must be admitted to trading on a regulated market or must be traded on at least one regulated market, MTF or OTF, and
(2) the class of derivatives or a relevant subset thereof must be considered sufficiently liquid.
ESMA sees its role mostly to "respond to decisions taken under the clearing obligation".
It is noteworthy, Article 32(4) of MiFIR empowers ESMA to identify and notify to the European Commission also on its own initiative the classes of derivatives or individual derivative contracts that should be subject to the trading obligation but for which no CCP has yet received authorisation under EMIR or which are not admitted to trading or traded on a trading venue.
Following the notification, the European Commission may publish a call for development of proposals for imposing the trading obligation on those derivatives.
ESMA's Discussion Paper of 20 September 2016, The trading obligation for derivatives under MiFIR (ESMA/2016/1389) contains in this regard an important information that "at this stage, ESMA does not intend to identify on its own initiative classes of derivatives that meet the conditions in Article 32(4) of MiFIR and should be subject to the trading obligation. This is without prejudice that ESMA may use this possibility at a later point in time if considered necessary."
Criteria for determining whether derivatives subject to the clearing obligation should be subject to the trading obligation
Commission Delegated Regulation (EU) 2016/2020 of 26.5.2016 supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on criteria for determining whether derivatives subject to the clearing obligation should be subject to the trading obligation provides clarity in the determination of a class of derivatives or relevant subset thereof which is sufficiently liquid, in particular, through specifying some metrics for indication of the level of third-party buying and selling interest (Article 1), and in particular:
- the average frequency of trades (Article 2),
- average size of trades (Article 3),
- number and type of active market participants (Article 4), and
- average size of spreads (Article 5).
Where the ESMA has established that a class of derivatives should be subject to the clearing obligation under EMIR and that the derivatives are admitted to trading or traded on a trading venue, ESMA should follow the criteria stipulated in the said Regulation to determine whether the derivatives or subset thereof are considered sufficiently liquid to trade exclusively on trading venues.
ESMA's assessments in that regard can be found in the Discussion Paper, The trading obligation for derivatives under MiFIR of 20 September 2016 (ESMA/2016/1389), which were followed by the Consultation Paper, The trading obligation for derivatives under MiFIR, 19 June 2017, ESMA70-156-71 and concluded in the Final Report, Draft RTS on the trading obligation for derivatives under MiFIR, 28 September 2017, ESMA70-156-227.
In the said Final Report of 28 September 2017 ESMA, in particular, maintained its approach that no specific exemption from the trading obligation should be granted for large trades.
List of classes of derivatives subject to the trading obligation under MiFID II
List of classes of derivatives subject to the trading obligation under MiFID II pursuant to the ESMA's Consultation Paper, The trading obligation for derivatives under MiFIR of 19 June 2017 (ESMA70-156-71)
The draft list of classes of derivatives subject to the trading obligation under MiFID II has been firstly proposed in the Annex to the Draft Commission Delegated Regulation (EU) supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on the trading obligation for derivatives (included in the ESMA's Consultation Paper, The trading obligation for derivatives under MiFIR of 19 June 2017 (ESMA70-156-71)).
The said list is set out in the tables below.
Fixed-to-float interest rate swaps denominated in EUR
Fixed-to-float interest rate swaps denominated in USD
Fixed-to-float interest rate swaps denominated in GBP
List of classes of derivatives subject to the trading obligation under MiFID II pursuant to the SSMA’s Final Report of 28 September 2017, Draft RTS on the trading obligation for derivatives under MiFIR (ESMA70-156-227)
In the Final Report of 28 September 2017, Draft RTS on the trading obligation for derivatives under MiFIR (ESMA70-156-227) little change has been made in the final draft RTS to the instruments proposed to be subject to the trading obligation in the Consultation Paper of 19 June 2017.
ESMA has decided to generally maintain its initial approach regarding the classes of interest rate derivatives to be subject to the trading obligation, however, based on the feedback took into account some propositions submitted by market participants.
Modifications to the trading obligation made by ESMA in the Final Report of 28 September 2017 include:
The table on the trading obligation for Index CDS, has not been changed by ESMA in the Final Report of 19 June 2017.
Classes of derivatives subject to the trading obligation as proposed by ESMA in the Final Report of 28 September 2017 are specified in 4 tables in the Annex to the draft Regulatory Technical Standard attached to the said Report - see boxes below.
Application of the derivatives trading obligation to package transactions
The scale of the problem is underlined by the "enormous number of conceivable permutations including but not limited to packages consisting of cash equities, cash bonds, exchange traded derivatives, and all other types of OTC derivative (including those subject to mandatory clearing under EMIR, those not subject to mandatory clearing but otherwise generally accepted for clearing at several CCPs, and those not clearable at any CCP" - see the above-mentioned ISDA MiFID II Discussion Paper Submission).
It was observed that the simultaneous execution of a package with a single counterparty using a single execution method alleviates the timing and mechanical risks and lowers bid/offer costs to those of the intended risk of the package.
Exposing one component transaction to the derivatives trading obligation will jeopardise the ability of market participants to execute the entire package, particularly where no trading venue offers trading in the intended package
1) separately trading the components of a packaged tansaction incurs the possibility of the market moving between executions of each component because such executions cannot be precisely time-matched,
2) there are likely to be differences in contract specifications, mode of execution, clearing/settlement workflows and relative liquidity when components of a packaged transaction are executed separately and/or on different venues, and
3) accessing different sources of liquidity for the various components when traded across different venues or over-the- counter incurs additional bid/offer spreads.
Inevitably, ESMA in its draft MiFID/MiFIR implementing legislation need to pay special attention to package transactions in the context of trading obligation and to propose solutions that will not inadvertently increase market risks.
Conclusions on trading obligation for derivatives
To summarise this part of trading obligation considerations, MiFIR framework requires clearing eligible and sufficiently liquid derivatives to trade on a trading venue.
The only derivatives contracts that will in future continue to trade OTC are those that do not meet the test of being ‘clearing eligible and sufficiently liquid’.
In effect of EMIR and MiFIR legal developments, the entire set of to-date OTC derivatives contracts is categorised into mutually interlinked subsets of:
(1) classes of derivatives declared subject to the clearing obligation, and
(2) classes of derivatives declared subject to the trading obligation.
The former of the above groups will inevitably be more spacious.
Moreover, finalizing subordinate legislation on the trading obligation for derivatives is closely interlocked with OTF developments (necessary for passing trading venue and liquidity tests).
Another aspect are dynamic adjustments of both a clearing and trading obligations to fluctuating market arrangements and conditions with regard to trading venues compositions and liquidity flows.
EU law-making process may occur not entirely fit-for-purpose in that regard, due to its potential delays in issuing or adjusting the relevant regulatory technical standards.
ESMA made an interesting observation that this might lead to a de facto ban on trading in an instrument, if it was no longer capable of trading on venues, but was required to do so by the trading obligation.
ESMA also noted the risks involved in the potentially misaligned lists of contracts subject to the clearing and the trading obligations.
The emphasis should be placed, therefore, on ensuring that the trading obligation is only applied to derivatives where reasonable expectation exists to remain liquid in the foreseeable perspective taking into account variable market conditions and an instrument life cycle.
Furthermore, it seems that it would be useful for market participants to incorporate in their IT trading infrastructure feeds from ESMA’s website registers for the above categories in order, for instance, automatically stop any potential OTC trading that would infringe on the class of derivatives declared subject to the regulated market trading obligation.
Article 32(1)(b) of MiFIR requires ESMA to specify the dates from which the trading obligation takes effect, including any phase-in and the categories of counterparties to which the obligation applies, where such phase-in and such categories of counterparties are envisioned in the regulatory technical standards pertinent to EMIR.
The earliest date from which the trading obligation can apply is the date of application of MiFIR, i.e. 3 January 2018.
Important considerations are:
- trading obligation must be aligned with the clearing obligation, and
- mandatory trading with respect to a class of derivatives should not apply to a category of counterparties prior to such category of counterparties being subject to mandatory clearing with respect to that class of derivatives.
Given the regulatory technical standards on the clearing obligation provide for a phase-in for different categories of counterparties, it is considered necessary to ensure that the trading obligation applies at the earliest from the date the respective counterparty is subject to the clearing obligation.
Regulatory technical standards (RTS) adopted so far for the purposes of the clearing obligation provide, in particular, for a phase-in for four different categories of counterparties which covers a period of three years following the entry into force of the RTS.
Dates at which the the trading obligation will take effect - earliest application dates
* Dates in brackets for counterparties in Category 3 reflect amendments made by the Commission Delegated Regulation (EU) of 16.3.2017 amending Delegated Regulations (EU) 2015/2205, (EU) 2016/592 and (EU) 2016/1178 as regards the deadline for compliance with clearing obligations for certain counterparties dealing with OTC derivatives, 16.3.2017 C(2017) 1658 final.
The same categories of counterparties are intended for the purpose of the trading obligation.
It is to be considered yet whether to provide for some longer phase-in periods for operational reasons.
It is argued, this may be necessary as counterparties that will be subject to the trading obligation may require sufficient lead time to update their systems and procedures to comply, to ensure connection to trading venues etc.
However, the draft Commission Delegated Regulation (EU) supplementing Regulation (EU) No 600/2014 of the European Parliament and of the Council on markets in financial instruments with regard to regulatory technical standards on the trading obligation for derivatives (included in the ESMA's Consultation Paper, The trading obligation for derivatives under MiFIR of 19 June 2017 (ESMA70-156-71)) does not foresee any such longer phase-in periods.
The draft Regulation only ensures that its provisions do not apply before the application of the clearing obligation in relation to the four categories of counterparties identified in accordance with the EMIR Regulation for the clearing obligation purposes and before the MiFID II application date (3 January 2018).
Practically, in effect of the considerations made in the aforementioned Consultation Paper of 19 June 2017, the following schedule of the dates on which the the trading obligation takes effect has been presented by ESMA.
Date on which the the trading obligation will take effect
according to the ESMA Consultation Paper, The trading obligation for derivatives under MiFIR
of 19 June 2017 (ESMA70-156-71))
In the Final Report of 28 September 2017, Draft RTS on the trading obligation for derivatives under MiFIR (ESMA70-156-227), despite some reservations (regarding mainly the trading obligation being applied to counterparties of category 1 and 2 on 3 January 2018 without prior favourable venue equivalence determination being made in time for major jurisdictions, including the US), ESMA decided to maintain the dates proposed in the Consultation Paper of 19 June 2017 as set out in the above table.
Accordingly, under the ESMA’s draft RTS of 28 September 2017:
- for counterparties of categories 1 and 2 the trading obligation would take effect on the date of entry into force of the RTS, i.e. the day following the publication of the RTS in the EU Official Journal,
The above timelines raise some operational issues regarding the Organised Trading Facilities (OTFs) on the MiFID II entry into force.
Given that OTFs will not be authorised until 2018, investment firms will have no time to connect to these types of venues, test connections and ensure that legal documentation is in place prior to 3 January 2018.
The consequence is that the application of the trading obligation on that day would temporarily favour using the existing market infrastructures (i.e. regulated markets and Multilateral Trading Facilities (MTFs) for the trading obligation.
Trading obligation for investment firms for shares and equity like instruments
The entirely separate issue is the MiFIR requirement imposed only on MiFID-licensed investment firms.
Such firms must ensure that the trades they undertake in shares admitted to trading on a regulated market or traded on a trading venue take place on:
1) a regulated market,
2) MTF or
3) systematic internaliser, or
4) a third-country trading venue assessed as equivalent in accordance with Article 25(3)(a) of MiFID II Directive, as appropriate;
unless their characteristics include that they:
- are non-systematic, ad-hoc, irregular and infrequent, or
- are carried out between eligible and/or professional counterparties and do not contribute to the price discovery process.
Moreover, an investment firm that operates an internal matching system which executes client orders in shares, depositary receipts, exchange-traded funds, certificates and other similar financial instruments on a multilateral basis must ensure it is authorised as an MTF under MiFID II Directive and comply with all relevant provisions pertaining to such authorisations.
|Last Updated on Tuesday, 10 October 2017 23:59|