Featured Commentary - EU Regulation - David Field, January 2013
EU and UK’s Regulatory Alphabet, from EMIR to FTT to LCR and LEI
By David Field, Rule Financial
David Field is keeping a close eye on regulation in Europe and the US as executive director of Rule Financial, a transatlantic, business and IT consultancy to the global investment banking community. Field spoke with John Lothian News’ editor-at-large Doug Ashburn about the latest regulatory news from Europe and the UK. Field says 2013 will be a big year for regulatory reforms in Europe as EMIR’s standards kick in. He also discusses the good and bad of the financial transaction tax (FTT) and the potential impact of a UK withdrawal from the European Union.
Q: Now that we are into 2013, what are the key regulatory issues that will be looked at, proposed and/or finalized in the coming year?
A: From a European perspective, one of the biggest pieces of regulation that will really start to bite this year is the European Market Infrastructure Regulation (EMIR). That is Europe’s equivalent of the Dodd-Frank Act, and driving toward mandatory clearing and things that are operationally proven to reduce risk around OTC derivatives. This includes both cleared and uncleared assets, which is forcing more collateralization and central clearing.
EMIR technical standards are slated to come into force in the first quarter of 2013, once they do, CCPs will have to apply to regulators for approval and (re)authorization will be granted for this over the course of the year.
Like Dodd-Frank, EMIR requires trade reporting into the equivalent of swap data repositories. This data will be required for all issuers over the course of the year, with both interest rate and credit default swaps by the summer and everything else by end of the year. Mandatory clearing itself, with its latest date, could happen in 2014, but all the work the banks have to do needs to be in 2013.
Q: Are there other items on the agenda as well for 2013 worth mentioning?
A: From a systemic risk point of view, regulators require is the ability to see across the market and know where various exposures and liabilities reside. To do that, they need someone to add up all the numbers from the swap data repositories, by counterparty. The result is regulators needing a way of seeing one bank’s numbering system compared to another.
There is a global initiative called the Legal Entity Identifier (LEI) and January marks the first meeting of the newly formed Regulatory Oversight Committee (ROC). The ROC has to deliver the global central repository identifiers in time for the regulatory reporting that will allow regulators to add up the numbers by legal entity. At the moment, there is significant work for banks to do to improve their databases and take advantage of the LEI central scheme; however there is an issue in that the LEI may not be ready in time.
There is a plan B of sorts, which is to introduce an interim plan and add LEIs later. With two separate courses of action being suggested this does leave plenty of room for confusion as to what will be ready, when.
Q: And the European Parliament is beginning a "rethink" on certain rules. What are you hearing and how do you see the issue progressing from here?
A: The primary concern is the liquidity coverage ratio (LCR). The European Parliament has slowed down implementing this, to give banks more time to comply and increase the eligible collateral. UK banks are largely unaffected by the slowdown because they more than meet the requirements of LCR.
However, the new collateral is taking some pretty large haircuts and can only be a low concentration of the total assets supporting the LCR. It’s a gesture from the European Parliament and it gives banks that are not compliant more time to build their assets and that can only be considered a good thing.
A: By comparison, the Vickers report is more intrusive than the Volcker Rule. Volcker isn’t proposing a business model change; it’s ‘just’ eliminating prop trading by banks. Even then, there are loopholes that will allow US banks to hold proprietary positions provided that they are long-term.
In contrast, the Vickers proposal approved in December provides a ring fence between retail and wholesale banking. The view among some quarters seems to be that the recommendations don’t go far enough. These critics claim banks will find their ways around, under or over the top of the fence.
The result is a call for the ring fence to be ‘electrified’ and for reserve powers to force separation among banks, to almost force ‘Glass-Steagall’ if a bank is found to be attempting to crawl or climb around the ring fence, making it a much more draconian approach than Volcker. There is strong backing to strengthen the ring fencing rules which are now in draft and will be mandated in due course.
The UK is keen for European law to follow suit, to avoid British banks being disadvantaged compared with European counterparts. There is a European equivalent developed by Erkki Liikanen, a Finnish central banker, but the German Bundesbank is not in favor of it and is defending Germany’s banking model. Deutsche Bank would stand to lose if it was broken up so there will be plenty of movement around this before it becomes law.
Q: It is looking as if a financial transaction tax is imminent - an issue at which the UK is at odds with the continent. How do you see this issue playing out?
A: As you are aware, Europe as a whole doesn’t speak with one voice on this. Eleven European countries are in favor of implementing a financial transaction tax (FTT). In order to allow them to go ahead with their own rules, the EU has to grant them special dispensation. It is called ‘enhanced cooperation’ and in this instance has been granted. However there are definitely going to be problems fragmenting the EU with an FTT area and a non-FTT area.
For example, based on the nationality of the firm trading, a German bank trading a German equity in London would be caught by the FTT and must pay the tax. But if you had two British banks trading the same equity, they would not be caught by the tax. This would incentivize trading outside the FTT area and be of benefit to the UK financial services. The European authorities have spotted this and there is now talk that the tax may be based on the nationality of the instrument and not the nationality of the firm trading it.
Having said that, the increased cost of trading a German equity at the margin volumes are likely to reduce. That would lower liquidity in these stocks in the FTT area and widen spreads, further reducing the attractiveness of those stocks. There is a potential raft of unintended consequences from this. So unless it’s universal and global, an FTT isn’t going to work.
Q: We are also seeing signs that there will be clampdowns on high frequency trading and algo trading systems. Will these have any teeth? Do you see them impacting liquidity?
A: High frequency trading is definitely here to stay and it does provide benefits to buyside firms in terms of liquidity, yet there are areas of concern. In times of high volatility, high frequency trading exacerbates price falls and liquidity issues with interrupted orders. Systematic errors from bugs or failures in the trading infrastructure can also move the market.
Regulators are trying to put in some sophisticated circuit breakers to pause trading, for as long as a few minutes. They are putting in place the comprehensive logging of orders and trade flow, and looking at the proprietary database of market activity from Nanex, which apparently comes out to a half trillion quotes in trades in the US market. That would at least allow post-trade forensic analysis of market events for things such as the flash crash in the US.
We’re very interested in the impact on collateral management. I think we’re going to see, as a result of EMIR and Dodd-Frank, a high volume of collateral transactions. As everything becomes collateralized, banks can react much faster as they optimize the use of available assets. That’s going to generate collateral transactions which could lead market participants who don’t have collateral management systems becoming overwhelmed by collateral movements. There is the possibility of a parallel happening in the collateral markets to what’s happened in high frequency trading. There could well be some problems arising.
Q: In all of the above issues, there is concern that such rules will not be applied consistently across the EU, let alone with other jurisdictions. Are these signs that the regulatory arbitrage that we were all warned about is actually happening in earnest? Alternatively, do you see evidence of rule harmonization?
A: The new regulations really haven’t kicked in so we’re not seeing regulatory arbitrage just yet, but there are major concerns about it, particularly about the extraterritoriality of Dodd-Frank. For example, the Volcker Rule applies to European institutions that happen to have a US subsidiary or even a branch, and that’s every bank of note.
Dodd-Frank also insists that non-US regulators such as the FSA have indemnified US swap data repositories before they can access swap data that the regulator has an interest in. There are quite a lot of US-European extraterritoriality concerns. I think what we really need is a policy of equivalence and mutual recognition, which we don’t really have that yet.
Within the EU, there is a lot of effort being placed on harmonizing regulation. There is some growing concern from Prime Minister David Cameron’s recent speech, where he promised the British people the opportunity to vote on pulling out of the European Union. If the UK was to withdraw, Britain would have no basis for shaping European regulation to protect its financial services industry. In this scenario, France and Germany would have no reason not to try and tilt European regulations against London and build a continental financial services industry that benefits Paris or Frankfurt. Today, the UK is the dominant European financial services center. Yet if it was to pull out of Europe it’s not unreasonable that our neighbors would threaten our golden goose.