Build a car engine from scratch, and it’s a fair bet that it won’t be purring the first time it’s switched on. That doesn’t mean the engineer has failed, and it doesn’t mean the whole thing needs to be smashed up. It’s just likely to need fine-tuning and refinement before the engine is really performing as it should.
A similar thing can be said of financial regulation. Draw up a whole new framework for derivatives clearing and reporting when nothing like that has existed before, and it stands to reason that not everything will work out quite as it’s meant to. The easy thing to do would be to say that the legislation is set in stone and to move on. The more difficult approach is to take the time to tinker under the bonnet and make it as good as it can be.
That’s why Europe deserves credit for taking a cold, hard look at existing European regulation to see what’s working well and what’s not, and thinking about how it can be made better. This requirement for a review was baked into the European Market Infrastructure Regulation (EMIR) legislation, and the European Commission last week published an initial report, incorporating feedback received as part of the EMIR review and so-called ‘call for evidence’ on European financial regulation.
The report highlights a number of areas that require further review, including an assessment of whether the rules have a disproportionate impact on non-financial corporates and small financial entities. Such a review makes sense, as these firms may not pose systemic risk, yet they face significant compliance costs in meeting the rules, which could limit their ability to invest and/or lend.
For instance, European rules currently require both parties to a transaction to report each new derivatives trade. This is out of line with the approach taken by many other regulators, which typically take an entity based approach, where sole responsibility for the accuracy of reported data is assigned to one counterparty – usually the dealer for a bilateral transaction. The dual-sided mechanism within European rules creates cost and complexity for little apparent gain.
According to research conducted by ISDA, the aggregate cost for end users in meeting Europe’s dual-sided reporting requirements is estimated to be in excess of €2 billion. Despite this, data quality is poor. A lack of clarity around what needs to be reported and how, and differences in reporting requirements between repositories, means pairing rates are low – around 60%. We think moving to an entity based approach would not only reduce cost for end users, but would actually improve data quality and consistency.
There were also positive noises on clearing. Notably, the EC highlights the importance of a mechanism to promptly suspend the clearing mandate. As it stands, this can only be achieved following the approval of regulatory technical standards, but this takes time. A market shock that impacts liquidity or the failure of a clearing house would require a much faster response – which is acknowledged in the report.
The highly controversial frontloading requirement is also flagged for review. ISDA has long raised concerns about the operational complexity of this rule – which is unique to Europe – and the European Securities and Markets Authority has already made several adjustments to it. We think the challenges caused by this requirement far outweigh any possible benefits, and removing it would not reduce the effectiveness of the incentives to clear within EMIR.
Access to client clearing for small financial institutions with limited derivatives activity is another area highlighted by the EC (an issue examined by ISDA in a recent research report). This has been largely attributed to the impact of the Basel Committee on Banking Supervision’s leverage ratio, which does not allow clearing-member banks to recognize client collateral as risk reducing in the leverage ratio exposure calculation. The EC has proposed changes to this approach in its revised Capital Regulations Regulation and directive proposals, which is intended to reduce the cost of offering client clearing services.
So, what’s the next step? The EC has recommended a legislative review of EMIR next year, as well as a look at the relevant technical standards linked to the legislation. We welcome that approach, and think other jurisdictions should consider doing something similar. The chances of getting everything 100% right first time on such a far-reaching piece of legislation are small. Regulators and legislators should not back away from reviewing what they’ve done to ensure everything is working as they intended.