Next year could end up largely determining how derivatives trade across borders. As the European Union (EU) puts the finishing touches to its revised Markets in Financial Instruments Directive (MIFID II) ahead of implementation on January 3, 2018, the need for regulators to consider whether the rules align with those in the US will become critical. Failure to find agreement could change the nature of the global derivatives market forever, transforming what was a single pool of liquidity into smaller, shallower, more fragmented pools.
This issue was very much front and centre at ISDA’s first ever trade execution conference last week, and our speakers gave some fascinating perspectives. Our first keynote speaker, Edwin Schooling Latter at the Financial Conduct Authority, stressed the importance of mutual equivalency, and argued that derivatives markets would be more liquid if European firms subject to the trading obligation can trade at the same venues as US firms subject to the swap execution facility (SEF) rules.
Our second keynote, the Commodity Futures Trading Commission’s (CFTC) J. Christopher Giancarlo, also warned about the risks of market fragmentation, and pointed out that liquidity pools have already divided between those in which US persons are able to participate and those in which they are not – a fact picked up in successive ISDA research reports.
The cause of this fragmentation in liquidity, he said, is “ill-designed rules and burdensome regulations”, and he called on the CFTC to revisit its SEF requirements. To get an idea of what those changes might be, it’s well worth looking back at Commissioner Giancarlo’s January 2015 whitepaper on the CFTC’s swaps trading rules.
We agree that targeted changes to certain elements of the SEF rules could help promote more trading and make cross-border equivalence and substituted compliance determinations more achievable. For example, in a petition that ISDA filed with the CFTC last year, we argued that the CFTC’s SEF rules – particularly an obligation for ‘required transactions’ to trade on an order book or a request-for-quote system where requests are sent to three participants – is unnecessarily restrictive and at odds with language in the Dodd-Frank Act, which merely requires trading to take place “by any means of interstate commerce”. The end result is a regime that discourages and restricts trading on SEFs, rather than encouraging it.
Emergence of further detail in the MIFID II rule-making would also be helpful to the goal of cross-border convergence. In particular, ISDA would like to see a high level of granularity in the setting of the trading obligation. This would ensure that firms have a clear and defined product list, and would avoid confusion about whether a particular product is in scope. It would also have the advantage of aligning Europe more closely with the US.
Even with changes such as these, however, US and European rules are unlikely to ever be identical. It’s therefore crucial that equivalence and substituted compliance decisions are based on broad outcomes.
The good news is, speakers at our trade execution conference recognized this point. Regulators and market participants on both sides of the Atlantic spoke about the importance of equivalence – and the need to make the necessary determinations based on outcomes. There was a broad consensus that the US and EU regimes are largely the same in in terms of objectives, even if the detail of the rules differ. That mirrors analysis ISDA conducted on the two regimes earlier this year.
This is positive news to end 2016. The challenge for 2017 will be to follow that through. The ability for derivatives users to trade safely, efficiently and cost-effectively by accessing a global liquidity pool depends on it.