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EU trading rules delay creates global confusion

At issue is a coordinated effort to ensure less risk from trades that were at the heart of the financial crisis.

Banks and other financial institutions are calling on the United States to follow the European Union in putting off new rules on trading of a type of complex securities to stave off a potentially messy market disruption.

The European Commission recently diverged from the U.S. and Japan by delaying until mid-2017 a global regulation put in place following the financial crisis. The rules require banks to put up billions of dollars in collateral to reduce the risk of trading derivatives — speculative financial instruments, which allow investors to bet on future market movements, from the price of pork belly to the level of interest rates.

Derivatives shouldered some of the blame for the financial crisis due to their opacity and subsequent investor losses. As a result, politicians decided at the G20 summit in Pittsburgh in 2009 that certain standardized derivatives should be settled at a clearing house, which stands in the middle of transactions as the buyer to every seller and seller to every buyer — ensuring payments are honored even if one side defaults.

Politicians also stated that the remaining bilateral — or non-centrally cleared — derivatives should be subject to higher capital requirements. The collateral required by these rules makes direct trading between banks and other financial firms safer, as the money covers losses that would arise if one party defaults.

But the varying speeds of legislative processes in key jurisdictions have tripped up the plan for coordinated implementation across the world’s major capital markets. Unsurprisingly, lots of bankers are unhappy about it.

The additional collateral required by the rules will make bilateral derivatives trades more expensive. In other words, non-EU banks that must follow the rules from September 2016 will be at a competitive disadvantage.

“You’re left with different regimes coming in at very different times,” said one banking source who asked not to be named. “You’re going to have people constantly repapering, and it would create quite a lot of market disruption and uncertainty.”

That has led financial institutions to call for the U.S. to follow suit with a delay until 2017.

But so far, U.S. and Japanese regulators have publicly stated that they will stick with the timeline set by the Basel Committee on Banking Supervision and the International Organization of Securities Commissions.

One influential U.S. regulator — Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation — echoed this message in saying  he saw no reasons to delay U.S. implementation of the rule.

“U.S. margin requirements will go far to reduce the systemic risk … and to help ensure that banks have a measure of collateral protection against potential counterparty defaults,” he said.

This stance, however, still leaves open the question of a global delay for the second wave of the rules. The rules take effect for the biggest banks in September 2016, but it’s not until March 2017 that all other financial firms must start posting collateral.

That means the U.S. could compromise and meet the EU part way by aligning the second wave with the EU’s revised mid-2017 date. But with major U.S. politicians already opposing a delay, it might not be politically viable.

In the Commission’s statement on June 9, it said the objective was to deliver final rules by the end of the year and for firms covered by the first wave of the rules to comply before the middle of 2017.

A Commission official told POLITICO the delay was unavoidable: “The international rules were finalized in March 2015, and we received the standards from the ESAs (European Supervisory Authorities) in March 2016. This timeline would not have allowed for the standards to be finalized by September, including time for the sector to prepare on the basis of a stable legal text.”

It begs the question how the U.S. and Japan were able to stick to the international timeframe, but the EU process from final rules to implementation is arguably more time-consuming. After the Commission receives the text from the ESAs, it must review it from a legal and policy perspective, translate it into every EU language and give the Parliament and Council a scrutiny period — a process which in itself can take six months.

The derivatives delay, however, is the latest EU hold-up in the implementation of post-crisis rules. After it became apparent in October 2015 that the European Securities and Markets Authority would not be able to finalize key technical infrastructure on time, the Commission proposed in February a one-year delay to the revised Markets in Financial Instruments Directive.

Market disruption isn’t the only reason the industry is fighting for a uniform start date to the derivatives collateral rules.

The International Swaps and Derivatives Association (ISDA), an influential industry group, is working with law firms to provide a market-wide protocol to enable industry participants to change their collateral documentation. This is a mammoth task, which has been undertaken by three law firms along with ISDA to prevent the industry from having to manually renegotiate collateral contracts. It was due to be finalized before March 2017.

One lawyer working with ISDA on the protocol says it needs to be built imminently to be ready in time, so there are question marks over whether the protocol will be able to cover the EU rules, known as the European Market Infrastructure Regulation (EMIR).

“We don’t know what the phase-in of those final rules will be or whether there will be any changes that would affect the content of the protocol,” the lawyer said. “There is the question of whether it goes ahead at all, or whether it goes ahead without EMIR.”

Lawyers from two of the law firms working on the protocol say they think it will most likely go ahead without the EMIR rules, if there is no delay granted from the other two jurisdictions. To do so, any provisions based on the EU rules would have to be removed from the protocol.

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It sounds simple, but given the cross-border nature of the derivatives market, the confusion has left bankers scratching their heads. The scope of the U.S. margin rules reaches any banks dealing with U.S. firms, meaning any EU banks either based in the U.S. or transacting with U.S. banks will still find themselves subject to the rules and will have to put in place interim documentation.

“The announcement by the EC that Europe’s rules will not be ready until the end of the year complicates this initiative,” said Katherine Darras, ISDA’s general counsel. “But no decision has been taken on how to proceed at this stage.”