Listed derivatives face MiFID II clearing threat (free content)

5 min read
Helen Bartholomew

As much as half of the exchange traded derivatives market is under threat from proposed regulation that would prevent clients from accessing futures and options trades without a direct clearing broker relationship.

Indirect clearing, which enables derivatives users to access clearing houses by facing a client of a clearing broker rather than the broker itself, is set to be overhauled in an attempt to boost client protection via the second version of the Markets in Financial Instruments Directive, due to be implemented in 2017.

But market participants believe that regulatory attempts to standardise the treatment of positions and collateral in the event of a bankruptcy in the indirect clearing chain could jeopardise access to key financial markets.

“Being able to easily identify clearing assets is a great goal but regulators don’t have to insist on a common bankruptcy regime,” said the clearing head at a European dealer. “Without a standard bankruptcy regime it’s going to be impossible to achieve the target and could have a material impact on client ability to access global markets.”

A well-established practice in the listed derivatives market, indirect clearing enables CCP access for those clients without a direct relationship with a clearing broker.

It is a common occurrence, either because the broker doesn’t want to be exposed to the credit risk of the client, or more typically because the client’s portfolio of derivatives could have a large negative impact on the broker’s balance sheet due to the leverage ratio under CRD IV and regulatory capital rules.

Leapfrog payments

New rules written by the European Securities and Markets Authority state that following the insolvency of a direct client offering clearing access to indirect clients, leapfrog payments must be made from clearing broker to indirect client to make good on the position.

Under the current market structure, if the direct client is deemed to be insolvent, the indirect client simply becomes a creditor and subject to the relevant bankruptcy proceedings of the jurisdiction. That would typically make the indirect client a creditor of the insolvent entity.

“The idea of a leapfrog payment is totally new in the exchange traded derivatives world,” said Simon Puleston Jones, CEO of the Futures Industry Association Europe.

“There are significant legal challenges involved when seeking to ensure the enforceability of a leapfrog payment in a way that is scalable.”

The aim is for new rules governing exchange traded derivatives to mirror changes currently afoot in the over-the-counter swaps world under the European Markets Infrastructure Regulation, which incorporates a similar approach.

However, no indirect clearing has yet taken place under EMIR as European rules forcing swaps transactions through central counterparty clearing firms are not expected to go live for derivatives dealers until later this year, while clients will not be captured by the mandate until 2016 at the earliest.

“The swaps clearing regime under EMIR is being created from scratch in a market that doesn’t have any indirect clearing relationships today, so the impact is very limited. By way of contrast, indirect clearing has existed in the exchange traded derivatives world for many decades. It typically happens whenever a US client trades in Europe and whenever a European client trades in the US,” said Puleston Jones.

Global web

And there are further problems created by the global nature of relationships in the chain.

“The jurisdictional scope needs to be clarified as there are at least four entities in the chain and the proposals don’t state which jurisdictions are relevant. Does it apply only if all four are in the EU of does it still apply if some are outside? We need clarification on that,” said Puleston Jones.

FIA members propose that the leapfrog payment only applies only where a both the clearing house and indirect client are located in the EU.

The FIA also proposes that clients are given the choice of opting in or out of leapfrog payments through their selection of segregated account type. The industry body suggests that for net omnibus accounts (which pool client assets), the new rules are not implemented.

For gross omnibus accounts, however, which offer increased investor protection by isolating each client’s collateral, some form of leapfrog payments could be included, potentially via a security arrangement. That would grant an interest in a portion of collateral to the indirect client.

“It’s important that clients be given the choice of segregation and asset protection options, but even if they choose additional protection through a security arrangement, there are still questions over the enforceability across jurisdictions, which makes it difficult to see a security interest model as a scalable solution,” said Puleston Jones.

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