THE IMPACT OF NEW EU LEGISLATION ON DERIVATIVES TRADING Anthony Belchambers, CEO, FOA

1. THE IMPACT OF NEW EU LEGISLATION ON DERIVATIVES TRADING Anthony Belchambers, CEO, FOA 16th November 2011

2. Eu REGULATORY APPROACH TO DERIVATIVES • To more closely regulate OTC markets and dealers • To incentivise CCP clearing of OTC contracts • To favour multilateral execution on “organised trading venues” (ie regulated markets, MTFs and OTFs) • To develop tougher capital rules to cover the risk of OTC transactions (ie prudential capital, collateral and margin) • To incentivise standardisation and strengthen transparency and transaction reporting requirements • To improve back office processing of OTC transactions • To retain some flexibility for non-financial end users • To approximate, but not necessarily copy out, the US position

3. MAKING THE CASE FOR A BALANCED APPROACH • “The Commission believes that a paradigm shift must take place away from the traditional view that derivatives are financial instruments for professional use, for which light-handed regulation was thought sufficient…” • “The Commission does not want to limit the economic terms of derivatives contracts, neither to prohibit the use of customised contracts nor to make them excessively costly for non-financial institutions.”(COM(2009) 563/4) • “Over-regulation slows down financial innovation and therefore undermines economic growth in the wider economy” (The De Larosière Report) i.e. Effective regulation should accommodates good business and preserve market functionality and diversity – not compress it

4. European markets infrastructure regulation (emir) (1) • Identifying OTC contracts which are “eligible” for CCP clearing • Incentivising enhanced back office processing of OTC transactions • Requiring comprehensive transaction reporting of transactions to trade repositories (or CCPs or the relevant authorities) • Setting high standards of regulation for CCPs, including the imposition of capital requirements, default funds, robust standards in governance, conduct of business, organisation, conflicts of interest management and systems and controls for managing risk • Establishing rights of OTC clearing access to CCPs (cf MiFIR) • Fair and transparent pricing of CCP services

5. European markets infrastructure regulation (2) • Regulation of trade repositories, including gathering, securing and retaining trade data, maintaining confidentiality and requiring public disclosure of aggregated data • Exempting inter-group dealings and non-financial end users from being compelled to centrally clear otherwise “eligible” OTC contracts, up to certain “thresholds” • Ensuring segregation of client positions and assets and the “portability”, in the event of default, of positions and the related collateral • A statutory right of interoperability is provided in relation to “cash instruments” and ESMA is required to report on its feasibility in relation to all other instruments by September 2014

6. CRITERIA FOR CCP CLEARING eligibility • Standardisation • Liquidity • “Plain vanilla” or simplicity • Transparency • Valuation capability • CCP risk management capability • Business viability

7. MARKETS IN FINANCIAL INSTRUMENTS REGULATION AND DIRECTIVE (1) • Classification of “trading venues” into regulated markets, MTFs and OTFs • Extend the scope (and review conditions) of a systemic internaliser to include non-equity transactions (NB. They may not cross customer transactions) • “Clearing eligible”, standardised and “sufficiently” liquid OTC transactions to be traded on a multilateral trading venue • Access rights to CCPs, market data and indices (cf. EMIR) • Enhance pre- and post-trade transparency, which will be “tailored” and be subject to waivers • Extend transaction reporting to cover all financial transactions, with some limited exemptions

8. MARKETS IN FINANCIAL INSTRUMENTS REGULATION AND DIRECTIVE (2) • Tighten certain exemptions, including inter-group, own-account dealing and commodity exemptions • Strengthen the regulation of high-frequency trading in terms of risk management and authorisation • New key business conduct standards (e.g. municipal authorities, new disclosure standards and overarching integrity requirements, greater clarity around client money / title transfer) • Powers to ban products/services and manage positions in commodity markets (including the use of position limits) • A revised approach to recognition and access rights for jurisdiction firms • Wide harmonising powers for ESMA and the obligation to produce extensive technical standards and thresholds

9. Market abuse REGULATION/Market abuse directive (1) • Extending the scope of market abuse to cover trading on MTFs, OTF and in certain OTC transactions which impact on listed products • Harmonising the approach to market abuse as between financial and commodity markets and between derivative commodity markets and physical commodity markets • Wrongful intent will apply if abuse is to be the subject of criminal proceedings • Introducing new offences of attempt, incentivisation, aiding and abetting

10. Market abuse REGULATION/Market abuse directive (2) • Adapting the regime to take into account the specificities and resources of small and medium sized enterprises • Strengthening and harmonising enforcement • Harmonising member state approaches towards defining, identifying and enforcing market abuse and increasing coordination and information-sharing amongst national regulators • Asserting the international reach of EU market abuse

11. Proposed treatment of commodity derivatives • Many of the new requirements under EMIR, MiFIR, MiFID, MAR and MAD will apply to dealings in commodity markets • The Commission will, essentially, apply the IOSCO Principles for commodity market supervision, including transparency, tighter supervision, enforcement and sanctions, ability to access position, transactional and price information • The specific own-account trading exemption is to be removed, but the exemption regarding ancillary transactions undertaken for physical customers of a non-financial group will remain (but will other comparable exemptions for intra-group dealings and own account trading apply?) • Position management, including powers to apply position limits, will be introduced and will be subject to certain harmonising powers across the EU by ESMA • Contract design must be appropriately correlated with the underlying commodity • Inclusion within scope of trading and emissions certificates • Definition of “inside information” in MAR

12. POSITION LIMITS: ARE THEY JUSTIFIED? • Free markets must accommodate all forms of legitimate trading motivation, including financial trading • Price formation v. price control • The role of financial traders/“speculators” in commodity markets: the evidence so far • The US approach, the EU approach and the UK approach • US extra territoriality

13. IMPACT OF DODD FRANK LEGISLATION • The basis for its extraterritorial application is very wide with potentially serious consequences for compliance, legal risk and regulatory conflict e.g.- US commercial/economic effect- US customers- US presence- non-US affiliates of US regulated institutions- perceived evasion of CFTC rules- definition of “swaps” eg what is domestic/non-domestic? NB There are comparable extraterritorial issues in EU legislation2. The scope of US extraterritorial application of domestic rules is expected to become clearer with the release by the SEC and CFTC of draft guidance/interpretation at the end of the year

14. KEY DIFFERENCES between Dodd Frank and EMIR/MIFID/MIFIR NB. Implementation of Dodd-Frank and the outcome of negotiation EU legislation and the drive for convergence could enlarge or reduce this “differences” profile “High” margin and capital requirements for bilaterally “cleared” swaps Multilateral execution of CCP-cleared swaps Regulatory scope for large-size end-users Derivatives capability of banks Exemption for non-financial end-users Scope of the intra-group exemption

15. key differences (2) Position limits v position management Segregation of client money Ownership of market infrastructures Scope of CCP access rights Protection of the price formation process Foreign regulatory recognition Top-down / bottom-up approach to CCP clearing eligibility

16. key differences (3) Business conduct rules, particularly in the area of duties owed to unregulated wholesale counterparties (e.g. standard of execution, product disclosure and other “fiduciary” duties) The approach to market abuse, in both the EU and the US, is subject to change, but will continue to be different, although they both have extraterritorial application_____________________________________________________ Scope of Basel implementation, which in the US is focused on “internationally active banks”. Time differences in implementation

17. DRIVERS FOR TRANSATLANTIC CONVERGENCE • Shared post-crisis policy objectives and market targets • Industry priority to avoid needless regulatory duplication, conflict and cost of cross-border dealings • ESMA, SEC and CFTC convergence work • EU legislation is still under negotiation and susceptible to change • US enthusiasm to encourage the EU to “copy out” the US approach, which is less susceptible to change, BUT…

18. drivers AGAINST TRANSATLANTIC divergence • The likelihood that the Republicans will win next year’s election and have a majority in the Senate as well as in Congress, could mean substantial changes to Dodd-Frank, so EU copy-out of Dodd-Frank as it exists now could be an “own goal”! • Differences are inevitable, given different legal systems, market structures, political pressures and regulatory priorities • Jurisdictions tend to “cherry pick” international standards • Industry need to sustain market diversity, customer choice and business flexibility • Differentiated approach of non-US/EU jurisdictions

19. Key UK changes relevant to derivatives • FSA to be split into the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA) • Wholesale regulation to be differentiated from retail regulation, but FCA to be a strong consumer authority • Stronger regulatory policy focus on prudential supervision, product oversight, people risk, supervisory intensity and credible deterrence, and continued reliance on business and approved persons principles • Exchanges to be regulated by the FCA, and CCPs by the Bank of England • Each authority is to have specific statutory public policy objectives, tempered by the statutory principles of good regulation, founded on proportionality, choice, innovation, etc. • FCA to have a new competition role

20. IMPACT OF REGULATORY REFORM (1) • Under a more people focussed and commercially interventionist supervisory regime • There will be greater focus on risk profiling and systems and controls, back-office processes and more exacting comprehensive reporting and disclosure requirements • Potentially, 60/70% of contracts in most key OTC markets could be CCP cleared – changing the risk profile and regulation of CCPs • New transaction, position and other more comprehensive reporting requirements will result in closer regulatory scrutiny of risk and market abusive transactions – assuming the regulators can effectively analyse a substantially increased data flow • Bilaterally cleared “bespoke” transactions will become significantly more expensive (e.g. more loss-resistant collateral, higher prudential requirements, mandated margin calls and “pass-on” costs of regulated counterparties.

21. IMPACT OF REGULATORY REFORM (2) • Incentivised use of “standardised” ETD transactions to cover tailored risks could increase basis risk (and deny access to “hedge accounting” treatment) • Regulatory compression and increased costs of OTC dealings will restrict economically the emergance and operation of specialist markets serving a narrow client base • Regulatory use of prudential rules to achieve market changes (rather than just cover risk) and the impact of high “pass on” costs will challenge the underlying economics and affordability of risk management, particularly for small and medium-sized end-users • The post-crisis “safety first” approach to markets means that there will be less innovation and less product diversity – and the prospect of product bans, unless closely controlled, could have a chilling effect on product development/innovation

22. IMPACT OF REGULATORY REFORM (3) • End-users will be deprived of execution choice – paradoxically one of the original regulatory objectives of MiFID • Imposing significantly higher capital rules on proprietay trading and in the US, precluding banks from trading derivatives could severely reduce order flow and liquidity with adverse consequences for commercial users and small specialist markets • The proposed exemption for non-financial end-users to CCP clear their hedging contracts discriminates against the equivalent hedging activities of financial end-users such as fund and asset managers • How will political prejudice against OTC markets, speculative trading activities and high-frequency trading be translated in terms of regulatory controls – and how will constraints on market participation impact liquidity?

23. Commodity market ISSUES AND CONCERNS • Many of the concerns identified earlier will impact commodity dealers and endusers • Adoption of a “one size fits all” approach and “spill-over” of banking regulation of non-banks and specialist commodity dealers • Reduced choice for end users and less competition in the markets • The future of the current commodity derivatives exemptions • New approaches to segregation • Impact of regulatory compression on financial order-flow and commodity market liquidity (especially smaller and more specialist markets)