Financial Regulations Tend to Interact

When proposing new regulations and directives, the Regulators always have clear objectives and goals that they are trying to achieve. Now this might seem like a rather obvious statement, but it can actually be quite a useful fact to remember when trying to navigate through the regulatory jungle. If overlooked, and you put too much focus on one regulation at a time, then there is a very high risk that you will end up with suboptimal solutions.

One simple example of this is the 'OTC derivatives reform' that was agreed upon at the 2009 G20 summit in Pittsburgh. In the US, it has manifested in the Dodd-Frank Act, which contains several reforms all clumped together in one act. In contrast, the equivalent regulation in Europe has been split into at least three blocks: CRD IV, EMIR and MiFID2/MiFIR. If too much focus is placed on finding rationales and solutions that maintain some derivatives as OTC-traded, then you might overlook that fact that MiFID2/MiFIR will soon be in force, which may require all derivatives to be sufficiently standardised for clearing – should be traded on market places – and thereby lose a wide range of OTC aspects.
The following overview demonstrates the implications on trading in OTC derivatives from three different regulations.

Impact on OTC derivatives from three different regulations

EMIR

Mandatory Clearing

The demand for clearing will be phased in – details have not yet been agreed. Central counterparty clearing will be required, in order to reduce the overall market counterparty risk.

Trade Reporting

All derivative trades - listed and OTC – must be reported to new TR organisations.

Risk Mitigation

Stricter rules on non-cleared OTC derivatives, such as timely signed confirmations, portfolio reconciliation, dispute management, mark to model, portfolio compression and exchange of collateral.

CRD IV

Higher capital costs (directly for banks and indirectly for others) will follow:
If trades are not sufficiently collateralized;
If the collateral is not deemed to be bankruptcy remote; or
If OTC-derivative trades have not been central counterparty cleared.


MiFID2/MiFIR

N.B. There is still a significant amount of uncertainty about MiFID2/MiFIR.
OTC-derivative trades that will require mandatory clearing are likely to require mandatory trading on a MiFID marketplace in future, such as a Request for Quote marketplace or an MTF. Increased pre-trade and post-trade transparency requirements are also anticipated.

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