The apparent drive for 100 percent transparency in equities could actually lead to less transparency.
Let's say, for example, that MiFID II bans small order crossing at the mid-point of the equity primary market. Any retail or hedge fund customer seeking that economic outcome can do so instead with a synthetic instrument. Would the industry be required to trade CFDs at the mid-point of a cash equity market? Unlikely.
Equally, if an institution cannot do a risk trade to exit a large block (because delayed trade reporting is prevented, making it too expensive to do so) then they can do so via some form of derivative or synthetic. Exchange for Physical (EFP) trades can make a comeback.
EMIR may seem to counteract this by increasing the regulatory burden for synthetics, but by driving structure and standardization it has the potential to move this form of trading outside of bilateral ad-hoc arrangements and into well understood, well documented formats. One potential outcome is that it will ease the tax concerns of the more cautious buy sides: an EMIR-regulated contract carries less ambiguity than a bilateral, individually negotiated swap.
MiFID II and EMIR do not mark the end of the synthetic industry: it may even be the catalyst for a new growth phase. Yet with an industry slow to understand the implications, and political dispute and lack of detail obscuring the debate, there remains a growing concern that the key players’ diplomatic reserve may have morphed into a more short-sighted sense of denial.
How synthetics are affected by EMIR
The synthetic product phenomenon is not new. How many global hedge funds trade UK equities? The answer is very few since the market is dominated by UK CFDs or swaps. While their tax treatment makes them the obligatory first choice, they are also attractive in terms of flexibility, capital handling and operational efficiency meaning some organisations gain equity exposure exclusively in swap form.
This is not unique to hedge funds – spread betting (economically similar to CFDs) is an established part of the UK retail segment, as are CFDs themselves. The European retail community also has a growing CFD element, alongside the more visible equity share.
Synthetics here also cover a range of products – CFDs, swaps, spread bets, ADRs, P-Notes, ETFs and ultimately other derivative products.
To dispel any doubt: CFDs and swaps are firmly within EMIR’s scope. Similarly, this is likely to mean significant changes to the market. Unfortunately, everything else is uncertain.
It is worth stressing that CFDs’ inclusion in EMIR is due to their classification as an OTC derivative, not from any specific action. In fact, CFDs appear to have been forgotten: the EC’s impact analysis (incorrectly) states that “OTC derivatives are reserved for professional investors and are thus not accessible to the general public,” thereby denying the existence of the retail market and not factoring them into the EMIR analysis. Indeed, while prime brokerage circles are abuzz with talk of regulation as a general concept, EMIR is rarely mentioned and the most extreme outcome – mandated central clearing of CFDs – seems peculiarly absent from conversation.
The word that will determine the regulation of CFDs is: standardization. EMIR foresees three possible outcomes for any class of OTC derivative:
Mandatory central clearing;
Optional central clearing where a CCP option is available but not mandated;
Continuing OTC provision.
Standardization will be one of the key determinants. Non-standardizable derivatives without a CCP service will fall under the third category, highly standardized contracts will fall into option one. The appetite for option two is unclear, although its initial target appears to be situations where CCPs would be placed at greater risk by being forced to clear complicated or difficult to price contracts in size and scale. This is the most uncertain category.
Those elements of the industry that have addressed this appear to be assuming that CFDs will automatically fall into the third option because of the highly negotiated nature of the legal contracts. This assumption is well worth questioning.
The EC’s thought processes categorize standardization in three broad terms: legal (contract standardization); valuation (product standardization) and process (STP, confirmation, etc…). With standard contract frameworks already existing, valuation largely straightforward and contracts being processed in scale, a superficial view is that CFDs are not only possible for mandated clearing, they are ideal candidates.
The European Securities and Markets Authority (ESMA) will provide technical guidance to the European Commission and is central to this decision; its view is untested. With both ESMA and the EC oblivious to CFDs, there may be a hope that this will continue to be the case. This is also unlikely. Derivative classes are referred to ESMA in one of two scenarios:
By ESMA itself to address systemic risk;
By a CCP’s national regulator when that CCP is approved for clearing of that class of derivative.
This is where the LCH CFD contract comes into play, forcing a clearing decision on CFDs. The very fact of its existence is sufficient to make ESMA analyze the market and consider imposition of clearing.
If the OTC market remained
While mandatory clearing may be one aspect of EMIR, there are other possible regulatory outcomes. These focus primarily on post-trade processing, namely the need to affirm trade flows, to perform regular (potentially daily) reconciliations, the reporting of data to trade repositories and well regulated processes of exchanging collateral.
The collateral itself is the other area of focus. EMIR’s thinking is deeply affected by the fate of AIG and how a change in credit rating materially affected the margin and collateral payments imposed upon the company. It wishes to give less discretion to brokers in terms of the type, frequency and structure of both collateral and margin payments on OTC contracts.
The other area of uncertainty is capital requirements. The G20 commitments include that “non-centrally cleared contracts should be subject to higher capital requirements.” But any implementation of this would be done outside of EMIR, so its financial impact on the brokers providing the derivative is unclear.
This may seem bleak, but a more subtle analysis is required, involving:
Potential areas of uncertainty, or loopholes
While we may be ringing the warning bell, this, like many other regulatory changes, is also an opportunity. The focus upon automation and standardization may incur investment costs, but they can reduce failure rates, reduce variable costs and establish valuable industry utilities.
Those locked into prime broker relationships by the fickleness of credit rating, legal contracts or sheer difficulty of switching providers can look to EMIR as a means of improving competitive tension and flexibility. Service providers will enter the industry to solve not just the immediate requirements of EMIR, but introduce other efficiencies.
Finally, we expect the evolution of mechanisms to ease or even step-out of the EMIR framework. The most inviting of these is proffered by the German government’s pro-Eurex stance: contracts traded on-exchange are not covered by EMIR. The use of BOAT, an equity infrastructure provider, gives a clue how the synthetic market could make use of this exemption: from a regulatory standpoint it is a small step from trade reporting to actually bringing a trade onto an exchange. Should the German lobby succeed, a clever equity exchange could provide a CFD trade reporting service that would classify the trade as being on-exchange.
How synthetics are affected by MiFID II
As with EMIR, MiFID II documents (based on the consultation exercises and on documents leaked out to the industry) do not appear to recognize or deal with synthetic products. From this position, one of two outcomes must be considered as a starting point:
First that synthetics are treated as their own asset class (e.g., a CFD as a part of the OTC derivatives world) and obligations to trade on regulated venues, pre- and post-trade transparency and so on are applied distinctly; or
Alternatively that synthetic products are considered an extension of the underlying asset class for these obligations.
It is actually the second route that is followed today, while it is hard to see the future under MiFID II being anything other than the first route.
What do we mean by this? Take a simple arrangement today whereby a client is offered CFDs via an equity DMA route to a lit exchange: at present the trades are transparently traded (by virtue of the equity lit market trading), printed as equity volume on those exchange tapes and then “wrapped” by a bank as a CFD.
With delineation between the synthetic and the underlying equity in the future, we may consider the bank as being a Systematic Internalizer in CFDs. We then have a tape of SI prints in a CFD, but does that tape add any value vs the underlying equity tape from the exchange? Not really as overall we see twice as much volume being printed.
What about crossing two orders? If it’s a CFD order against a CFD order, then does that print as a CFD MTF/OTF? What about a CFD order “crossed” with an equity order? Well that probably would be an MTF/OTF print in the equity plus an SI trade for the CFD leg. It starts getting messy.
Transparency waivers also take on new meaning in this space. As outlined in the opening sections, waivers for synthetics that are not tied to the underlying class waiver regime will create arbitrage. Equity may be price constrained but synthetics are not. Rather than encourage more volume onto exchanges, we start to encourage an OTC derivative market.
Dare we discuss?