Quick View: Europe’s MTF problem

Agreeing how global derivatives should be policed across borders has been one of the most difficult questions for markets regulators after the financial crisis.

It has been because the rules emerging from the US Dodd-Frank act potentially give regulators extensive extraterritorial jurisdiction but also because the US has been much further ahead in its reform programme. Now the issue is moving to the top of the agenda of the main US derivatives regulator, the Commodity Futures Trading Commission.

US rules have mandated that swaps trading be conducted on Swap Execution Facilities (Sefs) but regulators have wrestled with how they monitor US markets participants when they trade with overseas counterparties.

Market participants have worried that conflicting or overlapping derivatives regulations may fragment the market, raise costs for investors and force participants to choose their favoured legislative regime.

Delays to resolving this issue have long suited other global regulators working through their rules. But that game is coming to an end, and Europe has the most to consider.

Seeking to harmonise the rules, the CFTC and the European Commission, the EU’s executive arm, have agreed on substituted compliance. However a temporary patch agreed last month may have further legislative consequences for Europe.

The CFTC-EU deal agreed that US banks could trade swaps on European venues provided those venues met standards largely similar to those in the US. Those European venues, designated as Multilateral Trading Facilities (MTFs), will be exempt from US trading rules until new European legislation is in place, probably at the end of 2016. That exemption will extend to US banks that trade on them as well.

A deadline of March 24 has been set for European companies to apply for the exemption. Given its importance, it may sound surprising that no European companies have applied as yet.

At last week’s Futures Industry Association’s annual meeting in Florida, Mark Wetjen, the acting CFTC Commissioner, struggled to explain why although he almost certainly knew the answer.

As building and connecting these platforms according to Sef rules is time-consuming, the deadline was close to impossible. “I don’t see how that could result in anything before March 24 that’s more than a proposal, or an announcement of an intention,” one senior general counsel admits.

A formal extension seems inevitable and a new deadline of July 1 has been mooted. But will that still be enough time?

Venues getting CFTC approval will rely in a large part on meeting the MTF requirements as laid down by the UK Financial Conduct Authority (FCA), on whose turf the vast majority of swap dealing by brokers and interdealer brokers takes place.

An MTF, under European legislation, is supposed to be a venue that conducts non- discretionary business and are almost all are purely electronic – ie not the world of a swaps dealer who trades over the telephone.

To allow for swaps dealers suggests there will have to be flexibility on the MTF definition. Indeed, some MTFs and interdealer brokers have been talking to the FCA about changing standards and allowing voice trading. If that it to be the outcome, it could effectively create a European Sef.

Without it, the alternative could be the CFTC having direct oversight over pockets of business in the London market. It’s not an idle threat. ICAP, the world’s largest interdealer broker, has already applied to run a London-based, US-compliant Sef.

While this may be a practical solution, it may mean Europe having to rethink its incoming Mifid legislation, in which the new rules are contained. Mifid even has separate category – the Organised Trading Facility – that addresses trading in illiquid instruments on a discretionary basis. Europe and the CFTC will have to set standards for substituted compliance with these venues too. It may make more sense to amend the OTF rules to better dovetail with the existing MTF category now, while they are being written.

The irony is that, for a variety of reasons, swaps trading on Sefs has yet to take off. It’s still unclear if the liquidity in wholesale markets will really trade under a Sef regime.