They’re out there — in open forums and behind closed doors, top-level regulators from all sides of the Atlantic and Pacific have formally converged at least 12 times in the past two years. And that doesn’t include countless informal get-togethers.
Their mission: to reduce regulatory barriers while promoting regulatory certainty around the world.
It’s a tough line to walk, and for E.U. regulators, such meetings have special significance because the continent is struggling to implement the Markets in Financial Instruments Directive (Mifid), which is nothing less than a sweeping redefinition of its internal markets. As such, Mifid will have repercussions for brokers and traders on both sides of the ocean long after its measures are implemented.
Under the current timetable, member states have until the end of January to get their national laws into synch with Mifid (see www.FuturesMag.com/mifid for a detailed explanation of the Lamfalussy Process and Mifid, as well as other related links). Regulatory structures must be in place by November 2007.
Not everyone is convinced the deadlines will be met. Anthony Belchambers, chief executive of the U.K.’s Futures and Options Association (FOA), points out the European Securities Committee (ESC) still has to deliver its opinion on Mifid, and then the European Parliament will have a month to determine whether it feels the European Commission has overstepped its authority.
“It’s a difficult directive with a nasty timetable,” he says. “Each authority that makes up CESR (the Committee of European Securities Regulators, pronounced “Caesar”) runs different kinds of financial services sectors.” CESR, as the name implies, is an independent advisory body made up of securities regulators. Within Europe, its guidelines, though nonbinding, are defining the shape of European regulation.
For its part, the European Commission is publishing a “Lamfalussy Scoreboard” to track the state of compliance of member states — and if that scorecard shows a critical mass of states off track for compliance late this year, you can expect a lobbying effort to get the deadlines extended.
FUTURES IN FOCUS
Whatever the final implementation date, the reforms impact derivatives traders on several fronts — primarily by defining mandatory transparency requirements for over-the-counter (OTC) derivatives transactions and regulating commodity based transactions at an E.U. level for the first time in the continent’s history.
“The tricky bit is to make sure the physical business underlying derivatives is not hit by banking rules,” says Belchambers. “It comes down to definitions — and how you define the boundary between the physical space and the derivatives space.”
CESR already has stated that physical forward contracts and spot deals should not be subject to derivatives regulation, but Jonathan Marsh, an attorney with Hunton & Williams in London, says one area of contention will be who is and who is not exempt from licensing requirements. Mifid states, for example, that undertakings whose main business is dealing in their own account in commodity derivatives won’t have to become licensed provided they are not part of a group whose main business is the provision of investment or banking services. The application of this exemption will depend on what is meant by “main business,” and even if firms fall within the exemption they should not get too comfortable as the continuing appropriateness of the exemption is to be reviewed after Mifid is implemented.
Marsh says U.S. firms dealing in European commodities may find themselves subject to regulations they didn’t expect, depending on which European country they primarily do business in. “Mifid sets out a bare regulatory minimum,” he says, adding, that if you are not careful, you may find that the business you do in Europe may suddenly require licensing, even if you don't have an office there.
Investment advice is also now regulated for the first time on a pan-European basis and there is plenty of room to interpret the obligations of service providers. Newsletters are clearly exempt from registration, and retail securities brokers offering execution only may be off the hook for certain due diligence procedures in determining which customers are “appropriate” for the investment and which are not.
But the moment a firm begins offering advice coupled with execution, its execution becomes subject to the “suitability” and “appropriateness” tests — the exact meanings of which are also still a bit fuzzy.
DERIVATIVES: COMPLEX?
And the freedom to offer execution only without carrying out those tests stops at “complex” transactions. And what is a “complex” transaction?
“The level of complexity of a financial instrument’s structure will affect the ease with which the risk attached to the product may be understood,” states a European Commission explainer. “Thus, all derivatives are assumed to be complex because their value is derived from another financial instrument or asset, adding a level of complexity to the understanding of the characteristics and valuation of those instruments.”
Current debate is focusing on Mifid’s “best execution” provisions, as well as on the boundary between retail investor and professional investor — a significant distinction, as it determines the amount of due diligence brokerages will have to take in accepting customers. It’s a boon to technology providers.
“Best execution comes down to transparency in terms of margin calculation and exchange fee/brokerage calculation,” says Dave Thompson, product manager for Rolf & Nolan’s Merlin project. “A lot of Mifid’s focus is on the systematic internalizes, but many software tools that enhance transparency are of relevance to all players.”
And there will be plenty of work for companies like his as regulators hammer out the rules of engagement for cross-border trading and brokering. In March, the Commodity Futures Trading Commission (CFTC) hosted regulators from Europe and Asia in Washington, D.C., for closed-door meetings, where the agenda ranged from the use of omnibus accounts and/or give-up relationships, to “how diverse rules globally cause client confusion regarding the status of their accounts with brokers,” according to a CFTC statement.
Also on the agenda: the extent to which regulators should define or influence the market structures of clearing houses and governance structures of exchanges, and the extent to which derivatives regulators should police anticompetitive behavior, review exchange mergers and oversee intellectual property disputes.
RULES AND PRINCIPLES
Principles-based regulation was formally adopted in the United States with the Commodity Futures Modernization Act (CFMA) in 2000, and now Mifid will enshrine the approach across the continent. “Here in the United Kingdom, the Financial Services Authority (FSA) has always been a principles based regulator, and now the internal European argument is very principles-based as well,” says Belchambers.
He’s at the center of two initiatives: Mifid Connect, which is a five-stage project designed to ease the U.K. into compliance with Mifid (see “Mifid connect,” page 63) and the E.U.-U.S. Coalition on Financial Regulation (the “Coalition”), whose mission is to promote regulatory agreement between the two continents.
The Clifford-Chance law firm is providing legal support to both projects, and has produced two exhaustive analyses of the transatlantic regulatory challenge, which can be downloaded via www.futuresmag.com/mifid.
THEORY AND PRACTICE
Mifid could provide a boon to U.S. brokerages interested in attracting more European customers, because by opening a subsidiary in one member state they can “passport” all their products and services to all member states. But there are several catches. They can’t just open a branch in Europe, instead they have to open an autonomous entity with its own balance sheet and management; a requirement not likely to be dropped in the wake of the Refco debacle.
In that sense, a European company looking to market its products across the United States has an easier go of it than a European company trying to break in overseas — even if it engages in securities regulated by the U.S. Securities and Exchange Commission (SEC). Such a company can open a branch anywhere in the United States and get access to the whole country, provided they conform to state securities laws.
But there is a payoff for that as well, and it’s a doozy: any SEC-regulated securities company has to abide by SEC rules not only in the United States, but around the world.
The debate over transatlantic regulatory cooperation is wide ranging, and several views have emerged. In the short term, some sort of Dubai-like regulatory regime independent of U.S. and E.U. regulators but coordinated by both of them could take shape for institutional traders. For the bulk of us, however, the relevant solution will likely come from steps that take longer to implement and require more give and take in the existing regimes.
“The goal must be mutual recognition of equivalence,” says European Union Commissioner for Internal Markets Charlie McCreevy. “You can also call it the home-country principle. If you agree to accept each other’s system as equivalent, then duplicative requirements disappear. You can then operate in the other country under the rules of your home country. We should find more areas in our transatlantic relation where we can apply this principle.”
But that’s easier said than done. To begin with, regulators will have to first rewrite the gaggle of memorandums of understanding that exist to accommodate two major trends of the past few years: the hub-and-spokes structure of a growing number of financial institutions (which consolidate back and middle office functions in one central location, often outside both the E.U. and the U.S.) and the adoption of multi-regulator surveillance visits to registered firms.
“A common complaint is that genuine coordination is rare and the burden of recycling information, often tailored to the specific preference of an individual regulator, is time-consuming and expensive,” the firm states in the report. “On the other hand, the failure to establish a proper and workable framework of information sharing means that regulated institutions still have multiple reporting requirements, often required to be submitted in different formats but covering the same information, to a variety of regulatory authorities — a major administrative cost that could be avoided through a structured and properly resourced information-sharing program between regulators.”
Even within the E.U., passporting is more theory than practice. Before advice and other services can be passported, it has to be made equivalent. That’s no easy task because laws vary on such basic issues as short-selling, which is still banned in Spain, to such micro issues as which transactions have to be reported to the government, and when.
NO ACTION: A QUICK FIX FOR TODAY?
In its report for the Coalition, Clifford-Chance stopped just short of endorsing the use of no action letters as a way of incrementally providing cross-border recognition. Such letters are the method used by U.S. authorities to recognize regulatory agencies and exchanges outside their jurisdiction.
“They provide comfort to market participants in situations where either the law, the interpretation of the law or particular regulations may be open to argument in terms of how a relevant regulatory agency views matters,” the report states. “No-action letters (or similar) are barely used in E.U. member states. Some industry participants would like to see greater use of such techniques for resolving queries or ambiguities.”
For now, there are ambiguities aplenty — so let’s hope those regulators enjoy each other’s company. They’ll be getting a lot of it in the years to come.
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