ESMA Proposal Sets the Stage for Mandatory Trade Execution Requirements in Europe

October 3, 2016

On September 20, 2016, the European Securities and Markets Authority (ESMA) published a discussion paper seeking comments on draft regulatory technical standards (RTS) for its OTC derivatives trading obligation (the Discussion Paper) under the Markets in Financial Instruments Regulation (MiFIR).[1]  The Discussion Paper proposes technical standards and an implementation schedule for the determination of which derivatives will be subject to the European trading obligation.[2]  In contrast to existing U.S. rules, ESMA’s proposed approach seems to appropriately consider the imposition of the trading obligation on market liquidity generally and non-financial end users specifically.  European clients, U.S. clients who trade derivatives with European counterparties, derivatives trading platforms with European operations, and any other parties interested in, or potentially affected by, the proposal will have an opportunity to submit comments to ESMA on or before November 21, 2016.   

I.    Background. 

Article 32(1) of MiFIR requires that ESMA develop draft RTS specifying, among other things, the class of derivatives that will be subject to the European trading obligation and the date(s) from which the trading obligation will take effect including any phase-in measures.  Under Article 32(1), once a class of derivatives is subject to the European clearing obligation under the European Markets Infrastructure Regulation (EMIR),[3] ESMA must determine within a six-month period whether those derivatives (or a subset of them) should be subject to the European trading obligation.[4]  Derivatives that are subject to the European trading obligation are required to be traded on a regulated market (RM), multilateral trading facility (MTF), organized trading facility (OTF), or a third country trading venue (e.g., a swap execution facility (SEF) based in the United States) that the European Commission has deemed to be equivalent.[5]

Article 32(2) of MiFIR provides that ESMA’s trading obligation determination must be based on the following two tests:

• The venue test, which requires ESMA to analyze whether the class of derivatives under consideration are admitted to trading or traded on at least one admissible trading venue; and
• The liquidity test, which requires ESMA to analyze whether the derivatives under consideration are "sufficiently liquid" and there is sufficient third-party buying and selling interest.  

Currently, the following classes of interest rate and credit derivatives are subject to the European clearing obligation, and therefore, are eligible to be subject to the trading obligation following an ESMA determination.

Interest Rate Derivatives:

• Basis swaps denominated in EUR, GBP, JPY, USD;
• Fixed-to-float swaps denominated in EUR, GBP, JPY, USD;
• Forward rate agreements denominated in EUR, GBP, USD; and
• Overnight index swaps denominated in EUR, GBP, USD.

Credit Derivatives:

• Untranched iTraxx Europe Main that are settled in EUR in series 17 and onwards, with 5 year tenor
• Untranched iTraxx Europe Crossover that are settled in EUR in series and onwards, with a 5 year tenor

The following sections summarize how ESMA proposes to make its determination under each test.

II.    Proposed Determination Procedure. 

Data Set Used in the Procedure.  ESMA proposes that its initial determination would be primarily based on data that it receives from trade repositories for OTC derivatives (i.e., data on listed derivatives that are traded on RMs would not be included), and secondarily based on information provided by RMs and MTFs on a voluntary basis.  ESMA notes that it will not consider data from OTFs for its first trading obligation determination since these trading venues do not begin operating until January 3, 2018.  

In terms of the level of granularity at which the trading obligation requirement would be initially applied, ESMA proposes to consider only certain benchmark dates (plus a number of days around those dates) of the classes of interest rate derivatives, which are currently subject to the European clearing obligation, to be subject to the trading obligation.[6]  For credit derivatives, ESMA would apply the requirement to the on-the-run series and the series that is immediately prior to the current on-the-run series.  Finally, as part of its analysis, ESMA only plans to consider price forming transactions (i.e., it will exclude from its data set intragroup and portfolio compression transactions).

Venue Test.  While all of derivatives currently subject to the clearing obligation can seemingly be traded or are available to trade on RMs and MTFs, ESMA notes that it is unsure whether its analysis should instead focus on whether actual trading of these derivatives takes place.  ESMA will likely address this test more fully in its second public consultation on this topic.

Liquidity Test.  In determining whether a particular class of derivatives is "sufficiently liquid" and there is sufficient third-party buying and selling interest, ESMA proposes to consider the factors set forth in Article 32(3) as well as additional factors adopted by European Commission in draft RTS 4.[7]  Specifically, ESMA proposes to consider the following five factors.

1. The average frequency and size of trades over a range of market conditions. 
2. The average size of trades over a range of market condition. 
3. The number and type of active market participants – In analyzing whether this factor is met, ESMA proposes to further examine: (i) the total number of market participants trading in that class of derivatives is not lower than two; (ii) the number of trading venues that have admitted to trading or are trading the class of derivatives; (iii) the number of market makers and other market participants under a binding written agreement or an obligation to provide liquidity; (iv) the ratio of market participants to average size/frequency of trades; and (v) the number and types of financial and non-financial counterparties actives in the different classes of derivatives based on trade repository data.  In addition, Article 32 of MiFIR expressly requires that, in preparing the draft RTS, ESMA must take into consideration the anticipated impact that the trading obligation might have on the liquidity of a class of derivatives (or a relevant subset thereof) and the commercial interest of non-financial end users.
4. The average size of spreads – In analyzing whether this factor is met, ESMA proposes to further examine: (i) the size of weighted spreads, including volume weighted spreads, over different periods of time; and (ii) spreads at different points in time of trading sessions.  Since data on spreads is not widely available, ESMA proposes to use a proxy for the assessment of this factor.  As a result of not having the best available data, ESMA proposes not to give much weight to this factor as part of its overall analysis. 
5. Whether transactions of the particular class of derivatives under consideration are only sufficiently liquid below a certain size – ESMA has stated that this factor would be closely linked to the concept of waivers and deferrals (i.e., similar to the concept of special treatment for block trades), which are set forth in European Commission’s draft RTS 2.  In the Discussion Paper, EMSA proposes exempting transactions that are above a certain threshold (known as the "large-in-size" or "LIS" threshold) from the trading obligation.

III.    Proposed Implementation. 

As a result of the overall delay of European derivatives regulations, the earliest possible effective date on which any trading obligation can commence is January 3, 2018.[8]  As a result, ESMA plans to finalize its legislative process for the trading obligation closer to that date in order to ensure that the classes of derivatives under consideration continue to meet the liquidity test. 

In addition, ESMA proposes to align the implementation of the trading obligations with the clearing obligation in order to ensure that mandatory trading do not apply to a category of counterparties prior to such category being subject to mandatory clearing.  Thus, ESMA proposes the following phase-in calendar.

Earliest Proposed Effective Dates of the European Trading Obligation

IV.    Comparison to Third Country Regulatory Regimes. 

The Discussion Paper provides an overview of the derivatives trading obligations in other countries, as well as the interconnectedness of the trading obligation with the European clearing obligation for derivatives.  The Discussion Paper details that its proposed approach contrasts with the "made available to trade" rules adopted by the U.S. Commodity Futures Trading Commission (CFTC) in the following three respects.

• ESMA, instead of the trading venue, would initiate the determination of whether a class of derivatives will be subject to the trading obligation.
• ESMA will consider each factor noted above in its determination.  In contrast, CFTC regulations do not require trading venues to consider all of the enumerated factors in their determinations.[10]  Under CFTC regulations, U.S. trading venues may consider any one factor or any combination of factors in its "made-available-to-trade" determination.
• As noted above, the level of granularity that ESMA may consider for the trading obligation may be less granular.  This level of granularity could mean more derivatives (such as forward starting swaps) would be subject to the trading obligation.

The Discussion Paper notes that the CFTC has announced its intention to propose changes to its "made-available-to-trade" process before the end of 2016. The CFTC also has indicated that it plans to codify many of the no-action letters that CFTC staff has issued since the CFTC adopted its trading regulations in 2013.

V.     Next Steps. 

In the Discussion Paper, ESMA acknowledges the need to further develop limited and more tailored standards for the trading of package transactions (i.e., transactions comprising several linked and contingent components aimed at allowing counterparties to reduce transaction costs and manage execution risks), which contain derivatives subject to the trading obligation.[11]  In an effort to learn more information regarding how package transactions are executed, the Discussion Paper includes several questions that seek input on the types of package transactions that may be affected in view of the classes of derivatives that are currently being considered for the trading obligation.

Following its consideration of the comments received in response to the Discussion Paper, ESMA has expressly stated that it expects to issue a second proposal and public consultation based on the comments received in response to the Discussion Paper sometime in the first quarter of 2017.  ESMA has further stated that it plans to issue draft regulatory technical standards in the summer of 2017.  As noted above, notwithstanding this plan, ESMA does not plan to submit the draft regulatory technical standards to the European Commission as part of the legislative process until closer to the effective date (i.e., January 3, 2018).

   [1]   Regulation (EU) 600/2014 of the European Parliament and of the Council.

   [2]   As of now, it is expected that the final RTS will apply to the U.K. as a member of the European Union.  It is unclear, however, that when the RTS goes into force whether it will apply to U.K. as a result of the Brexit vote.

   [3]   Regulation (EU) 648/2012 of the European Parliament and of the Council.

   [4]   It is noteworthy that MiFIR also empowers ESMA to identify and notify the European Commission on its own initiative individual derivatives contracts that should be subject to the trading obligation that: (1) no central counterparty (CCP) has yet received authorization under EMIR to be subject to the clearing obligation; or (2) are not yet admitted to trading or traded on a trading venue.  Following the notification, the European Commission could request that proposals be developed for imposing a trading obligation on those derivatives.  In the Discussion Paper, however, ESMA states that it does not intend to identify any such derivatives.

   [5]   The European Commission is expected to address the issue of third country trading venue equivalency separately.  The timing of their action is currently unknown.  Some industry groups have already begun advocacy and policy engagement with the European Commission and CFTC regarding this topic.

   [6]   It is important to note that this approach is different than the approach used in draft RTS 2 for calibrating the transparency regime for non-equity instruments, which includes all contracts irrespective of their maturity date.  See citation to the draft RTS 2 infra.  For that reason, on a subset of those instruments that are in scope for the transparency requirements under RTS 2 will be considered for the trading obligation.

   [7]   See draft RTS 2 and 4 at:  https://www.esma.europa.eu/sites/default/files/library/2015/11/2015-esma-1464_annex_i_-_draft_rts_and_its_on_mifid_ii_and_mifir.pdf.

   [8]   On May 18, 2016, the European Commission approved a one-year delay in the application of Markets in Financial Instruments Directive 2014/65/EU (MiFID II) and MiFIR from January 3, 2017 to January 3, 2018. 

   [9]   The following category designations for the clearing obligation would also apply to the trading obligation:

Category 1: Counterparties that are clearing members of at least one CCP, which is authorized to clear any of the class of derivatives subject to the clearing obligation, and whose membership enables clearing of one or more of the relevant classes of derivatives.

Category 2: Financial counterparties (FC) not included in Category 1 (non-clearing members and clearing members not meeting the condition of Category 1), and Alternative Investment Funds (AIFs) that are non-financial counterparties above the clearing threshold.  Moreover the counterparties must have average gross notional outstanding over a three-month period exceeding EUR 8bn (un-cleared, at group level and for AIFs or UCITS at fund level) derivative contracts.

Category 3: FCs and AIFs not included in Category 1 or 2 with a lower level of activity in un-cleared derivatives (i.e., derivative contracts with gross notional outstanding over the three-month period below EUR 8bn).

Category 4: All non-financial counterparties above the clearing threshold not included in Category 1, 2 or 3.

[10]   Under the CFTC regulation 37.10(b), a designated contract market or SEF must consider, as appropriate, at least one or any combination of, the following factors: (i) whether there are ready and willing buyers and sellers; (ii) the frequency or size of transactions; (iii) the trading volume; (iv) the number and types of market participants; (v) the bid/ask spread; and (vi) the usual number of resting firm or indicative bids and offers.

[11]   The need for limited and tailored treatment for package transactions is also noted in recital 10 to the European Commission’s draft RTS 4, in addition to the amendments to the level 1 text to postpone the application of MiFID II and MiFIR.