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Category Archives: MiFiD2

A Snitch in Time!

13 Friday Nov 2015

Posted by LEENBROEKHUIZEN in MAR, MiFiD2, REMIT

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MiFID2, Regulation, Surveillance

With all our recent focus on whether REMIT transaction reports are getting to the regulator at all, even with a T+1 reporting mandate, it is easy to loose sight of the importance of the relevant timestamps of orders, executions, and lifecycle events.

MiFIDII is very explicit on the subject, RTS 25 states:

“Competent authorities need to be able to reconstruct all events …… over multiple trading venues on a consolidated level to be able to conduct effective cross-venue monitoring on market abuse.”

This requirement is no less true of REMIT, which hands ACER the challenge of consolidating EMIR, REMIT and MiFID transaction reports from various venues and intermediaries. According to Tabb Group a ‘major European trading venue’ had to jump 30 seconds a few years back. Imagine today how many revised transaction reports that might entail today?  This is one area where things could get worse if MiFIDII really is delayed!

It might be worth checking your own infrastructure and also RRM service level agreements include timestamp accuracy tolerances.

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MiFIDII Ancillary Activities Exemption: Progress Made …. More Work Required

09 Monday Nov 2015

Posted by LEENBROEKHUIZEN in Ancillary Activities, Main Business Threshold, MiFiD2

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MiFID2, Regulation

Anyone familiar with even a snippet of MiFIDII will have come across threshold tests. On 28th September ESMA published its ” Regulatory technical and implementing standards – Annex I” (RTS), a document that uses the word ”threshold” no less than 439 times. Few of us will have had occasion to look into detailed calculation requirements of even one of these calculations, so I hope it will be useful to share some first impressions.

I have had occasion to look at one instance in some level of detail, the ‘Main Business Activity’ exemption threshold which intends to specify the conditions under which non-financial firms who engage in commodity trading may be exempted from applying for a MiFIDII license, thus sidestepping all the obligations that would entail.

Even a relatively short dip into the subject showed very clearly there is still a lot of uncertainty in the methodology to resolve, potentially unintended consequences to avoid, and some potentially perverse incentives that are introduced. The uncertainty is amplified to a large extent by a combination of inconsistency between the RTS text and the accompanying consultation feedback commentary, and silence in the RTS on some key computational assumptions.

Main Business Threshold

The Main Business Threshold (MBT) compares a 10% threshold against a ratio calculated (roughly speaking) a group’s European speculative derivatives trading activity divided by a proxy measure of the size of its main business. If the result is <10% then the group does not need to register a MiFID entity. If the result is >10%<50% a further test is required to establish exemption. I won’t go into that second test today.

Progress has been Made

First let’s recognise some progress made in this iteration. ESMA has made several sensible (N.B. Not every industry commentator/body agrees with me!) decisions since its first attempt at how this ratio should be calculated.

  • ESMA has withdrawn the suggestion that accounting measures should be used, apparently acknowledging that the cost of overhauling the double entry book-keeping for MiFID derivatives of an entire firm globally might actually be quite expensive, would produce a subjective result due to wide variances in accounting policy and practice, and most likely deliver the number too late, due to year-end close and audit timetables not aligning with the timeframe in the Level 1 text for exemption applications.
  • Instead ESMA has proposed a new calculation based on filtering and aggregating and comparing values that can be derived from individual trades and positions. This should be welcomed by the market participants at least in terms of simplicity, not least because it is a similar approach to the one they will recently have implemented for the EMIR NFC/NFC+ Threshold calculation.

The Calculation

The MBT compares speculative commodity derivative transactions of the group with third parties (sum of gross notional, or “GNV”) with the aggregate gross notional of all Financial Instruments of the group, speculative or hedged.

I should declare some simple but important interpretations on which my analysis relies:

  1. “Financial Instrument” means all asset classes, unless otherwise qualified. This means that the denominator includes tradeable securities, i.e. Equities and Bonds as well as derivative instruments in interest rates, FX and commodities. This is basic explicit MiFID Level 1 and RTS text so shouldn’t be too controversial.
  2. The calculation is performed on a ‘trading turnover’ or trade date window basis, not on contracts liver in the window as is the case with the EMIR NFC Threshold. The RTS is silent on this subject, but the momentum of the consultation commentary is consistent with the trade date window assumption.
  3. ‘Group’ means the whole group of companies globally, unless qualified by the term ‘European’. Again, this should not be controversial, but is easily confused when reading the text and various commentaries on various threshold calculations at once.

With these straightforward interpretations declared thee are some very problematic outcomes of the calculation as it is currently specified, outlined below:

Funding and Hedging Frequency Bias

The same firm may produce a different MBT ratio depending on how and when it last raised funds from the market, and how it chose to hedge the financing transactions. This is because the trade date window is a maximum of three years, and initially will be only one year.

  • Unlike many commodities the tenor of financial hedging instruments has no influence on Notional Value expressed in currency, so a 1 year EUR1m Interest Rate Swap has the same gross notional as a 10 year EUR1m IRS, and conversely ten 1 year swaps has ten times the gross notional of 1 ten year swap with the same terms and cash flows.
  • Regularly extended Short term finance (<3 years), by way of equity or bonds will have more impact on the ratio than long term hedging of the full investment payback of the underlying assets (often >10 or even >20 years)
  • Foreign Currency Bond finance plus Interest Rate hedge plus Foreign Currency hedge might count three times in comparison to the equivalent local currency bond with no hedges.

Reporting/Operating Currency Bias

  • A European firm of a particular business size will produce a different MBT ratio if its geographic profile means it needs to hedge foreign currency flows using Financial Instruments (which count in the denominator), as opposed to a single country/single currency entity with the same assets, and turnover.

Funding Instrument Bias

  • Equity is a significant portion of the balance sheet of most real-economy firms that use the financial markets. It should definitely be recognised in measuring the size of the main business. However the notional value of equity issued bears no resemblance to the size of most large public firms. I checked a sample of balance sheets and found that shares issued at 10 Euro cents often raise EUR10 funding for the business.   Measuring Equity Financial Instruments at notional just doesn’t make sense.

Conclusion

Anomalies like this lead to uncertain or arbitrary regulatory status, wasted resources, potentially provide perverse economic incentives, and at worst incentive to game the system. More work is required. ESMA might start with the following:

  • Adopt the EMIR approach of measuring outstanding contracts in the measurement window rather than new trades done thus avoiding spurious bumpiness of the MBT denominator.
  • Choose to measure the GNV of the bonds not their related Interest Rate/Currency derivatives, thus avoiding the double counting and potential gaming of the calculation.
  • Measure Equity as Shareholders Funds rather than notional value thus representing the true size of the business that is funded.

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MiFID2 Consultation: Ask the CFO

21 Wednesday Jan 2015

Posted by LEENBROEKHUIZEN in EMIR, MiFiD2, Regulations

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MiFID2, Regulation

I have been reviewing the recent MiFID2 consultation paper (here), in particular Chapter 7.1 Commodity Derivatives | Ancillary Activity. While ESMA has attempted and generally succeeded in taking a pragmatic approach to defining what constitutes ancillary activities there will still be some very significant challenges for many organisations in implementing this approach for a regular monthly calculation, and in some areas real costs which the regulator has explicitly (and, in my opinion wrongly) discounted as zero.

The devil is in the detail, which does not lend itself to a quick elaboration (give me a call to discuss?). However it is worth noting that in the cost/benefit analysis (Annexe B) ESMA estimates both the trading activity test, and the capital employed test to be trivial to implement. I would tend to agree with the former because it is based on the EMIR gross notional data which firms should already be producing and sending to Trade Repositories; on the other hand I doubt very much that today’s finance teams can produce the data for the capital employed threshold calculation without significant workload.   This is because balance sheet accounting is rarely as detailed as for profit and loss, and the balance sheet equity and debt specific to unhedged, non-intercompany MiFID2 Derivatives will not be separately booked in the chart of accounts.

When responding to the consultation NFCs should consider the implications of a change to their global chart of accounts, posting rules and monthly group consolidation, not to mention endless industry discussions on how to allocate equity and long term debt to derivative vs physical portions of their commercial business within the same legal entity.

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Recent Posts

  • KPMG Commodities Trading Survey 2016
  • A Snitch in Time!
  • MiFIDII Ancillary Activities Exemption: Progress Made …. More Work Required
  • River Row 2015 Sponsorship
  • Clearing Fees & MiFID2: Is there any pleasure to be had?

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