Currently in its consultation phase, the European Commission (EC) review of the Markets in Financial Instruments Directive (MiFID) has caused anxiety among a wide range of organisations that could be affected by the new legislation. The proposed changes, known in the financial services industry as MiFID II, are intended to bring transparency of trading across asset classes by moving a large proportion of over-the-counter (OTC) products onto exchanges. The aim is to reduce the large number of non-standard, non-exchangetraded products changing hands, that were not covered by the original MiFID legislation in 2007. Although the legislation is unlikely in many cases directly to regulate corporate treasurers directly (unless their company is very large) the review is almost certain to affect the way treasurers manage their assets. Access to liquidity could be reduced and could also become more expensive. However, MiFID II could also bring benefits in the shape of increased investor protection.
Despite originally being conceived as a directive regulating all asset classes, in practice MiFID came to define only equities trading. It therefore did not affect corporate treasurers except the minority issuing stock. However, in its new form, a series of other products used by corporate treasurers to manage their exposures, such as currency and interest rate derivatives, will be affected by the review. “The extent to which, in the world of tomorrow, you will be able to do all of that over the counter, rather than exchange-traded, is a big issue,” says Jonathan Herbst, partner at law firm Norton Rose.
Different Products: Different Effects?
Larry Tabb, chief executive officer (CEO) and founder of consultancy and research firm Tabb Group, says the proposed changes could be either to corporate treasurers’ benefit or to their detriment, depending on which products they are trying to buy or sell and how standard – and therefore liquid – they are. When managing the balance sheet, it is much more viable to manage unstandardised exposures OTC, while exchange trading works well for liquid and standardised products. “If they want to buy sovereign debt, currency or standard on-the-run [the most frequently traded and therefore the most liquid] bonds, it might be fine,” he says. “If they’re looking for swaps, or less liquid instruments or foreign exchange [FX] in odd amounts for odd settlement dates, they won’t be able to go to their local banker and say, ‘Give me a quote for this,’” Tabb adds.
Conversely, for more liquid products, the proposed changes could open up the market. For example, treasurers could see a much wider array of product prices than previously. Instead of having to get a range of prices from different dealers, treasurers would be able to use market data products for a montage of the best offers to ascertain whether they were paying the right price. Tabb adds: “[If the regulations provided for] mechanisms to handle odd dates, amounts and transactions, and do that in a much more transparent and less risky way, that would be great.”
Effects of Increased Product Transparency
The increased product transparency could also have a bearing on the pricing offered by banks for less standardised products with a specific maturity date or for non-standardised amounts, since these transactions will now be transparent to the market. Clearly, where a bank has a relationship with a specific corporate, it might be able to offer the treasurer better than average terms – and not want this quote to be transparent to the rest of the market.
“[Under the new rules] it could be that if the bank is going to quote a certain price for one person, then they have to use the same quote for everybody. If banks have to make quotes public, there might be fewer that are willing to quote” Tabb says. One solution would be forcing treasurers to buy predetermined exposure. He notes that, with this information, other intermediaries, proprietary trading funds or hedge funds could manipulate the price of that product to the owner’s deteriment. “By trying to make things more transparent, it may actually wind up pushing people out of the market.”
The size of the marketplace could also be affected by an increased level of transparency, as intermediaries could experience greater difficulty in managing their risk – and they may therefore decide it’s not worth offering the products in question. This could result in a much more transparent market, but one that has fewer participants present to satisfy treasurers’ needs.
This loss of transparency could also affect corporate treasurers who deal significant volumes on the capital markets, as their trades will also be more transparent to the market than historically. The emergence of reference data proposed under MiFID II is highly likely in the drive for greater transparency, according to PJ Di Giammarino, chief executive officer (CEO) of financial regulation thinktank JWG. This will affect corporates with large portfolios to the greatest extent – leading to increased scrutiny from both shareholders and regulators. “Fundamentally, you can’t have transparency on these instruments unless you know who you’re talking about and what products you’re dealing in. Both the instruments themselves, as well as the legal entities being used to purchase them, are going to require a much greater level of transparency,” he says.
Cost of Exchange Trading
A particularly contentious issue is one of possible exemptions for collateral requirements for exchange trading. Whereas in OTC trading the corporate credit rating is factored in, and the clearing house bears the default risk, the same is not true of exchange trading. Highly-rated corporates will therefore have to put up much more collateral to trade – capital that could be used elsewhere. The cost is therefore much higher on the regulated markets. The question of whether there can be an opt-out for companies over a certain size is key.
A knock-on effect of a wider move to exchange trading, according to the CEO of financial software firm Quod Financial, Ali Pichvai, is liquidity fragmentation, where different exchanges list the same shares. This occurred with equities following the original MiFID legislation, but could now affect the asset classes likely to be regulated under MiFID II. “It is a knock-on effect of the legislation, but one that is being carefully watched by those trading derivatives, such is the marginal effect of listing twice.”
Better Investor Protection?
One potential boom for corporate treasurers is a more stringent investor protection regime. “It is difficult to know how that will go, “Herbst points out,” but will affect areas such as best execution, inducement and, more generally, the effect of categorisation [which affects the level of protection afforded to a client]. Categorising a corporate as a professional client won’t automatically mean that the bank can assume their expertise.” He adds that that this could, however, lead to brokers raising their rates.
The regulations affecting treasurers who deal on their own account for hedging purposes are also poised to change – but the exact form of this change is not yet known. This will be governed by the extent to which treasurers will be able to avoid regulation if their trades are purely for hedging purposes. But the danger is real. “The minute you cross the line into speculation could bring you into the regulatory scope of dealing for yourself. That is an important issue to be aware of. Some in Europe believe that anyone who is ‘speculating’ should be regulated and we have to be aware that that is out there, Herbst says. This could make it much more difficult for corporate treasurers, some of whom are quite sizeable dealers, to rely on the current exemptions. But Herbst believes the picture offers some hope. “There is undoubtedly pressure to narrow the exemptions, but I don’t think there’s a plan to abolish them completely, so I don’t think corporate treasurers should be panicking,” he notes.
From a practical perspective, the implementation of the legislation, while tabled for summer 2011, is being hampered by a lack of budget for staff to write the regulations at the bodies created by the EC: the European Securities Markets Association (ESMA), the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA). “[The EC] has to decide how much progress it’s really going to make this year, it has the agenda but the bottom line is that the regulators must take the lead in areas that require real expertise and funding to get the job done. Resourcing the regulatory functions is a real problem: the US, with its aggressive implementation timescales and lack of budget has been quite vociferous about this,” Di Giammarino notes.
With the legislation’s final form unlikely to be apparent for some time, there are still many unknowns about MiFID II. However, it is certain that, whatever form the new legislation ultimately takes, it will have an impact on the way corporate treasurers do business and their relationships with other market participants. David Newman, principal consultant at Rule Financial, sums up: “The risks are the scale of the change required, co-ordinating the move to the new regime at the same time as addressing other regulatory changes (such as Dodd-Frank), and of course hitting the hard deadline of an industrywide regulatory requirement.”
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