Including updates on new regimes for venture capital funds and documentation for cleared swaps


EC: Position limits are needed in commodity markets

In October 2008, the UN Conference on Trade and Development suggested that, “stricter regulatory measures that help contain speculation on commodity markets could be one important step” in moderating price instability that effects economic growth, financial stability and regulation.

The use of commodity derivatives by producers and consumers of commodities and raw materials to hedge against prices variations has grown in importance in the last decade. During the 2007/2008 food crisis, many believed that speculation in these markets exacerbated price volatility skewing the commodity markets and disrupting the process of price discovery to such a degree that both producers and consumers were negatively affected. A lack of transparency in the physical markets also made it difficult for financial markets regulators to detect market abuse.

Politicians and regulators alike are now pushing for more disclosure of, and control over, commodity and raw material markets. French President Nicolas Sarkozy last week suggested that the recent record volatility of prices for raw materials was due, in part, to the increased ‘financialisation’ of commodity markets. He noted that commodity derivative contracts dwarf their physical markets: for example, oil derivatives are valued at 35 times more than the global volume of oil, and wheat derivatives are worth 46 times the annual wheat production in the United States. Bart Chilton, CFTC Commissioner, speaking at the same conference hosted by the European Commission (EC), noted that “there are more speculative positions in commodity markets than ever before”, particularly through the influx of the “massive-passive” (large institutional investors) whose trading strategies are not “a secret and others in markets base decisions upon what they know the massive passive will do, which is to go long, by and large”. Chilton said that President Sarkozy “got it exactly right when he spoke about the need for thoughtful regulations to address excessive speculation and the need to harmonize regulations” and expressed the hope that the EU would introduce position limits similar to those currently proposed in the US.

However, many EU regulators are currently fighting blind. Michel Barnier, EU Commissioner for Internal Market and Services, said that “only transparency” can help us understand the “structural changes” we are seeing in the markets. He outlined proposals that the EC are considering to give national regulators the power to impose position limits on commodity derivatives in order to preserve “the integrity and stability” of the markets. The European Securities and Markets Authority (ESMA) will be mandated to develop a common set of rules to supervise commodity derivates markets, ensure a uniform and coordinated application of rules and facilitate greater cooperation between financial regulators and regulators of physical markets (where appropriate). The new rules (incorporated as part of the MiFID review) will be tailored to reflect the ‘specificities’ of the each commodity market. Simultaneously, the Market Abuse Directive will be revised to clearly define what constitutes market abuse in commodity derivative trading and ensure that both actual and attempted abuse is covered by the rules.

However, as Alexander Justham of the UK Financial Services Authority noted recently (see EU Market Update 20 June 2011), position limits are only one tool that regulators should have in their arsenal. Underpinning their effective use is good position management by firms. To make their use effective, first more information is needed on the “financialisation” of the markets to that measures taken in the future do not cut off speculation which provides essential liquidity to the markets. Ensuring a consistent approach - which still differentiates between the different commodity markets - will be a challenge: there is the danger of creating a blunt instrument as opposed to a precision tool.


FIA and ISDA publish documentation for cleared swaps

On 16 June 2011, the Futures Industry Association (FIA) and the International Swaps and Derivatives Association (ISDA) published a Cleared Derivatives Execution Agreement in an effort to provide some initial structure to the OTC market pending the full implementation of the reforms mandated by the US Dodd-Frank Wall Street Reforms and Consumer Protection Act (Dodd-Frank) and similar reforms elsewhere. The need for a common template arose as major clearing houses published proprietary agreements in anticipation of clearing requirements in Dodd-Frank. This resulted in the OTC market having to deal with multiple clearing houses, each with its own required documentation which proved cumbersome and ineffective.

This new agreement harmonises procedures for submitting trades for clearing across major clearing houses, including time requirements for parties to affirm trades and the obligations of parties when a trade is not accepted for clearing. It outlines that when a trade is accepted for clearing, “each party’s agreement with its clearing firm will govern” and both parties have no further obligations to the other. Second, it establishes the rights and obligations of the parties in the event that a trade is not accepted for clearing. Third, the agreement includes optional annexes for those parties that want a clearing firm to be party to the agreement.

Swaps market participants can use the FIA/ ISDA template in negotiating execution related agreements with counterparties to swaps that are intended to be cleared. It will support the adoption of central clearing in the global derivatives markets by providing a model for the legal documentation supporting derivatives clearing. However, the use of the agreement is voluntary and may not be either “necessary or appropriate” in certain situations. ISDA stressed that the final template is clearing house neutral and was created with input from a range of both buy side and sell side participants.


EC propose a new regime for venture capital funds in Europe

In a consultation paper issued on 15 June 2011, the EC underlines that venture capital helps drive “innovation, economic growth and job creation” in the EU. It is an essential source of finance of small and medium enterprises (SME), providing finance to untested business models with strong growth potential. However, the annual amount invested by Europe venture capital funds in SMEs has decreased steadily in the last few years: figures for 2010 indicate investment is roughly half the 2007 level.

This does not result totally from the financial crisis. The EC contends that the fragmentation of Europe’s venture capital markets along national lines is depressing the supply of capital for innovative SMEs and that currently; there is “no real internal market for venture capital in the EU.

This situation will be improved when the Directive on Alternative Investment Fund Managers (AIFMD) comes into effect. However, only managers with funds in excess of €500 million will automatically benefit from a European passport. Although managers below this threshold can opt into the regime, the prospect of full compliance with AIFMD would be a “disproportionate” burden for venture capital funds. It would also be contrary to the spirit of AIFMD as venture capital funds are unlikely to pose important systemic risk or create specific investor protection concerns and, in some situations, could generate double taxation.

The EC now has a remit to take action in this area. On 23 February 2011, the Council of Economic and Finance Ministers concluded that every effort should be made to remove the remaining obstacles to the cross-border operation of venture capital funds. The EC’s consultation paper, entitled “A new European regime for Venture Capital”, sets out several policy options to create an internal market for venture capital.

Now, the EC suggests using legislation to stimulate the European venture capital market through one or two options: either a targeted modification of AIFMD rules for venture capital, or the creation of a stand-alone initiative in this area. The EC favours the second option, as the AIFMD requirements “are not tailored for venture capital managers”. The EC outlines other core elements for a venture capital legislative framework
  • Voluntary registration with a competent authority- requiring venture capital managers and their funds eligible for a European “passport” to provide services and raise and invest capital in all 27 member states.
  • Simple notification process- from the home regulator to other national regulations, identifying the manager and the funds.
  • Legal form of the venture capital funds- allowing venture capital funds to adopt any of the legal forms traditionally used in national jurisdictions.
  • Reporting obligations- venture capital managers would only be required to produce an annual report, which would be made available to investors and regulators.
  • Restriction for retail investors- venture capital funds covered by the proposed European passport would only be offered to professional investors as defined by MiFID.
  • Operating conditions for venture capital entities- minimising compliance costs relating to requirements on managers’ operating conditions compared to other fund managers.
  • Investment focus on SMEs- the passport would be targeted towards funds that invest the biggest part of their assets in SMEs, although would be interpreted in a flexible way.
The consultation period ends on 10 August 2011. The results of this consultation together with the EC’s impact assessment will form the basis of a legislative proposal to be put forward by the end of 2011.

On the face of it, a separate regime makes sense. However, the existence of a dual regime leaves to the door open to gaming. As always, there will be important issues to resolve around the threshold, particularly if transition from one regime to the other requires a step change in requirements. One objective of the proposal is to permit more economies of scale for venture capital funds operating across borders: thus suggesting a growth objective, potentially pushing more operators into the threshold ‘zone’. Therefore, the interaction of the new venture capital regime with AIFMD and other EU Directives would need to be properly calibrated and clarified.


Geithner and Barnier spar on regulatory arbitrage concerns

On 16 June 2011, Timothy Geithner, US Treasury Secretary, raised concerns about regulatory arbitrage, citing the UK’s “tragic” experiment in “light-touch” regulation. He warned that veering away from global compliance on tougher regulatory guidelines will concentrate risk in jurisdictions with the least regulatory oversight— undermining global efforts to strengthen the stability of the financial system. He suggested that a simple common equity surcharge, over and above Basel III, should be adopted for all internationally for all systemically important financial institutions. He also called on for a global agreement on how much collateral to require for uncleared derivative transactions.

Geithner’s speech came following comments by Michel Barnier in a recent visit to the US where he urged international adoption – including the US – of the Basel III regime. In effect, it followed a letter from Barnier on 27 May 2011, details of which were published in the Financial Times, where he called on the US to speed up and toughen its banking rules. He underlined European concerns about commitment of the US administration to Basel standards, given that they have still not fully implemented Basel II, a regulation which was adopted in the EU in 2006. On bank bonuses, Barnier suggested that the US decision to use non-binding guidelines to implement regulations to curtail incentives for risk-taking, gave scope for financial institutions to “circumvent globally-agreed principles”.

Geithner noted the EU’s plans, however, to deviate from the Basel III regime. Barnier has admitted that the EU will tailor the regime in certain respects to EU “specificities” although the details of this are pending the release of the proposals on CRD IV, due in July. However, recent commentaries and press reports provide some insight into possible deviations. Some EU countries, for example, see the need for flexibility to raise equity ratios above Basel III standards to ensure they can effectively manage financial stability risk with their jurisdictions. Other countries, including Germany and France, have voiced concern about protecting their banks’ competitive position in the global market, suggesting that Basel III should represent the maximum standards for European banks. There have also been heated discussions about capital definitions and the use of hybrid forms of securities and reserves as forms of core capital. On this point, Geithner believes the European regulators give their banks too much latitude on capital definitions.

However, these mutual jibes do not dissipate wider concerns in Brussels and Washington. There are concerns about developments in other regions which create opportunities for regulatory competition and arbitrage. Minor differences in the regimes on either side of the Atlantic will not jeopardise global standards: but indications from other territories suggest that there is still some way to go to achieving a global regime.


Central bank and financial stability governance

On 14 June 2011, the Bank for International Settlements (BIS) published a report on the role of central banks in financial stability policy. With the G20 due to consider financial stability oversight mechanisms at its summit in November, the BIS report bears close scrutiny. It highlights a number of general themes arising within the wide variety of “institutional settings, historical contexts and political environments” in which central banks operate. The BIS report highlights the central banks should play a “prominent role” in design and implementation of financial stability policy, as financial stability affects:
  • Price stability and the monetary policy transmission process;
  • The macroeconomic environment;
  • Liquidity in the financial system; and
  • Monetary policy.
Clarity about financial stability responsibilities is necessary to alleviate the risk of inconsistency between what the public expects and what central banks can deliver, as well as to promote accountability. The BIS notes that the extent and nature of collaboration with other public authorities will be shaped by how responsibilities for “supervision and regulation, bank resolution, deposit insurance, the provision of public guarantees and solvency support are allocated”. However, various policies can affect interested parties in different ways that generate tensions, providing a compelling rationale for careful attention to the design of governance arrangements.

Even in situations where a central bank is given sole responsibility for financial stability, it requires appropriate tools, safeguards and information to carry out this role effectively. On the latter point, central banks require information which sometimes can be hard to capture accurately, such as on the interconnections between financial institutions, markets and systems. Finally, consistent with conventional wisdom, independence for the political system is required to ensure that financial stability policy is “shielded from short-term political pressure” and capture from business and industry.