Including updates on FX financial supervision, CRAs and automated trading


Preparing for FX supervision

The systemic risk associated with unhedged foreign currency lending has increased rapidly in the past few weeks, according to the European Systemic Risk Board (ESRB). The source of the risk has shifted from that of exchange rate risks at Eastern European banks exposed to euro loans without matching currency income, to some large European banks effectively unable to roll-over dollar dominated loans from their U.S. peers. In its press release of 21 September following the third regular meeting of its General Board, the ESRB expressly flagged unhedged foreign currency loans as a significant threat to financial stability in Europe.

Foreign currency loans have always been remarkably prevalent in Europe. At the end of 2010, the majority of outstanding loans to the non-bank sector in many Eastern European countries were denominated in euros, according to research carried out by the Swiss National Bank. Where national currencies are pegged to the euro, it has become a de facto currency locally, particularly in relation to corporate lending. However, the Swiss franc has also been used in many of countries as the currency of choice due both to low interest rates and the stability of the currency, a situation which has put many local economies in jeopardy in recent weeks as the Swiss franc’s substantial rise in value over the summer seriously stretched borrowers’ ability to repay the loans. For example, Hungary recently announced a plan to allow households to repay foreign currency debts at fixed exchange rates by which it hopes to alleviate the pressure on Hungarian retail borrowers. This move will prove costly for the banks though. According to recent press reports, Hungarian households' foreign currency debt - mainly in Swiss francs - amounts to about 5.6 trillion forints ($27 billion), equivalent to 18 percent of Hungary's GDP.

Supervisors’ concerns are exacerbated by banks in some eurozone countries being particularly active in funding foreign currency loans with short-term foreign funding. The crisis has seriously restricted their ability to sustain this practice. According to some press reports, even some major financial institutions in Europe are now completely cut off from dollar funding markets, as US institutions pull back capital in response to the region’s debt crisis.

The European Bank for Reconstruction and Development in December 2010 called on appropriate macroprudential policies and incentives to reduce the flow in foreign currency lending. For instance, supervisors may require banks to hold additional capital for exposures arising from foreign currency lending to borrowers without foreign currency income. Also, rules can be introduced to require banks to set more conservative loan-to-value or debt-service-to-income ratios in case of foreign currency lending. Greater supervisory scrutiny may also be levelled at risk management procedures around foreign lending and inter-group management of foreign currency in cross-border banks.


CRAs face tough reporting requirements

The European Securities and Markets Authority (ESMA) has released four separate consultations on Credit Rating Agencies’ (CRAs) disclosures to ESMA for registration and ongoing supervisory purposes, in line with the CRA Regulation. ESMA is seeking responses to the consultation papers by 21 October, from external stakeholders and its own Stakeholder Group. It will then seek input from both the European Banking Authority (EBA) and the European Insurance and Occupational Pensions Authority (EIOPA) prior to submitting finalised draft regulatory technical standards (RTS) to the European Commission (EC) by 2 January 2012. Assuming no concerns arise, the EC will then endorse the RTS through their adoption as delegated acts. The draft RTS cover four specific areas:
  • The information to be provided by a CRA in applying for registration or certification and the associated assessment of its systemic importance
  • The structure, format, method and period of reporting of CRAs to ESMA’s central repository (‘CEREP’)
  • The assessment of the CRA’s compliance with the requirements on credit rating methodologies
  • The content and format of ratings data to be provided as part of CRA periodic reporting.
Following the adoption of the CRA Regulation (1060/2009, subsequently amended by Regulation 513/2011), responsibility for the registration, certification and ongoing supervision of CRAs operating in the EU has been centralised in ESMA’s hands, effective 1 July 2011. ESMA is currently the only European Supervisory Authority (ESA) to have a direct supervisory role. Therefore, its approach may set a precedent for the future.

On registration, national authorities and ESMA have been working off Guidance produced by ESMA’s predecessor the Committee of European Securities Regulators (CESR) in June 2010. However, the RTS look to address certain inadequacies in the process which have come to light in the intervening period. The RTS considering periodic reporting builds on the CESR Guidance paper from August 2010 but sets out precise standards for the ratings data to be reported.

ESMA has not strayed from its remit of delivering ‘technical’ regulatory standards in each of the different areas, but it sweetens the pill by producing clear and concise assessments of the costs and benefits of the choices it has made. Despite the dry technical nature of these papers, all users of credit ratings should review them carefully, to evaluate whether they will achieve the intended results of ensuring that ratings in the future enhance stability in the financial markets, both in Europe and globally.


EFAMA publishes blueprint for a European consolidated tape

In anticipation of the EC’s upcoming proposals for the revision of the Markets in Financial Instruments Directive (MiFID), the European Fund and Asset Management Association (EFAMA), which in main represents the ‘buy-side’, has published a blueprint for a European Consolidated Tape (ECT) which aims to reduce both indirect and direct costs for investors and improve the quality of information on trading.

EFAMA believes that, the proliferation of trading venues has exposed problems in data quality and aggregation. MiFID opening up trading markets to competition has resulted in data fragmentation, creating “great difficulties” for investors in determining market prices and volumes with certainty and has also created difficulties for supervisory surveillance.

EFAMA’s blueprint draws on some of the elements discussed in the EC’s consultation paper on the revision of MiFID and includes:
  • the introduction of the Approved Public Arrangements (APA) regime, a regulated channel where post-trade data is made available by data providers
  • the creation and adoption of a European Mandatory Data Feed (EMDF) standard for post-trade data feeds to be provided to and by the ECT
  • the establishment of a single official ECT with enabling measures to facilitate competition.
The EC proposed three options on how the ECT would function in the MiFID II consultation paper. Firstly, it could be operated by single, non-profit entity, established and appointed by legal act, secondly, through a single commercial entity with strict requirements on costs and openness, and thirdly, a variation on second option with competing commercial providers. EFAMA’s release is timely coming just three weeks before the anticipated release of the Commission’s proposals, and clearly stakes out its preferred option.

EFAMA believes that market users would support a competitive commercial solution but its decision promote a single ECT was reflected, in part, by the absence of a comprehensive and enforceable solution, and the likelihood that ESMA will still need to set and supervise the standards.

Notwithstanding uncertainties surrounding what form the consolidate tape, EFAMA’s decision to put forward a blueprint preceding the publication of the MiFID II report is calculated to ensure buy-side input is taken into account by EU legislators, in advance of what are likely to be difficult negotiations over MiFID II. . Given that the EC is likely to extend the requirement for a consolidated tape to other asset classes in the near term, getting the precedent right is critical for the markets in the future.


ESMA seeks to apply common sense to automated trading

On 27 September, ESMA held a public hearing on its current consultation paper on the guidelines on systems and controls in a highly automated trading environment for trading platforms, investment firms and competent authorities which is open to comment until 3 October.

ESMA’s over-riding objective is to ensure the orderliness and resilience of markets. Apart from a limited number of drafting errors which were noted during the hearing, ESMA believes the draft guidelines which were published in July 2011, constitute best practice. They do not think they will be overly onerous on firms or platforms, and showed little sympathy for complaints about costs. ESMA intends these guidelines to encompass as broad a range of automated trading systems as possible, noting that ‘slow’ algorithmic trading systems can cause as much damage to the financial markets as high frequency trading systems. ESMA has deliberately avoided definitions to ensure that these do not create loopholes for regulatory arbitrage.

ESMA would like to see control mechanisms put in place by platforms (e.g. ‘throttling’ procedures in respect of capacity limits, circuit breakers) with as much transparency as possible between platforms and their members, while recognising that the platforms need to retain flexibility to enable them to react to new situations. ESMA would also like to see some harmonisation across platforms - in the same and in different jurisdictions - around controls such as circuit breakers designed for the same assets: however ESMA also recognises that total harmonisation is not achievable or probably desirable. ESMA intends to adopt the guidelines as soon as possible following the close of the consultation period, and by the end of the year at the latest. They go as far as possible under the existing MiFID regime but the guidelines may be subject to modifications following the MiFID review. That said, ESMA was keen to stress that these guidelines form key building blocks for requirements in the future and that any subsequent changes will only improve upon them. Under the existing regime, there will be an expectation on national supervisors to ensure the appropriate outcomes, however, with MiFID II, these requirements may become binding.


EIOPA’s insurance and reinsurance stakeholder group 2nd meeting

In mid-September, , the European Insurance and Occupational Pensions Authority’s (EIOPA) Insurance and Reinsurance Stakeholder Group held its second meeting following its establishment in March this year.

The Group, which meets a minimum of four times a year, is mandated to facilitate EIOPA’s consultation with stakeholders in Europe on issues relating to technical standards in addition to the guidelines and recommendations that apply to the insurance and occupational pensions industry. Members of the stakeholder groups can submit opinions and advice to EIOPA on any issue related to its task. Furthermore, the stakeholder groups are expected to notify EIOPA of any inconsistent application of European Union law as well as inconsistent supervisory practices in the different European member states.

EIOPA published materials for meeting on its website including the draft notes of the initial Stakeholder Group meeting held in May. Two of discussions though are relevant more broadly.

The Equivalence Committee Chair provided some insights into EIOPA’s work on equivalence assessments in relation to Solvency II. EIOPA’s advice in relation to the equivalence of Bermuda, Switzerland and Japan in the three separate areas of the Directive where equivalence assessments are required is due to be submitted to the European Commission in October. Interestingly, in addition to the three articles which call for equivalence assessments (Articles 172, 227 and 260), the Chair, Edward Forshaw, stressed that equivalence is terms of professional secrecy is a pre-requisite in all the assessments. The exercise overall has taken 11 months, involving three separate teams (representatives from 4 member state authorities plus one from EIOPA) which have had to be closely coordinated. The Equivalence Committee met 11 times during that period, a clear indication of the amount of supervisory effort and time involved in undertaking these assessments.

Another presentation focused on consumer protection issues, a forerunner of the upcoming proposals around Packaged Retail Investment Products (PRIPs). In the future, EIOPA will increasingly focus product development and will monitor market activities closely to fulfil its reporting and prohibition role. This will involve ongoing communication with national supervisory authorities and other stakeholders. EIOPA will also begin to focus on financial literacy and education in collaboration with the other ESAs through the Consumer Protection Sub-Committee to be set up under the Joint Committee. EIOPA is planning a separate Consumer Protection panel at its upcoming annual meeting on the 16 November and also a ‘Consumer Day’ on 6 December.

This type of transparency from the ESAs to stakeholders more broadly (and not just those represented on the Stakeholder Group) is very welcome and could go a long way to stem industry concerns, evidenced by the recent complaint lodged by the European Consumers’ Organisation (BEUC) against EBA and EIOPA in relation to the composition of their stakeholder groups.