Including updates on Basel III, UCITS and market transparency


European approach to Basel III implementation: Getting stressed over EBA stress tests and Basel III

After much debate, on 17 May 2011 European finance ministers agreed measures to ensure that all Member States have credible backstop mechanisms in place for financial institutions that fail to meet the threshold of the 5% CT 1 capital ratio under EBA’s stress test scenarios. Ahead of the publication of the stress tests in June 2011, Member States will prepare a “specific and ambitious strategy for the restructuring of vulnerable institutions”, including a robust framework for the provision of government support. However, banks and regulators are encouraged to use private funds to reinforce their balance sheets, with public funds used only “as a last resort, in case of need and subject to strict conditionality”. Financial institutions that fail the stress test will have until August 2011 to present clear plans to address any vulnerabilities identified to the EU Council of Finance Ministers and a further three months to implement remedial strategies.

Last year’s stress test exercise, which was designed to restore market confidence, concluded that the entire European banking system required only €3.5 billion of new capital. The 2010 tests were roundly criticised when only four months following this prognosis, the Irish government admitted that its banking system alone required around €37 billion of extra capital—more than ten times EBA’s figure for the entire European financial system. EBA says that this year’s tests are more stringent, applying negative projections of gross domestic product growth (0.5% contraction) and equity prices (15% contraction). However, critics argue that the metrics underpinning the tests are too optimistic. For example, EBA’s adverse scenario for UK GDP assumes a 0.2% contraction of GDP in 2012, versus a 4.3% contraction scenario in the UK’s own bank stress tests. Additionally, many consider that the refusal to build scenarios on the possibility of a sovereign debt default undermines to the credibility of the test, given current developments in Europe. Standard and Poor’s believe that the potential losses from a sovereign default or debt restructuring would exceed the trading book haircuts applied in EBA’s methodology. Concerns have also been expressed that the CT 1 benchmark capital EBA is using is too low, although EBA had to fight hard for this measure. The CT 1 benchmark will be set at 5% of risk weighted assets (Basel III requires 7%).

EBA has a difficult task in attempting to reconcile conflicting views amongst the Member States, while ensuring that the compromise reached is credible. According to press reports, the EC’s proposals, backed by Germany and France, would effectively turn the minimum capital requirements of Basel III into the “maximum level” for EU banks. Seven finance ministers, lead by the UK, recently wrote to Michel Barnier, the EU Internal Market and Service commissioner asking the EC to scrap plans to prevent national regulators from setting tougher capital rules over and above capital requirements laid down by Basel III. They argued that some countries may need to set higher capital levels “in specific circumstances to protect financial stability”, and that allowances need to be made for the varying levels of importance of the financial sectors in different economies and the varying sizes of banking sectors relative to GDP across the EU.


European regulation of markets and trading: dark liquidity

Dark liquidity pools are trading venues that, in contrast to traditional exchanges, do not publicly show bid and offer quotes. They have been long used by traders to preserve anonymity and execute orders, lowering submission and execution fees and limiting market impact.

With the emergence of algorithmic trading programs which can automate the routing of orders to a number of different trading venues—taking into account prices, liquidity and market impact—dark pools have grown sharply in significance. According to the Committee of European Securities Regulators (CESR), for the first quarter of 2010, 8.5% of all trading in EEA shares on regulated markets and multilateral trading facilities (MTFs) was executed under the pre-trade transparency waivers (i.e. dark pools) established by the Markets in Financial Instruments Directive (MiFID). However, regulators recognise that “internalisation” of trades by investment firms or broker-crossing networks, and “over-the-counter” trading, may also be leaving a significant volume of trading activity in the dark. Because dark trading does not contribute to pre-trade price discovery and may ultimately affect the quality of price discovery mechanisms (and thus market efficiency), they have attracted much greater regulatory focus as a result of the financial crisis.

On 24 May 2011, the Technical Committee of the International Organisation of Securities Commission (IOSCO) published a report mapping out a number of principles to assist regulators, venues and market participants to deal with the growing number of formally organised dark pools (i.e. dark pools operating as separate trading facilities) and dark orders entered into transparent trading venues. Designed to reduce the adverse consequences of dark trading, these principles also seek to mitigate against the increased fragmentation of information and liquidity and to ensure that regulators and market participants receive adequate information. They are general in nature: IOSCO does not believe a “one-size-fits-all” approach is appropriate, instead it recommends that regulators consider the characteristics of their respective markets to determine how best to implement the principles. But, from a European perspective, the principles are timely, coming not long before the anticipated MiFID revisions.

The first principle establishes that the price and volume of firm orders (i.e. pre-trade) should generally be transparent to the public, although regulators should be able to waive this requirement for certain market structures and orders. IOSCO recommends that regulators consider actionable Indications of Interest (IOIs) as firm orders. The second principle states that all trades should be made public once executed: if these are dark trades, regulators should consider whether to identify the dark venue or that it was a dark order. The third principle relates to prioritising transparent orders over dark orders at the same price, thus providing incentives for their use.

The last three principles centre on access to information and the supervision of dark pools and orders. IOSCO suggests that regulators should ensure they receive sufficient information either through formal reporting or other means; that sufficient information is made available to market participants to allow them to understand how their orders are handled and executed; and that regulators periodically monitor the development of dark pools and orders to ensure no damage is occurring to the price formation process.

In Europe, under MiFID, dark pools may be operated by regulated markets, or as regulated MTFs which must apply for regulatory waivers from pre-trade transparency requirements. In preparation for the European Commission’s (EC) consultation process earlier this year, CESR advised that these waivers should be reviewed, and possibly recalibrated, in light of recent market developments. It also anticipated IOSCO’s opinion that actionable IOIs should be considered firm orders. The majority of CESR members also felt that below-threshold, non-executed “stubs” of large-in-scale orders should be subjected to pre-trade transparency requirements. CESR recommended that the waiver process in the EU is made more formal (i.e. “rules-based” rather “principles based”) to enhance supervisory consistency.

Details of the new regime have not yet emerged but there are some underlying motivations —reinforced by IOSCO’s principles —which will significantly influence the amendments. Firstly, additional disincentives to dark trading can be expected in the proposals, given the Own Initiative report of the European Parliament’s Economic and Monetary Affairs Committee which was adopted in November 2010. These measures which include: size restrictions on dark orders and a requirement to reclassify all broker dark pools as MTFs/systematic internalisers, are likely to receive strong political support. Secondly, the new European Securities and Markets Authority (ESMA) will be given more power: therefore we can expect a more formal, consistent but perhaps less flexible approach to pre-transparency waivers across the EU. Buy-side commentators have already expressed concerns to the EC about increased transparency, pointing out that the potentially negative market impact of operating in “lit” environments may discourage trading. Buy-side and other stakeholders will need to remain active in the debate once the legislative proposals are tabled to ensure that a workable balance is achieved between market efficiency and investor protection.


Newcits: EFAMA argues Newcits are just UCITS

On 16 May 2011, the European Fund and Asset Management Association (EFAMA) published a robust defence of the UCITS brand, designed to answer concerns expressed by some regulators about the riskiness of funds known as “Newcits”, a term coined by the media to cover a wide range of techniques and instruments to manage the trade-off between risk and return, including employing derivative techniques to generate “absolute” returns to investors. EFAMA urges regulators and market participants not to use the term Newcits, because it unhelpfully suggests that these funds are somehow different from other UCITS funds, whereas they and their managers are in fact subject to the full panoply of UCITS regulation. EFAMA argues that the existing UCITS regulatory framework, particularly the framework in force from 1 July 2011 under UCITS IV (2009/65/EC) is sufficient to capture the changing nature of UCITS, provided that framework is enforced by ESMA and national regulators. In defending Newcits, EFAMA may also be attempting to avert the risk that some UCITS may be classified as complex products as part of the investor protection measures proposed in the MiFID review.


Market Transparency: UK reinforcing support for transparency in European financial markets

On 19 May 2011, David Lawton, Head of Market Infrastructure and Policy at the UK Financial Services Authority (FSA), gave a speech on “Strengthening transparency in the markets transaction chain” at the Xtrakter Annual User Conference in London. In assessing how the “information set” available to regulators and market participants might change as a result of the extensive reform agenda, Lawton outlines some of FSA’s views in terms of upcoming EU legislative revisions which will obviously orientate its overall stance in the associated negotiations. Above all, Lawton emphasised that “high quality, transparent and open markets remain vital for the UK’s position as a leading international financial market centre”.

In primary markets, the FSA would like to see comparable steps to those already taken in the UK to extend disclosures to equity derivatives and short positions. The extension to the UK major shareholding disclosure regime in June 2009 covered all long economic interests of 3%, and captured in particular Contracts for Difference (CfD) which the UK believes were being used to circumvent Transparency Directive (TD) requirements. The FSA believes reducing the initial disclosure threshold from the current 5% in TD to 3% will enhance investor confidence leading to deeper liquidity. The FSA also supports the EC’s intention to create a tailored regime for small- and medium-sized enterprises (SME) but notes two necessary components: defining a trading venue as an SME platform, and determining appropriate issuer and investor disclosure requirements.

From the FSA’s perspective, the EC’s Approved Publication Arrangement regime should operate data publication arrangements according to prescribed standards, check trade reports for accuracy before dissemination, and ensure information is provided in a format that facilitates consolidation. Noting the EC’s intention to extend pre- and post-trade transparency requirements to all derivatives eligible for clearing and/or reported to trade repositories, and all bonds and structured projects with a prospectus, Lawton stressed the importance of getting the calibration and the mix of pre- and post-trade requirements right so as not to negatively impact liquidity in the different markets. In terms of transaction reporting, the FSA believes that new requirements should capture all financial instruments admitted to trading on (only) EU regulated markets and MTFs (and other designated trading platforms if appropriate), as well as all instruments that are “dependent” on Advocating that regulators receive client details from these reports.

Finally, under EMIR, all derivative transactions involving an EEA counterparty will have to be reported to a trade repository. The FSA expects that such reports will include information on the legal parties to the transaction and the main characteristics of the contract (maturity, notional value). It appears that the FSA may not support mandating the use of global legal entity identifiers: Lawton said “we also expect trade repositories to make use of the nascent global legal entity identifier”.


ESMA publishes final guidelines on Credit Rating Agencies

The EU credit rating regulation 1060/2009 of 16 September 2009 (CRA Regulation) came into force on 7 December 2009, but was subsequently modified on 15 December 2010 by an amending regulation empowering ESMA to undertake the supervision of all credit rating agencies (CRA) in Europe. However, how this new regime will interact with third country regimes, CRAs and ratings remains to be seen: a transitional measure in the CRA Regulation postponed final determination of this issue until 7 June 2011.

The CRA Regulation stipulates that credit ratings used by financial institutions for regulatory purposes in the EU should be issued by an EU registered CRA. Where issued by a non-EU country, the credit rating should either be endorsed by an EU CRA or by a certified CRA in that country (if the country has received a positive “equivalence” assessment from the European Commission).

On 18 May 2011, ESMA published its final guidelines. Thus, from 7 June 2011 EU CRA may only endorse the use of credit ratings issued in a third country if they meet the conditions set out in Article 4(3)(f), (g) and (h) of the CRA Regulation: the third country CRA must be authorised or registered and subject to supervision in the third country; the third country regime prevents interference from regulators or other authorities in respect of the content of the credit rating or methodologies used; and an appropriate cooperation agreement is in place between the relevant EU and third country regulators.

A key issue for ESMA was the inter-relationship between its assessment in relation to these points (or indeed an equivalence assessment by the European Commission) and the requirement that a third country regime should be “as stringent as” the EU regime. Against industry’s hopes, ESMA in its final report and guidelines has determined that the assessment needs to rest clearly on an assessment of the third country legal and regulatory regime: there can be no possibility of a “top-up” in terms of self-imposed requirements by third country CRAs which bridge any gaps between the national regime and the EU regime.

Ratings from third country CRAs can continue to be used until such time as the CRA is registered. If, during the registration process it is determined that on the basis of the relative stringency of the third country regime, the ratings are not “endorsable”, then financial institutions must stop using them for regulatory purposes within three months (with a possible extension of a further three months in exceptional circumstances to avoid market disruption or financial stability). EU CRAs will have to inform the public of third country ratings that are not endorsable in the EU. It is unclear how a third country rating may be used where no determination has yet been made of a third country regime.

The “endorsement” regime will coexist with a “certification” regime. Where the EC deems a third country regime to be equivalent to the EU, as it has done recently with Japan, financial institutions can use ratings issued by CRAs from those territories without their needing to be endorsed by EU CRAs, provided the national CRAs concerned have been certified by ESMA. Certification can bring less onerous requirements on the third country CRAs (for example, smaller third country CRAs may not be required to establish or register in the EU) but essentially does not change the obligations of EU CRAs. The new regime basically puts responsibility on CRAs registered in the EU for all third country ratings that it endorses.

ESMA has also been mandated by the European Commission to assess the equivalence of Australia, Canada and the US, but the report does not indicate the status of these reviews. For the US, ESMA will continue to monitor improvements to legislation anticipated by the Dodd-Frank Act and continue its assessment once the Securities and Exchange Commission has issued its draft secondary legislation. Clearly, here too there are some open questions.

The endorsement requirements apply from 7 June 2011 but cannot be totally put into effect. Financial institutions will need to keep under review any credit ratings issued by third country CRAs which they use for regulatory purposes, and consider the implications of having to cease using these ratings if, in due course, they are deemed unendorsable (or are not endorsed by an EU CRA). The ESMA guidelines also make it clear that any determination of “endorsability” will be subject to ongoing review and could be overturned at any times if circumstances in the third country change.