Including updates on MiFID, EMIR, Basel III and Sovereign debt management


Transparency, stability and international coordination: Maijoor speaks out on ESMA regulatory objectives

On 26 May 2011, Steven Maijoor, Chair of the European Securities and Markets Authority (ESMA), speaking at the ICMA Annual Conference, discussed the ESMA’s key objectives and how it will promote them. He said “it is all about transparency, stability and international co-ordination”, noting that, given the “size and complexity” of regulatory reform, it is essential not to lose sight of these fundamental objectives. He also made some important comments on ESMA’s organisational structure.

On transparency, Maijoor cited examples from AIFMD, EMIR and MiFID. He argued that greater disclosure of alternative investment management activities is essential to ensure regulators can carry out their supervisory tasks effectively. AIFMD will also ensure that appropriate information is available to investors to enable them to assess the risk profile of funds. Mechanisms, such as trade repositories, should enable national regulators to capture and share information in a consistent and efficient manner—ensuring greater visibility of trades—a key failing of the previous regulatory architecture. They will also provide more information to the public. Under the MiFID regime, ESMA is seeking to extend a pre/post trade regime, similar to that which now exists for equities, to corporate and government bonds, certain structured finance products and all types of derivatives. In all these areas, though, Maijoor stressed that a balance needs to be struck between transparency and cost, and that the information required by supervisors should only be that necessary for supervisory efficiency.

Unsurprisingly, financial stability has moved from the wings to being a central objective of ESMA’s agenda. For example, ESMA is currently formalising provisions under AIFMD where national authorities will be required to inform other regulators, as well as the ESRB and ESMA, whenever a fund manager’s activities could have “potentially systemic consequences” on the functioning of markets. Maijoor also said that ESMA’s focus in terms of Exchange Traded Fund (ETFs) has shifted, in line with warnings from the FSB, from focusing on investor protection and disclosure requirements to their potential contribution to systemic risk through collateral and securities lending. ESMA intends to publish policy options on ETF in the coming months. In addition, ESMA will play a central role in defining the classes of derivatives that will be subject to the clearing obligation under EMIR. The short-selling regulation, currently being negotiated by the Council and European Parliament, may give ESMA responsibility for coordinating supervisory responses across the EU, thus avoiding the opportunities for regulatory arbitrage, and industry confusion, which became evident during the crisis. Referring to another systemic risk area identified by the FSB, Maijoor said that ESMA will do more work on shadow banking to understand the interconnection between banks and unregulated entities and channels for possible systemic contagion, not least the repo markets.

One of the main lessons of the recent financial crisis relates to a failure of international regulators to effectively co-ordinate with each other. Maijoor stressed that effective regulation and supervision requires the “avoidance of gaps across regimes.” ESMA will aim to ensure that the regulatory framework in Europe appropriately and consistently recognises third country regimes and service providers. Essentially, though, he advocated a more central role for ESMA in this regard. Under AIFMD, for example, national private placement regimes for non-EU funds and managers will continue to operate from 2013 to 2015 where appropriate cooperation agreements are in place between the EU and third country regulators. Maijoor believes it makes more sense for the third country authority to negotiate a single EU Memorandum of Understanding (MoUs), rather than multiple negotiations with various EU member state regulators. Noting that third country regimes are also envisaged in EMIR and now in MiFID, he underlined that it is “essential to consider the nature of the services to be provided across the border from third countries” and that, for example, it would be “natural to centralise the decision making on the mutual recognition of important third country market infrastructures”. The recent ESMA determination that equivalence assessments with regards to third country credit agency ratings (see Market Update, 30 May 2011) need to be made on solely the basis of third country regulatory regime may provide an indication to ESMA’s future approach in this regard.

On organisational issues, ESMA is stretching its supervisory muscles. Maijoor suggested that, although ESMA’s current budgetary allocation is probably sufficient in the short term, assessments need to be made in future legislation as to the financial impact of any additional tasks or responsibilities assigned to ESMA. He also feels that the responsibility for drafting technical standards warrants a different role for ESMA in the legislative process, advocating that it be allowed to present its views during legislative negotiations, or at least be able to observe them. He is “optimistic that the various parties involved fully understand ESMA's wish on this point”.

Clearly, the power equilibrium in the new EU supervisory architecture is not yet finally delineated. With evident tensions between the Council and the European Parliament over how much power to allocate the new EU supervisory regulatory authorities (ESAs) in the first place, the ESAs themselves recognise that increased responsibility must combined with commensurate authority to ensure their ongoing credibility. What ESMA achieves—as the only ESA currently to have EU-wide supervisory powers—is worth watching as its expansionary ambitions are likely to be followed by the other ESAs if successful.


MiFID delayed but it’s only a matter of time...

On 8 December 2010, the EC launched its consultation proposing a sweeping overhaul of the Markets in Financial Instrument Directive (MiFID II). The EC reportedly received over 4,000 responses to the consultation. Originally the EC planned to issue proposed rules in July. However, given the complexity of the issues involved, on 2 June, a spokesperson confirmed that the EC has decided to delay the publication of legislative proposals until October 2011, with a view to getting them on the statute books by the end of the year/ early next year. This means that fundamental changes to the way in which the securities markets, their operators and users function, could come into play in less than three years.

This short delay does not imply any dilution of the proposals that the EC put forward in December. Michel Barnier, European Commissioner for the Internal Market and Services, recently confirmed that the proposals remain extremely ambitious. To stay abreast on this issue, please visit PwC's MiFID webpage on our FS Global Regulatory Website which we will be developing further as MiFID II progresses.


EMIR: Delay in adoption could jeopardise G20 commitment

On 24 June 2011, the European Parliament’s Economic and Monetary Affairs Committee (ECON) approved its report on the Regulation on over-the-counter (OTC) derivatives, central counterparties and trade repositories. The new rules—nicknamed EMIR (European Markets Infrastructure Regulation) — have been crafted to ensure that a greater proportion of standardised over-the-counter trades are centrally cleared, to provide greater security and transparency in the markets. The Commission’s proposal also includes strict requirements on the operation of central counterparties (CCPs), the possibility of post-trade interoperability between CCPs, and obligatory reporting requirements by market participants to trade repositories. ECON rejected suggestions by some Members of Parliament (MEPs) to expand the scope of requirements to all derivatives classes (and not just OTC derivatives) but watered down its proposed removal of interoperability provisions to a three year grace period. ECON also agreed on a number of changes, calling on pension funds to have a “special regime” on clearing obligations, provided that national capital requirements provide a guarantee similar to cleared contracts. While recognising the legal difficulties in applying clearing obligations retroactively, ECON has asked ESMA to help in this regard, and has reaffirmed that central clearing should be mandatory on the date EMIR comes into force.

Following common practice over the past couple of years, the ECON report —voting on which was delayed for a month to negotiate compromises on the 977 proposed amendments— should form the basis for negotiations with the Council in ‘trialogue’ with the EC (the Council, as co-legislators, must agree the final rules before final adoption). Werner Langen, the MEP responsible for steering EMIR through parliament, rejected this “first reading” approach, stating that he wanted to follow the ‘ordinary legislative procedure’ and take a final vote in the European Parliament’s plenary session before opening negotiations with Council. This would mean a “second reading’ of the text, adding at least six months to the process. The reaction to this surprise announcement in ECON was mixed. Michel Barnier, European Commissioner for the Internal Market and Services, in an exchange of views with ECON immediately after the vote, stressed that, as this legislation responds to a key G20 commitment, he hopes ECON may still reach agreement in first reading. However, in the Council, Member States are still sharply divided on the scope of the rules, and current indications are that their negotiating position is unlikely to be clarified before the European Parliament plenary in early July. On the basis of a second reading, the regulation could not be adopted much before February or March 2012, putting significant pressure on ESMA to meet the June 2012 deadline set in the regulation for its draft technical standards. There are no formal indications yet that the EU will miss the G20 deadline of December 2012, but these latest developments raise serious questions in this regard.

ESMA has established a number of working groups to begin preparatory work on fleshing out the technical details associated with OTC derivatives, central clearing and trade repositories. However, it cannot finalise its drafts until the regulation is agreed by both Council and the European Parliament. Developing all the technical detail needed to put EMIR into action in just under four months is not an option. The postponement of the ECON decision will significantly complicate ESMA’s preparatory work, requiring it to adjust its work to policy shifts as negotiations proceed, and this could have consequences for quality of its technical standards. It will be important that industry continues to work closely with ESMA through this process to ensure no unintended consequences arise.


Defining capital in Basel III: Hybrid “silent participations”

Leaders of the G20 countries ratified the Basel III proposals for strengthening capital and liquidity standards to great fanfare in November 2010. In doing so, they committed their banks to significantly higher capital levels and a transition period that extended beyond 2019. The new regime strengthened the previous framework in terms of the quality and quantity of capital required and introduced new prudential requirements, such as capital buffers, the leverage ratio and liquidity requirements. However, as with most things in life, the devil is in the detail, and the detail is beginning to unravel and cause fractions across Europe. On the one side are those EU countries which believe Basel III measures are insufficient to prevent future crises and should be buffered by national and pan-European regulations. These countries, including the UK, point to a need for equity ratios above Basel III standards, regulation of the shadow banking system, a need for an equity capital surcharge for large financial institutions and the requirement for strict oversight on leverage and maturity transformation. The other side, including Germany and France, has voiced concern about protecting their banks’ competitive position in the global market. The French administration, for example, has stated previously it will not follow Basel III standards, unless the United States does so as well.

On 27 May, the Financial Times reported the EC had proposed that banks be allowed to circumvent part of a recent Basel accord on capital by allowing the use of hybrid securities and reserves from related businesses as equity. The move was seen as a sign that Berlin and Paris had pushed through demands for light-touch regulation. These hybrids called “silent participations” are bonds that combine characteristics of debt and equity securities, and have been used in the past to bolster banks’ capital cushions, but have fallen out of favour with regulators since the financial crisis. German regulators warned that its top 10 banks would have to raise as much as €105 billion of fresh capital if silent participations did not qualify as Tier 1 capital. Additionally, its smaller, regional banks are heavily reliant on these instruments and have little possibility of raising additional capital elsewhere due to their ownership structures.


Resolution and Recovery: ESBC responses to EC recovery and resolution framework

The EC presented its pan-European model on 6 January 2011 in a consultation paper entitled: “The technical details of a possible EU framework for bank recovery and resolution”. The framework centred on the following objectives.
  • provision of credible resolution tools for national authorities;
  • ensuring authorities have options to resolve institutions in a way that minimises risks of contagion;
  • enabling fast and decisive action with clear and well-defined powers and processes for regulating authorities;
  • reducing moral hazard concerns by ensuring shareholders and creditors bear some of the burden;
  • ensuring legal certainty in terms of appropriate safeguards for third parties; and
  • reducing distortions of competition following government bail-outs.
On 31 May 2011, the ECB published the response of the European System of Central Banks (ECB and the national central banks of all EU Member States) to the consultation paper. Firstly, the ESCB upheld the fundamental precept that all institutions should be allowed to fail in a way that does not jeopardise systemic stability and urged that national measures for crisis resolution need to be better coordinated. The EU regime needs to be based on an improved and harmonised set of preventative and resolution tools; on the delineation of national responsibilities balanced by appropriate EU coordination mechanisms; and financing arrangements that limit the burden of future crises on taxpayers.

In terms of preventative tools, the ESCB endorses the use of annual stress tests but insists that these should be “conducted in full autonomy as well as independently of authorities that provide resources for bank recapitalisation”. It also supports “living wills” for cross-border banks, as long as group supervisors are given a strong mandate to coordinate preparation of these plans. To complement their micro-prudential approach, the ESCB advocates a holistic analysis of the impact of multiple plans being implemented simultaneously. It also believes that ex-ante intra-group funding mechanisms could be a step forward but warns of the legal difficulties involved, particularly in terms of determining in advance the scenarios under which these mechanisms could be activated, and systemic risks if these mechanisms become “semiautomatic” procedures. Essentially, it believes early-intervention tools should remain at the discretion of national authorities.

The ESCB found the EC’s proposals for a resolution toolbox was sufficiently comprehensive but believes that the EC should provide more detail on the conditions required to trigger resolution. It argues that, if a resolution authority has the power to transfer assets and liabilities of a failing entity to another entity, there should be a legally robust set of safeguards for stakeholders.

The ESCB is also calling on clearly defined roles for national authorities, accompanied by co-ordination mechanisms at the EU level. It sees a role for central banks in systemic risk assessment in the resolution phase and, as appropriate, in recovery and resolution planning.

The ESCB thinks resolution funds should be built up in advance through fees paid by financial institutions on the basis of liabilities and backed up with ex-post arrangements: in no case should they lead to bail-outs for previous shareholders. The ESCB also believes that any use of a debt write-down tool (also referred to as a bail-in tool) should follow the solution adopted by the FSB and that case studies should be conducted on the practical implications of bail-ins.


Sovereign debt management, monetary policy and Greece

On 23 May 2011, a Study Group commissioned by the Committee on the Global Financial System published a timely report examining recent interactions of sovereign debt management (SDM) with monetary conditions and financial stability. SDM mandates govern choices about the structure and issuance of government debt. In most countries, the goal of SDM is to reduce the expected cost of funding the government’s activities over the medium to long term, subject to prudent risk management. The research indicates that effective SDM “can reduce financial volatility by spreading maturity, avoiding concentrated placement and developing stable and diversified investor bases”, which help in the recovery from crisis. It concludes that recent experience highlights that “medium-term strategic outcomes for the maturity structure and risk characteristics of outstanding debt do matter for financial stability”. Therefore, monetary policymakers should monitor SDM activities on an ongoing basis.

Greece is a pertinent example of the interaction between SDM and financial stability. Yields on the Greek government’s 10 years bonds climbed to a record high of over 17% last week. Yields are increasing because European officials now seem to be acknowledging the inevitable — that some form of restructuring of Greece’s €325 billion debt load is on the cards. A wide variety of options are open to policy makers to deal with the situation in Greece, from debt reprofiling, imposing haircuts of between 20-50% on the value of debt or a further bail-out package. Debt reprofiling is being actively considered in Brussels. Under debt reprofiling, the maturity on each bond would be extended while the government would still continue to pay coupons on bonds and to redeem them when they mature. A voluntary rollover of outstanding debt would be less painful for the European banks as it would avoid steep write-downs on bonds and postpone the need for extra EU and IMF bailout funds. This type of arrangement was used successfully in Uruguay when it reprofiled its foreign bond stock in 2003, according to The Economist.

The biggest stumbling block facing policy makers in dealing with the Greek problem is the contagion effects that could result from a debt restructuring programme. European banks’ exposure to sovereign debt in Greece is manageable (€154 billion) and might only affect a handful of French and German financial institutions. Banks’ exposure to other countries is far more significant, particularly in troubled economies like in Ireland (€565 billion), Portugal (€216 billion), and Spain (€727 billion). There is also a concern that a restructuring of sovereign debt will drive up private sector defaults in Greece, further compounding the problem. In an environment where banks are struggling to bolster their capital reserves, delaying a decision on Greece might be viable option. However, the longer Europe leaves it, the more uncertainty will breed in markets and the more pronounced the correction will be when it does happen.

On 2 June 2011, Jean-Claude Trichet, President of the ECB, called for a “deeper and authoritative” role for the EU over fiscal policy when finances in Member States “go harmfully astray”. He suggested it was necessary to find a new balance between “the independence of countries and the interdependence of their actions” in a common currency bloc. In this regard, he proposed a “new concept” for the euro zone that envisioned cases of “compulsory” intervention from EU leaders and the ECB in “major fiscal spending items and elements essential for the country’s competitiveness.” To coordinate this function, he floated the idea of establishing a European finance ministry whose powers to intervene in national economic policy would be “well over and above the reinforced surveillance that is presently envisaged”. Since the introduction of the single currency in 1999, fiscal policy of countries has remained largely under the responsibility of national countries according the principle of subsidiarity – a presumption in favour of national sovereignty. However, national policy was supposed to be formulated in the context of the provisions of the Stability and Growth Pact which imposed tight constraints on fiscal policy, particularly about budget deficits. However, following the launch of the euro, an increasing number of countries found it difficult to comply with the limits set by the Pact (including Germany and France). Since 2003, more than 30 excessive deficit procedures have been undertaken, with the EU reprimanding member states and pressuring them to tighten up their finances, or at least promise to do so. The EU, however, has never imposed a financial sanction against any Member State for violating the deficit limit, given the political sensitivities in implementing such measures. The lack of enforcement of the Stability and Growth Pact gave countries, like Greece, discretion to run up high levels of debt during the last decade. The EU had apparatus before to clamp down on excessive sovereign debt and failed to do so, adding more powers will not necessarily change this.


Reshuffle but not kerfuffle: The departure of key regulatory personnel should not interrupt the regulatory reform agenda in Europe

A number of key regulatory positions are coming up for re-election this year, as Jean-Claude Trichet, president of the European Central Bank (ECB) and chair of the European Systemic Risk Board, who is also chair of the Basel Committee on Banking Supervision’s oversight body and chair of the Group of Governors and Heads of Supervision, together with Nout Wellink, the governor of the De Nederlandsche Bank (the Dutch central bank) and chair of the Basel Committee, step down from their respective positions this autumn.

On 17 May 2011, euro-area finance ministers nominated Mario Draghi to become the next head of the Frankfurt-based ECB. However, Draghi currently chairs the Financial Stability Board (FSB) —the body which has been tasked by the G20 to globally coordinate the reform of financial regulation—and few believe he can continue in this role and act as ECB president. Klaas Knott will replace Nout Wellink as governor of the DnB, but a new chair of the Basel Committee still needs to be identified.

Despite the severity of the crisis according to Wellink “we are already seeing signs that its lessons are beginning to fade”. At the same time, key reforms still need to be pushed through to create a stable financial system while significant risks still remain on the horizon. Although international regulators remain resolute in advancing their reform agenda, filling these roles quickly with candidates appointed on merit—and not through political wrangling—is crucial to maintain momentum in global reforms. We don’t currently expect these role changes to result in directional change in regulation, but the new appointees will inevitably want to make their marks, so we will watch with interest as they settle into their new positions.