European Regulators Issue Addendum Consultation Paper on Certain Derivatives for Implementation of MiFID II/MiFIR
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February 25, 2015
TO: DERIVATIVES MARKETS ADVISORY COMMITTEE No. 13-15INTERNATIONAL COMMITTEE No. 11-15
ICI GLOBAL TRADING & MARKETS COMMITTEE No. 8-15
ICI GLOBAL MEMBERS No. 10-15 RE: EUROPEAN REGULATORS ISSUE ADDENDUM CONSULTATION PAPER ON CERTAIN DERIVATIVES FOR IMPLEMENTATION OF MIFID II/MIFIR
On February 20, the European Securities and Markets Authority (“ESMA”) issued an addendum consultation paper on draft regulatory technical standards (“RTS”) for the implementation of the revised Markets in Financial Instruments Directive (“MiFID II”) and Regulation (“MiFIR”). [1] The Consultation Paper covers the assessment of liquidity for certain asset classes and proposes certain thresholds that transactions must meet to be classified as (a) large in scale (“LIS”) or (b) above a size specific to the financial instrument that would expose liquidity providers to undue risk (“SSTI”). [2] These assessments are important because transactions in illiquid instruments and transactions meeting the LIS or SSTI thresholds will not be subject to full transparency. These transactions will have the advantage of certain pre-trade transparency waivers and a deferral period applying to publication of post-trade transparency data (currently proposed to be set at 48 hours across each category of instruments). ESMA proposes to apply the general methodology discussed in the December Consultation Paper to the sets of derivatives that were not covered by the prior consultation – (1) FX derivatives, (2) credit derivatives, (3) other derivatives, and (4) contracts for difference.
Comments on the Consultation Paper are due by March 20. We will be preparing a response to the Consultation Paper. If members have any concerns regarding the Consultation Paper, please contact Jennifer Choi at jennifer.choi@ici.org or at (202) 326-5876 by Tuesday, March 3.
Liquidity Analysis
For each class of derivatives covered by the Consultation Paper, ESMA identifies sub-classes on the basis of data collected from trade repositories over a three-month period (from March 1, 2014 to May 31, 2014). [3] These classes are classified as liquid or illiquid on the basis of the following criteria: (1) average notional amount per day greater than or equal to €500 million; (2) number of days traded greater than or equal to 80% of the available trading days in the period; and (3) average number of trades per day greater than or equal to 100. Each class that is categorized as liquid is further divided into sub-classes by an additional set of criteria – the average number of trades per day and average notional amount per day – which vary depending on the sub-class. In addition, to confirm the liquidity of each sub-class, ESMA generally determines that a sub-class meeting the thresholds for only one (or few) maturity(ies) will not be deemed to be liquid and a 50% coverage ratio in terms of the number of trades and notional amount have to be met for the entire sub-class for the sub-class to be considered liquid. The results of the assessment of liquidity for each sub-class are included in tables in the Consultation Paper.
Foreign Exchange Derivatives
ESMA undertakes an analysis of FX derivatives and identifies a number of subclasses – forwards (non-deliverable forwards or “NDFs” and deliverable forwards or “DFs”), options, swaps, spread betting contracts, and FX futures. ESMA applies the criteria to each class of FX derivatives. [4]
- FX Forwards: The class of FX forwards is divided into two classes based on the delivery type – NDFs or DFs. Each class of FX forwards is then divided into more granular sub-classes based on the underlying currency pair and the tenor. ESMA then applies the liquidity criteria of 1 trade per day and €10,000,000 notional amount per day to both NDFs and DFs.
- FX Options: The class of FX options is divided into more granular sub-classes based on the underlying currency pair and tenor. ESMA then applies the liquidity criteria of 10 trades per day and €500,000,000 notional amount per day.
- FX Swaps: The class of FX swaps is divided into more granular sub-classes based on the underlying currency pair and tenor. ESMA then applies the liquidity criteria of 5 trades per day and €250,000,000 notional amount per day.
- Spread Betting Contracts: The class of spread betting contracts is divided into more granular sub-classes based on the underlying currency pair and tenor. ESMA then applies the liquidity criteria of 50 trades per day and €10,000,000 notional
- FX Futures: The class of FX options is divided into more granular sub-classes based on the underlying currency pair and tenor. ESMA then applies the liquidity criteria of 1 trade per day and €30,000 notional amount per day.
Credit Derivatives
ESMA undertakes an analysis of credit derivatives and identifies the following classes defined by contract type and underlying instrument – CDS (CDS index, single name CDS, and bespoke basket CDS) and CDS options (CDS index options and single name CDS options). ESMA determines that bespoke basket CDS and single name CDS options are illiquid as a whole.
Each class that qualified as liquid is further divided into sub-classes.
- CDS Indices: To further define the subclasses for CDS indices, ESMA uses the criteria of the underlying index, the tenor, the notional currency, and the on/off-the-run status. ESMA then applies the liquidity criteria of 1 trade per day and €10,000,000 notional amount per day to each sub-class.
- Single Name CDS: ESMA uses the underlying type (i.e., whether the issuer is a sovereign entity or a corporation), the tenor, and the notional currency to define the sub-classes. ESMA then applies the liquidity criteria of 2 trades per day and €100,000,000 notional amount per day. ESMA concludes that the liquid classes of single name CDS should be contracts on corporate single name CDS denominated either in US dollars or in Euro and with tenors from 1 to 6 years and contracts on sovereign single name CDS denominated in US dollars and with tenors from 1 to 6 years.
- CDS Index Options: ESMA uses the criteria of the underlying index, the tenor, the notional currency, and the on/off-the-run status to define further the subclasses of CDS index options. ESMA then applies the liquidity criteria of 2 trades per day and €100,000,000 notional amount per day to each sub-class. In the Consultation Paper, ESMA presents 2 options for single name CDS. Under Option A, the classes of single name CDS included in Annex III, Section 7 of draft RTS 9 are liquid. Under Option B, a single name CDS would be considered to belong to a single name CDS liquid class only if in addition to being characterized by the combination of underlying issuer type, tenor, and currency, the reference entity/obligation is included in a liquid CDS index as provided in Table 60 in Annex II, Section 7 of draft RTS 9 so that only those corporate and sovereign entities that are included in a liquid CDS index would be deemed to be liquid.
Other Derivatives
ESMA undertakes an analysis of the residual classes of derivatives. ESMA is of the view that the following classes of financial derivatives are not liquid: freight derivatives, emissions derivatives, weather derivatives, and other exotic derivatives.
Contracts for Difference
A financial contract for difference (“CFD”) is a derivative product that gives the holder an economic exposure, long or short, to the difference between the price of an underlying asset at the start of the contract and the price when the contract is closed. ESMA identifies six CFD classes defined at the type of underlying level – equity, bond, futures on equity, option on equity, commodity, and currency. Based on the liquidity criteria, ESMA finds that the following classes are illiquid: bond, futures on equity, options on equity, and commodity.
The liquid classes are further refined into sub-classes based on the average number of trades per day and average notional amount per day. For CFDs on equity, the liquidity criteria applied are 10 trades per day and €1,000,000 notional amount per day. The liquidity criteria applied to CFDs on currency are 50 trades per day and €50,000,000 notional amount per day.
Large in Scale and Size Specific to the Instrument Thresholds
The Consultation Paper includes tables that present the results of the calculations to set the LIS and SSTI thresholds in Annex III of Section 6 of draft RTS 9 for purposes of waivers and deferrals permitted under MiFID II transparency requirements. [5] The LIS threshold for liquid sub-classes is determined as the greater of: (i) the threshold determined so that at least 90% of the trades would be below the threshold; and (ii) the threshold floor determined for the class as provided in Section 11 of Annex III of draft RTS 9. The threshold for illiquid classes and sub-classes is determined as the greater of: (i) the threshold determined so that at least 70% of the trades would lie below the threshold; and (ii) the threshold floor determined for the class as provided in Section 11 of Annex III of draft RTS 9. The SSTI thresholds would be set as 50% of the relevant LIS thresholds.
For all sub-classes of FX futures, the LIS thresholds are set equal to €100,000. This is as a result of a €100,000 “floor” (i.e. minimum) set on the value of the LIS waiver/deferral threshold, despite the fact that the LIS thresholds calculated for FX futures according to the methodology noted above would otherwise have resulted in significantly lower thresholds.
ESMA also includes results of the calculation of ESMA’s preferred option (which would require an annual recalculation of the LIS and SSTI thresholds). [6] The LIS threshold would be determined as the greater of the threshold determined so that at least 90% of the trades would be below the threshold, the threshold determined so that at least 70% of the total volume traded for that sub-class would be below the threshold, and the threshold floor determined for the class as provided in Section 11 of Annex III of draft RTS 9.
Finally, ESMA includes threshold selection tables, which show the selected LIS threshold as the greater of the threshold calculated so that at least 90% of the trades are below the LIS threshold and the threshold so that at least 70% of the notional amount is below the threshold.
Jennifer S. Choi
Associate General Counsel
endnotes
[1] Addendum Consultation paper, MiFID II/MiFIR, available at http://www.esma.europa.eu/content/Addendum-Consultation-Paper-MiFID-IIMiFIR (“Consultation Paper”).
[2] Consultation Paper, MiFID II/MiFIR, available at http://www.esma.europa.eu/system/files/2014-1570_cp_mifid_ii.pdf (“December Consultation Paper”); Consultation Paper – Annex B, Regulatory technical standards on MiFID II/MiFIR, available at http://www.esma.europa.eu/system/files/2014-1570_cp_mifid_ii_part_2.pdf. For a summary of the December Consultation Paper, see ICI Memorandum No. 28651 (Jan. 8, 2015), available at http://www.ici.org/iciglobal/pubs/memos/memo28651. The December Consultation Paper did not cover foreign exchange (“FX”) derivatives, credit derivatives, other derivatives and contracts for difference. The Consultation Paper provides similar analysis for these derivatives that were not previously covered to that undertaken for the classes covered by the December Consultation Paper.
[3] ESMA notes in each case that it needed to subject the trade repository data to a substantial “cleaning and screening” process.
[4] The notional amounts used in the analysis are first converted into Euro on the basis of a simple average of the European Central Bank exchange rate over the three-month period considered.
[5] As noted above, pursuant to the Level 1 text of MiFID II, pre-trade transparency waivers and post-trade transparency deferrals are available for: (a) transactions that are large in scale compared to normal market size; and (b) transactions that are above a size specific to that instrument that would expose liquidity providers to undue risk (although in the latter case pre-trade transparency waivers are limited to request for quote and voice trading systems).
[6] ESMA proposes two options with respect to the thresholds. Option 1 would apply the thresholds in Annex III of draft RTS 9. Option 2 would apply the thresholds in Annex III until April 30, 2018 and then be recalculated yearly thereafter. ESMA states a preference for Option 2. See ICI Memorandum No. 28651, supra note 2, for more information on the two options.