Regulatory outlook: 2011 and beyond

It is well documented that over the past two years the European and US Authorties have made numerous efforts to strengthen the regulatory and supervisory framework that apply to financial activities.

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This has been deemed necessary in order to restore confidence in the financial markets and to prevent the occurrence of a new crisis. European institutions have also decided to foster greater harmonisation of national laws to improve the integration of financial markets and the consolidation of market infrastructures. Once this has been achieved, the financial landscape will have changed considerably.

The new Internal Market Commissioner, Michel Barnier, has decided to legislate in all its areas of intervention. The post-trading arena, neglected under his predecessor, is now being addressed progressively, as demonstrated by the number of initiatives launched during the past few months.

Few of these regulatory initiatives, however, are at the same stage of development. The occasional snapshot of the progress made to date can prove very helpful. The texts relating to UCITS IV (Undertakings for Collective Investment in Transferable Securities) and FCD (Financial Collateral Directive) have already been adopted at European level and are now being transposed into national laws. By contrast, Level 2 measures are still under discussion for the AIFMD (Alternative Investment Fund Managers Directive). Also still under discussion among European Authorities are EMIR (European Market Infrastructure Regulations) and the Short Selling regulation. CSD (Central Securities Depository) regulation, UCITS V, ICSD (Investor Compensation Scheme Directive), MiFID 2 (Markets in Financial Instruments 2) and SLD (Securities Law Directive) are also in preparation. The European Commission intends to finalise the adoption of most of the texts during 2011 and target their transposition and entry into force in 2011 (SFD, FCD, UCITS IV), 2012 (Short Selling regulation, ICSD) or 2013 (Solvency 2, SLD, AIFMD). As far as European Central Bank initiatives are concerned, CCBM2 (Correspondent Central Banking Model 2) is currently forecast for mid-2013 while migration to T2S (Target 2 Securities) should begin by September 2014.

The goals of the different initiatives vary but they are largely complementary. They all target the same final objectives: soundness, effectiveness, transparency, and safety for markets, intermediaries and investors. A further overarching objective is the achievement of a level playing field for all market professionals, even if in the interim it can sometimes feel as if the goalposts are being moved regularly.

Financial Collateral Directive (FCD)
Settlement Finality Directive (SFD)

They have been revised in order to strengthen transactions carried out among market players by isolating pending transactions and guarantees from creditors in cases of counterparty bankruptcy. In terms of collateral, CCBM2 coupled with T2S will facilitate the mobilisation of collateral across Europe at a time when more and more transactions need to be collateralised for reasons of safety and liquidity

Securities Law Directive (SLD)

It is an attempt to remove "Giovannini barriers" 13 and 15 by tackling national differences in the legal treatment of securities and an uneven application of conflicting laws. These differences create obvious obstacles for cross-border investment. The SLD would also help in the removal of Giovannini barrier 3 for Corporate Actions, at a time when the industry is working very hard to implement Corporate Actions standards. The removal of these three barriers - or at least the mitigation of the constraints they represent - is of paramount importance for delivering most of the benefits expected from T2S.

EMIR and the CSDs regulation

They are the first regulatory initiatives from the European Commission that aim at regulating post-trading infrastructures. European Authorities were previously more concerned with front-end activities such as MiFID and initiatives related to investment funds such as UCITS. Before the full impact of the financial crisis struck, the emphasis was primarily on efficiency, economies of scale and cost. Since 2008, there has been a radical switch to focus on transparency and risk management. This has also led the authorities to consider enlarging the franchise of market infrastructures to include other financial products, mainly OTC (over the counter) derivatives, and consequently to implement a strong regulatory framework dedicated to these infrastructures at the European level (and beyond if possible) as they are now recognised as systemic.

- EMIR covers the eligibility criteria of OTC derivatives for central clearing, defines the harmonised regulatory framework that will apply to all Central Counterparties (CCPs) and Trade Repositories in Europe and specifies the rules for implementing interoperability links among CCPs for cash products.

- The regulation for CSDs intends to define the nature and role of a CSD at the European level, the services it is allowed to provide and its regulatory, prudential and supervisory framework. The main issue with the current proposal made by the European Commission is the level of service that it will be authorised to provide. Intermediaries are in favour of a very restrictive approach (i.e. a notary function and central settlement only), whereas the European Commission leans towards the inclusion of multiple banking services. In the latter case, CSDs are thus positioned as direct competitors to their participants rather than as pure systemic infrastructure. As already noted, the final content of the regulation could significantly reshape the future post-trading landscape.

AIFMD, UCITS IV and UCITS V

- UCITS IV mainly pursues three objectives :

  • reducing the administrative burden by simplifying the notification procedure for fund distribution (fund passports);
  • enhancing investor protection by implementing the Key Investor Information document (KII or KID) in replacement of the traditional simplified prospectus;
  • increasing market efficiency by adding flexibility for management company passports and by providing asset managers with tools to help rationalise their range of funds: facilitating cross-border fund mergers and the introduction of master-feeder structures.

The KID represents a significant burden for asset managers who may look for support from their providers in the delivery of this essential document. Choices made by asset managers in rationalising the range of funds will inevitably have an impact upon depositories and providers of valuation services.

- The Alternative Investment Fund Managers Directive (AIFMD) will impact Alternative Investment Managers rather than directly impact alternative investment funds. The directive introduces general operating conditions that AIFMs must meet, the role of an external valuer or independent valuer and, for the first time, a genuine single market framework which will allow AIFMs to passport their services throughout the EU on the basis of a single authorisation. The AIFMD requires that each alternative investment fund manager appoints a depository: although the exact scope of depository liability remains to be agreed in the Level 2 measures, the range of depository responsibilities is significantly increased in comparison with most previous European regulation and practice. French regulation stands out as an exception to this general rule, due to the gold plating ensured by the introduction of additional measures when UCITS III was transposed into French law.

- UCITS V aims at reviewing the current framework applicable to UCITS depositories in line with AIFMD dispositions and introducing new provisions for UCITS managers’ remuneration in order to improve investor protection. The Investor Compensation Scheme Directive (ICSD) pursues the same aim as, among other goals, it intends to cover the potential loss suffered by a fund shareholder in the event that the fund’s depository or one of its custodians is unable to return assets to the fund. This initiative is generally disregarded by the industry as it seems somewhat redundant with the new definition of the depository’s liabilities and because the amount called for to cover the level of potential risk seems totally disproportionate.

Markets in Financial Instruments Directive 2 (MiFID 2)

Last but most certainly not least, the Markets in Financial Instruments Directive 2 (MiFID 2) has come to the forefront in the last three years as the European Commission has deemed it necessary to review the market and financial product changes that have occurred during this time period and to draw lessons from the financial crisis. The European Commission would like to enlarge the scope of the text to fixed income and derivatives markets, including commodities. It also aims at improving current legislation in order to regulate or better regulate new players (dark pools, crossing networks, algorithmic traders) and to improve market transparency (pre- and post-trade), as well as increasing investor protection.

Eric de Nexon , March 2011

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