Regulatory burden has been a key concern for market participants since the Global Financial Crisis in 2008, with the report from Acuiti – in partnership with FIA – adding that new frameworks are ‘lengthy and complex’, requiring significant resource mobilisation to navigate current regulatory requirements.

Most respondents felt that the level of European regulation on their respective firms was disproportionate, however it’s worth noting that nearly a third of respondents were indifferent on this viewpoint.

Looking at specific EU regulations, Investment Firms Directive (IFD) and Investment Firms Regulation (IFR) were highlighted as the most challenging, with more than half of respondents expecting ‘critical’ or ‘major’ challenges associated with the implementation of these regulations.

European capital regulations, including IFD and IFR, have constituted a major compliance burden for principal trading firms, with significant implication for the prudential requirements that these firms have become subject to.

The report noted that the cost implications have pushed various principal trading firms to give up their Mifid II licences or relocate their headquarters or specific trading desks outside of the EU.

Interestingly, when looking at the risks on the horizon within the European listed derivatives markets, regulatory risk was found to be the second largest risk that respondents were most concerned about – coming in just slightly lower than cyber risk.

“Regulation is a constant of listed derivatives markets – when one framework takes effect another is usually coming down the line,” Acuiti said in its report.

“While market participants frequently support the objectives of regulation, often there are unexpected consequences from rule proposals. These then require substantial lobbying efforts to counter or moderate.”

Brexit

Elsewhere in the report, Acuiti explored the impacts of Brexit just over four years since the UK’s exist from the EU. Looking at the impact Brexit has had on London as a financial centre, most respondents (51%) believe that the city will remain a financial centre but at diminished size and influence.

Despite initial viewpoints that Brexit would lead to regulatory independence from the EU, the report suggests that appetite for this routed has shifted.

A key portion (41%) of respondents felt that the UK should pursue some divergence from the EU, however, noting this should not be done at the expense of equivalence with the bloc’s regulations. A larger proportion (45%) felt that the UK should seek convergence with EU laws to reduce regulatory fragmentation.

“While the European listed derivatives industry has faced multiple challenges during the last five years, its market participants are viewing the next five years ahead with optimism,” Acuiti said in its report.

“Challenges have not dissipated, with the effects of Brexit still playing out, cyber risk rising as a threat to systems and regulation imposing a constant and heavy burden on operations. However, confronting this multitude of challenges had also created a fortified and resilient industry.”

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The Association estimates that if you were to consider just the six largest US banks that offer clearing, these provisions would increase their capital requirements for client clearing by more than 80%.

Namely, the Global Systematically Investment Banks (GSIB) Surcharge Proposal’s changes to the treatment of client cleared OTC derivatives transactions would surge the required capital to engage in client clearing activities by over 58%.

The Basel III Endgame Proposal, which would apply to both GSIB and non-GSIB banks, would increase the required capital to engage in client clearing activities by over 22%, according to the FIA.

Read more: Derivatives clearing still at risk after Basel III review, says FIA

If these proposals were to come into fruition, FIA stated that the rules would make it a lot more expensive for banks to provide their clients with clearing services for futures, options and OTC derivatives.

Elsewhere, FIA argued that the proposed rules would have the unintended consequence of increasing systemic risk by reducing the capacity to move customer positions out of a clearing firm in case that firm goes bankrupt.

In a statement, FIA noted that it is “troubled by the absence of any apparent cost-benefit analysis” considering these potential negative impacts on end users and on systemic stability.

“In the wake of the 2008 financial crisis, regulators recognised the need to move more of the derivatives markets into central clearing,” said Walt Lukken, president and chief executive of FIA. 

“They understood that central clearing is one of the most effective ways to make the financial system more stable and resilient when markets are in turmoil. That makes it all the more surprising that US bank regulators are ignoring one of the most important lessons of the financial crisis.”

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The market is already pricing in rate cuts in Q1 although I, along with many others, don’t believe they will begin before the end of H1. This uncertainty will lead to heightened equity volatility in 2024. On top of this, many more companies will need to refinance their bonds in 2024 than they did in 2023 and higher rates will make this an expensive exercise. Finally, the era of QE is well and truly over and the investment environment where “everything is going up” has disappeared with it. Investors will need to think far more about the risk profiles of their portfolios.

All of this points toward a good year for convertible bonds. When volatility rises, convertible bonds tend to outperform equities. Convertible bonds will also provide cheaper financing options to those companies with other types of debt coming due which will lead to greater primary issuance. This issuance will have higher coupons than the recent average, therefore benefitting equity investors with an income component greater than that of equities while the overall asset class continues to offer diversification to traditional fixed income investors.

Lara Shevchenko, senior policy advisor, market structure, FIA European Principal Traders Association (EPTA)

In 2024, we expect to see significant strides made towards opening up European fixed income markets to a more diverse range of liquidity providers offering the prospect of greater efficiency and lower costs for end-investors, due to more competition and the ability for more data driven trading decisions by the buy-side.

This past year has seen significant steps taken by policy makers to create a framework for enhanced fixed income transparency. The Mifir review has laid the path for the EU consolidated tape and empowered ESMA to make downward adjustments to fixed income deferral periods over time. In the UK, the FCA are prioritising the bond consolidated tape and will be rounding off the year with a policy statement setting out the proposed bond CT framework and also consulting on what we hope will be an ambitious new transparency regime for non-equity instruments.

These developments mean the industry will be well positioned to launch initiatives in the coming year, some of which already announced, which promise to reinvigorate European fixed income trading, bringing much needed impetus for growth. It will be more important than ever to support government bond liquidity in the current high interest rate environment and ongoing volatile markets. The bond consolidated tapes and revised transparency frameworks will do this by opening up fixed income markets to new competitors and innovation.

Jack Seibald, global co-head of prime brokerage services and outsourced trading, Marex

One of the more notable developments in financial markets over the past year is the shift into fixed income instruments. This is a direct result of the sharp rise in interest rates to levels not seen since before the financial crisis some 15 years ago, and the attraction of such returns to investors. We’ve even seen equity focused investors taking steps to access liquidity in bonds as an alternative.

We think that this trend is likely to be sustained or even accelerated in 2024. While a schism seems to have developed between the “higher for longer” and the “Fed easing” crowds as they consider the outlook for interest rates in 2024, it appears that the developing economic trends – weaker growth and some persistent inflation – have laid the groundwork for a sustained period in which fixed income will offer competitive returns and thus play a more prominent role in portfolios. The opportunities for investors in bonds ought to be particularly pronounced in the lesser credit-worthy parts of the market as sovereigns and corporates with substantial maturities find themselves having to refinance at materially higher rates.

Jo Burnham, risk and margining SME, OpenGamma

Institutional investor betting on yield spread fluctuations between US treasuries to make a fast buck have faced ballooning margin costs this year. The margin for one lot of two-year listed treasury futures surged from $330 in November 2020 to a staggering $1,265 as of 20 November 2023, reflecting an alarming 283% increase. Similarly, the margin for 10-year treasury futures witnessed a significant uptick, rising from $1,540 to $2,200 in the same time period, representing a significant 42% increase.

This is likely to compound a desire to hold cash in moving into 2024, which could affect the funding costs that face institutional investors looking to engage in the treasury basis trade, which involves taking positions in debt markets that seek to profit from changes in yield spreads between US treasuries and interest rate futures. Heading into the New Year, institutional investors face a more complex landscape as they navigate the trade-off between holding cash and using securities in a market characterised by higher interest rates. As the margin costs for treasury futures continue to rise, traders will likely seek new ways to adapt their approach to maintain profitability in an environment marked by shifting monetary policy dynamics.

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Announced in December, the proposal by the European Commission would require all market participants to hold active accounts at EU central counterparties (CCPs) for clearing a portion of certain systemic derivatives contracts.

Read more: Post-Brexit derivatives clearing tussle continues as European Commission clamps down on non-EU CCPs

The new clearing threshold calculation has been designed to increase the attractiveness of EU CPPs, according to the European Commission, with the EMIR 3.0 proposals currently being debated by co-legislators in the European Parliament and Council.

In the joint statement, European trade associations including AIMA, EFAMA, BFPI Ireland, EACB, FIA EPTA, Federation of the Dutch Pension Funds, Finance Denmark, Nordic Securities Association, ICI Global, FIA and ISDA, have urged EU policymakers to delete the proposal and instead focus on streamlining the supervisory framework for EU CCPs across member states.

The trade associations noted that incentivising measures would offer sustainable growth of EU CCPs while maintaining competitive and open markets.

Read more: European clamp down on non-EU CCPs using mandated active accounts could counter competition, EFAMA finds

The negative impacts the proposed active account requirement would have on EU capital markets were highlighted in the statement, including introducing fragmentation, loss of netting benefits and reducing the resiliency of the EU to market stresses with no benefit to EU financial stability. The associations emphasised that the proposal will ultimately harm European pension savers and investors.

Elsewhere, the associations highlighted that the new requirement would create a competitive disadvantage for EU firms when compared to third-country firms, which would still be able to transact in global markets without restrictions.

To comply with an active account threshold, EU clients required to clear at an EU CCP would be forced to accept an uncompetitive price in instances where the price available at an EU CCP is higher than that available at a Tier 2 CCP.

“When making important decisions, such as imposing an active account requirement, policymakers should act prudently and be guided by comprehensive and robust cost-benefit assessments that include a review of the risks and impacts on financial stability and on the competitiveness of EU market participants,” the trade associations said in a statement.

“To date, such a comprehensive and robust cost-benefit assessment has not been produced.”

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Among the various aims of the new proposals, the EC sought to encourage clearing in the EU by simplifying the procedures for central counterparties (CCPs) when launching new products and changing risk models by introducing a non-objection approval for certain changes that do not increase the risks for the CCP. 

The EC also looked to make EU CCPs more resilient by further enhancing the existing supervisory framework through the new proposals, alongside efforts to strengthen EU open strategic autonomy and safeguard financial stability.

 The International Swaps and Derivatives Association (ISDA), the Alternative Investment Management Association (AIMA), the European Fund and Asset Management Association (EFAMA) and the Futures Industry Association (FIA) have responded to the EC’s proposed EMIR amendments with the following:

“Such measures would further reinforce the positive trends already observed in the clearing of euro-denominated contracts at EU CCPs. A strategy based on organic growth and market-driven solutions would best support the competitiveness of EU CCPs in a global clearing marketplace.”

However, the associations were less complementary about the EC’s proposals which would require firms subject to the EU clearing to have an active account at an EU CCP, alongside enabling the European Securities and Markets Authority (ESMA) to define the portion of certain euro and Polish zloty-denominated contracts that should be cleared through those accounts through secondary regulation.

“Changes to capital rules would reinforce this, making it less commercially viable for EU market participants to clear through CCPs based outside the EU,” highlighted the associations.

“We remain convinced that these measures, as proposed, would be harmful to EU capital markets. They would make EU firms less competitive and would have a negative impact on the derivatives market, EU clearing members and their clients, EU investors and savers, and the Capital Markets Union. For EU firms, this would not only hinder their ability to provide best execution to clients, but would also be costly to implement.

“We believe the EC should substantiate the risk of clearing through tier-two CCPs based outside the EU and provide a robust cost-benefit analysis of the proposed active account requirements.”

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The worldwide volume of exchange-traded derivatives reached 8.44 billion contracts in December, up 8.9% from November 2022 and up 37.4% from December 2021.

Options also continue to gain in popularity. Global trading of options reached 6.02 billion contracts in December, up by more than 67% from last year, with most of that trading taking place in the Asia Pacific region. Global trading of futures reached 2.42 billion contracts in December, down 4.8% from the same month last year.

On an annual basis, volume in 2022 was 83.85 billion contracts, up 34% from 2021, with the majority of that increase coming from equity index contracts.

Total options volume for the year was 54.53 billion contracts, up 63.7% from the previous year, while the total futures volume was 29.32 billion contracts in 2022, up 0.1% from 2021.

Total open interest at the end of December was 1.09 billion contracts. The December total was down 12.4% from November 2022 but up 0.9% from a year ago.

But while these volumes are great for exchanges, it’s not all blue skies for asset managers and buy-side traders: for whom the higher volumes pose a challenge from an exchange traded derivatives allocation perspective, as higher volumes result in higher operational risk and capacity burdens.

“Volumes hitting record highs reinforces why the industry needs to work together to solve the ETD workflow conundrum once and for all,” stressed Joanna Davies, head of FX and securities at OSTTRA, speaking exclusively to The TRADE.

“When volumes rise, the operational risk and capacity burden on market participants intensifies. Even if an asset manager is highly efficient in the allocation process during times of peak volumes, there could still be multiple allocations being communicated within minutes of the market closing. This creates an entire myriad of problems, which the industry continues to wrestle with.

“Even if the asset manager allocates early in the day, the challenge for executing brokers is to identify the exchange fills (executions) associated with a single order. These executions at different price levels must be average priced before they are given up. To compound the challenge, in keeping with their mandates, asset managers are executing multiple orders during volatile periods to manage the risk within their portfolios.

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The Futures Industry Association (FIA) and the International Swaps and Derivatives Association (ISDA) responded to the European Commission’s proposal to review the Central Securities Depositories Regulation (CSDR), in particular with respect to reforms of the mandatory buy-in regime (MBI).

The associations said they believe it is crucial to clarify that margin transfers and physically settled derivatives are not in scope of the MBI regime as its application would have a detrimental effect on derivatives markets.

The FIA and ISDA recommended, in their response, targeted amendments with respect to the Level 1 carveouts from the MBI regime, with a view to enhancing legal clarity and avoiding unnecessary costs for market participants.

Their primary concern is around uncertainties and unintended adverse consequences, as well as the disruption of existing contractual default provisions in ways parties did not contemplate when they entered into the agreement.

The CSDR review was launched by the Commission on 16 March. Alongside the review was an updated Q&A which removed – albeit temporarily, it seems – mandatory buy-in rules from the settlement discipline regime.

The Commission warned, however, it could reintroduce them if fail rates don’t improve.

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Brussels moved to prohibit PFOF for “high-frequency traders organised as SIs [systematic internalisers]” on 25 November as part of its Capital Markets Union (CMU) action plan. Under the changes, venues will instead have to earn retail order flow by publishing competitive pre-trade quotes.

In a follow-up statement to the changes, FIA EPTA said the Commission’s definition o left large gaps around what is considered PFOF, how its practiced and who can practice it.  and subsequently left loopholes that would allow these practices to continue in the EU.

The association said it is “critical” these loopholes are closed and suggested the Commission advocate a ban on PFOF that encompasses all direct and indirect monetary and non-monetary inducements, including all possible execution and routing scenarios between all types of participants.

“In FIA EPTA’s view these practices, which are observed in some member states, constitute an inappropriate conflict of interest, which undermines fair competition between market participants as well as best execution for end clients,” said Piebe Teeboom, secretary general of FIA EPTA.

“These practices [PFOF] undercut EU investor protection standards and ultimately risk to disadvantage and, in due course drive away, the very retail investors whose participation in European capital markets will be critical to their success.”

Elsewhere the FIA has voiced conditional support for the Commission’s plans to implement a consolidated tape in Europe.

The European Commission set out plans last week to introduce a real-time post-trade single consolidated tape provider for each asset class. However, FIA EPTA said that the scope of the derivatives tape was unduly narrow and suggested an equally comprehensive tape to the ones proposed for equities and bonds be implemented.

It also added that the Commission’s changes to bond market transparency – which includes harmonising the deferral regime and shortening post-trade publication delays – need to include a blanket 15-minute deferral as currently the changes are ambiguous and risk creating an overly complex regime with referrals ranging from 15 minutes to two weeks.

“This will also be the case for large-size transactions when jointly implemented with an effective volume masking regime, ensuring that liquidity providers are not exposed to undue risk and are still able to effectively hedge even after the deferral window has expired since the market does not know the full-size of the large trade,” added Teeboom.

The Commission’s consolidated tape proposals have attracted mixed reviews from various associations. Overall, the industry welcomes its introduction, but many have suggested improvements to the system proposed by the Commission.

 The Association for Financial Markets in Europe (AFME) has requested the consolidated tape for equities include pre-trade data, as well as the post-trade data the Commission has suggested to include and recommended that Brussels ensure the development of a bond consolidated tape before actioning any changes to the post-trade transparency regime. 

“This will avoid exposing committed liquidity providers to potential undue risks, especially when trading in illiquid instruments or transactions above a certain size, because if not properly considered, it may lead to diminishing liquidity available to corporates and investors,” said Adam Farkas, AFME chief executive.

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The FIA has provided three recommendations to improve the industry’s efficiency and resilience and has called on futures and options participants to work together on what it has called a “major initiative”.

The trade body said efforts to improve the workflow in the trading and clearing process have been limited by bespoke processes and the lack of interoperability of systems. 

“When Covid abruptly shut down the world economy in March 2020, the global futures and options markets experienced record trading activity and extreme volatility,” said Walt Lukken, president and chief executive of FIA.

“This period of stress exposed several long-standing bottlenecks in the trading and clearing infrastructure that cause costly delays in the processing of trades.”

FIA’s first recommendation is to create an independent, open-access markets standards body (MSB) that will encourage increased cross-industry engagement, leading to widespread adoption of standards and best practice.

In addition, this recommendation aims to improve the commitment, governance and accountability of the industry.

The second recommendation is to develop a collaborative and meaningful agenda, with three main priorities at this moment.

First, in respect to the trade allocation process, FIA views the opportunity to streamline and create standards and consistency across the industry as beneficial. The objective is to reduce operational workload and operational risk, as well as seeing better provision of trade status data.

By doing this, allocations can be sent in a timely manner which will benefit the entire ecosystem from a cost and risk perspective.

Secondly, with regards to the trade give-up process, FIA sees an opportunity to reduce complexity since there are multiple give-up possibilities at CCPs and several settlement timings and windows.

In a benefit statement, FIA said this recommendation would enable a better understanding of settlement time flexibilities and increase transparency.

Lastly, in respect to average pricing methodologies, FIA suggests an objective of an agreed general framework on the design and implementation of APS models resulting in fewer variations in functionality across market participants.

FIA’s third recommendation calls for the establishment of an action roadmap. In order for these plans to work, the industry needs to feel included in this call to action in developing a Markets Standards Body and agenda.

In addition, FIA stated that it must create a representative governance structure, make the case to the industry and secure early adopters and champions to optimise the chances of this initiative succeeding.

Through these recommendations, FIA plans to improve processes to create ‘effective fire prevention rather than effective firefighting’ for all sectors and participants in the listed derivatives markets.

The recommendations, created in collaboration with JDX Consulting, are based on insights gained from 25 organisations and over 60 people representing a wide range of the market segments and roles that make up the listed derivatives marketplace.

“FIA embarked on this open standards initiative to understand how we can make the ecosystem for trading and clearing more efficient through the adoption of standards and best practices,” added Lukken.

“Today’s Blueprint gives us a pathway for success, but more work needs to be done. FIA looks forward to beginning that dialogue and education with our industry.”

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In the build-up to the Brexit deadline, Brussels granted UK CCPs an 18-month temporary equivalence to EU regulation in September last year, due to expire next June, with the intention of allowing participants to reduce their exposure to them.

However, the Association of Financial Markets Europe (AFME), the Alternative Investment Management Association (AIMA), the European Association of Public Banks (EAPB), the European Banking Federation (EBF), the European Fund and Asset Management Association (EFAMA), Futures Industry Association (FIA), the Investment Company Institute (ICI), the International Swaps and Derivatives Association (ISDA), the Securities Industry and Financial Markets Association (SIFMA AMG) have requested this be extended.

In their letter, the associations suggest that the expiration of this equivalence decision next year would pose risks to the market relating to the simultaneous close-out of positions at UK CCPs, market fragmentation and lack of liquidity at EU CCPs, and increased costs.

They also highlighted that the expiration of the equivalence could minimise the oversight the European markets authority, ESMA, has over the market.

“There are a number of factors that limit their ability to prepare for the expiry of the current time-limited equivalence decision for UK CCPs at the end of June 2022, including the fact that the range and depth of clearing services offered by the UK CCPs is still not replicated in the EU5,” said the associations in their letter.

Their letter also highlighted that in line with the EU’s intention to move more liquidity onto EU CCPs, this was a process that should and is taking place naturally.

According to data from LSEG’s clearinghouse LCH and European CCP Eurex, Eurex has seen its market share for euro denominated interest rate swaps increase by 0.5% per month, while LCH’s share has decreased by a similar amount.

“There is already clear evidence of liquidity flowing towards EU CCPs, and our expectation is that this will continue,” the letter added. “We would welcome an extension to the current time-limited equivalence decision to allow this natural, market-led shift to continue and also to allow EU CCPs to continue to develop their offering.”

Clearing has been one of the key battlelines drawn between the UK and the EU following Brexit. Speaking to the Treasury Committee in February earlier this year the governor of the Bank of England, Andrew Bailey, warned that tensions between the two nations would rise quickly if the EU tried to push euro-derivatives clearing out of the UK.

At the end of the 18-month equivalence next year, 25% of euro-derivatives clearing would move to the bloc, however, Bailey has suggested this is not a viable chunk and that the EU could potentially try to “force or cajole” the remaining 75% out of the UK.

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