CESR Consultation on Transaction Reporting of OTC Derivatives and Extension of the Scope of Transaction Reporting Obligations

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1 CESR Consultation on Transaction Reporting of OTC Derivatives and Extension of the Scope of Transaction Reporting Obligations (CESR/10 809) A response by: The British Bankers Association August 2010

2 2 Introduction: The British Bankers Association welcomes the opportunity to respond to the Committee of European Securities Regulators (CESR) consultation on the Transaction Reporting of OTC Derivatives and Extension of the Scope of Transaction R eporting Obligations ( CESR / ). The British Bankers Association is the leading association for UK banking and financial services sector, speaking for over 200 banking members from 50 countries on a full range of UK and international banking issues. All the major institutions in the UK are members of our Association as are the large international EU banks, the US banks operating in the UK, as well as financial entities from around the world. The integrated nature of banking means that our members engage in activities ranging widely across the financial spectrum encompassing services and products as diverse as primary and secondary securities trading, insurance, investment bank and wealth management as well as conventional forms of banking. Our members are the strongest partners of Competent Authorities in tackling market abuse. Clean markets are a vital basis for the prosperity of the single European market. The BBA Transaction Reporting Working Group has worked closely alongside the regulators for the preceding three years in order to assist with developing and improving systems in respect of the requirements pertaining to transaction reporting under MiFID. A significant proportion of trading also takes place out of London which results in considerable volume of transaction reporting being undertaken to the UK regulator which is subsequently shared with the European authorities via the Transaction Reporting Exchange Mechanism (TREM). Our membership therefore possesses extensive experience with regard to reporting their activity, and welcomes the opportunity to respond to CESR s consultation Transaction Reporting on OTC Derivatives and Extension of the Scope of Transaction Reporting Obligations (CESR / ). This response represents our members considered view Organisation of Transaction and Position Reporting of OTC Derivatives Question 1: Do you agree with the solution proposed by CESR for the organisation of transaction and position reporting of OTC derivatives? General Comments: At the outset, we would like to emphasise that we do not agree with the approach taken by CESR in the consultation document. The objectives of transaction reporting and position reporting are fundamentally different to one another. Transaction reports are used by Competent Authorities as a tool to detect, and deter market abuse (market conduct purposes). It is envisaged that position reports will enable regulators to view easily the current outstanding market exposures of given market participants for the purposes of detecting

3 3 concentrations of systemic risk within the financial system (market supervision purposes). In addition to these differences, the scope and standards of position reporting have not yet been defined. Therefore, our members consider it is far too early to analyse how transaction and position reporting streams may be reconciled. Whilst this exercise will be a valid one, and may result in improved efficiency and a reduction in duplicative reporting, it needs to begin once the details of position reporting are more clearly defined. Currently, far too many questions regarding position reporting remain unanswered. Firms have sufficient clarity with regard to transaction reporting of OTC derivatives (at least, in those Member States that collect OTC derivative transaction reports). The rules around reporting are clearly defined. Firms are au fait with how they should report, and have had the appropriate systems in place for a number of years. The arrangements with regard to position reporting (via a trade repository) are in complete contrast. Very few details have been defined. Indeed, draft legislation (the European Market Infrastructure Legislation) is not expected to be published until September at the earliest. Concurrently, the industry has continued to push ahead with its commitment to establish global trade repositories for each OTC derivative asset class for the purposes of position reporting. CESR on instruction of the Commission are effectively forerunning the outcome of this work stream. The Commission within their July consultation on Derivatives and Market Infrastructure have assigned ESMA the role of developing draft technical standards to determine the details, type, format and frequency of position reporting for the different classes of OTC derivative. We therefore consider a more practical approach would be to await the outcome of the European Markets Infrastructure legislation, and ESMA s accompanying work on defining the scope and standards of position reporting, before attempting to link the two reporting streams together. This will then enable rule makers to establish what potential links and commonalities exist between transaction and position reporting streams, with a view to minimising any double reporting. More generally, in order to obtain a clear picture of where systemic risk lies, it will be necessary for trade repositories to understand whether a firm has a related hedge in place. For example, a firm could be exposed to a short call option (which will be reported to the relevant trade repository), but is likely to have hedged this exposure with a long cash equity position. If trade repositories only show a firm s OTC derivative positions, an accurate view of systemic risk would be hard to achieve. Option 1 Establish a single reporting regime for both transaction reporting and position reporting of OTC derivatives, based on reporting through trade repositories. Option 2 Define a new position reporting regime through trade repositories and allow MiFID transaction reporting through trade repositories.

4 4 For the aforementioned reasons, the BBA is strongly opposed to Option 1. We have strong reservations over how this approach would work in practice. Our members instead, have a strong preference for Option 2. That is, to define a new position reporting regime through trade repositories, and allow MiFID transaction reporting through trade repositories (whilst continuing to allow firms to continue MiFID transaction reporting through their Competent Authority). In this respect, we agree with CESR s preference in the matter, and the basis of their reasoning. Below we outline some of the issues that need to be considered before the two reporting streams can be unified many of which are touched upon by CESR in the consultation document. Reporting Cycles: Transaction reporting is flow variable. Transaction reports must be sent to Competent Authorities on a daily basis. Given the reports are used for the detection of market abuse, delays must be avoided at all costs. Contrastingly, position reporting is stock variable and can be considered with a frequency of lower than daily (i.e. weekly or monthly). Currently, the length of the reporting cycles of the trade repositories would preclude their effectiveness in the transaction reporting context. However, as the length of the trade repository reporting cycles reduce over time, it could well be in the interests of firms to begin sending the trade repositories their OTC derivative transaction reports. Timelines: The timelines of the two work streams are at odds with each other. Draft legislation concerning position reporting to trade repositories (EMIL) is not expected until September, whereas work on extending transaction reporting to cover OTC derivatives is at a much more advanced stage. Several Member States already collect OTC derivative transaction reports, whilst others are expected to introduce this in short order (under recital 45 of MiFID). CESR has also invested a significant amount of time and effort in defining the scope and standards that will apply when transaction reporting OTC derivatives, and how these instruments will be classified and identified when exchanged between Member States via TREM (the Transaction Reporting Exchange Mechanism). Scope of Reporting: As per Article 25 of MiFID, the obligation to transaction report falls only on financial intermediaries (investment firms) that are authorised to arrange transactions on OTC derivatives on a professional basis. The European Market Infrastructure Directive sets out two different options with regards to who the obligation to position report should fall upon. In the very least, all financial firms entering into an OTC derivative contract will be required to position report. There is however a strong possibility the obligation will apply to all firms entering into an OTC derivatives contract (including non financials).

5 5 It is not obvious at this stage which category of OTC derivative will be reported to which trade repository. Neither is it clear where the repositories will be based. The BBA advocates one global trade repository per asset class. Such an arrangement could mean firms having to transaction report to a trade repository based outside of Europe, only for the repository to have to revert these reports back to the relevant European Competent Authority. It is unclear how such an arrangement would work, and whether non EU repositories would, in fact, be willing to take on such a role. CESR/ESMA will also need to give consideration as to how firms should transaction report in the event that the relevant registered trade repository was not capable of recording the details of a specific derivatives contract; or if no registered trade repository existed for that type of contract. What does this imply for the transaction reporting arrangements of these contracts? Would firms be expected to position / transaction report these contracts to their Competent Authority? Reporting Standards: The Commission has so far announced only the very basic standards that position r eports will adhere to. Namely: the parties to the contract and, if different, the beneficiary of the rights and obligations arising from it are appropriately identified; and the characteristics of the contract, including the underlying, the maturity and the values are reported. Transaction reports encompass a great deal more information than this. Further, owing to the fact that transaction reports are conduct driven, it is not uncommon for a simple change in exposure of a particular security between two parties to require several transaction reports. However, the same information could be conveyed within a single position report (i.e. demonstrating a reduction in exposure of security X of client A, and an increase in exposure of security X of client B). After detailing what the scope and standards of position reports should look like, CESR/ESMA should examine whether the frequency, fields, and format of transaction reports map easily to the technical standards they have developed. Business Events: Competent Authorities do not need to be made aware of the outcome of OTC derivative contracts once they reach maturity. For instance, the outcome of a credit default swap, or the exercise of an option on maturity is not significant in terms of market abuse detection. However, it will be essential that this information is transmitted to the relevant trade repository, due to its effect the outstanding exposure of market participants. The discussions around position reports has also not considered the treatment of business events (change of ownership / novation / partial or full termination etc.) to any great detail, whilst they have been discussed extensively in the transaction reporting arena. Any unified regime must harmonise the treatment of business events. Otherwise significant discrepancies will exist between the two reporting streams.

6 6 Question 2: Do you have any other views on the possible ways to organise transaction and position reporting on OTC derivatives? Please refer to our comments in response to Question 1 of the consultation document. Extension of Scope of Transaction Reporting Obligations Question 3: Do you agree with the extension of the scope of transaction reporting obligations to the identified instruments? Extension to Financial Instruments traded only on MTFs We note that the Commission has recently undertaken a revision of the Market Abuse Directive (MAD). This consultation included proposals to bring Multilateral Trading Facilities within the scope of the Directive, of which the BBA was supportive. Bringing trading on MTFs within the scope of MAD would seem to make little sense if instruments traded on MTFs (only) are not transaction reportable. Therefore, the BBA supports CESR s proposal to extend, through a change to Article 25 of MiFID, the scope of transaction reporting obligations to financial instruments that are admitted to trading only on MTFs on the proviso that the Commission concludes trading on MTFs should be bought within the scope of the Market Abuse Directive. Extension to OTC Derivatives Scope The BBA supports CESR s proposal to extend, through a change to Article 25 of MiFID, the scope of transaction reporting obligations to include OTC derivatives on the proviso that this requirement is restricted to OTC derivatives whose underlying is admitted to trading on a regulated market (or MTF only). CESR stated within its decision on the technical standard for the classification and identification of OTC derivative instruments (CESR/09 987) that it has: decided that at this stage only transactions on derivatives whose underlying instrument is traded on a regulated market should be exchanged. Whilst CESR s latest consultation seems to imply that this will still be the case, it is not explicitly stated. We would therefore appreciate CESR clarifying that only OTC derivatives whose underlying is admitted to trading on a regulated market and/or an MTF must be transaction reported. We would be vehemently opposed to any

7 7 moves to make all OTC derivatives transaction reportable. We do not believe this would significantly improve the detection of market abuse in the EU. In any case, the limited marginal benefits potentially realised would not be justified by the huge costs involved in making such a change. Neither does CESR explicitly states that OTC derivatives on: commodities; interest rate; and foreign exchange are to be exempt from the reporting requirements. Again, CESR has previously stated that these derivatives would not be in scope of the reporting obligations in its consultation on guidance to report transactions on OTC derivative instruments (CESR/09 768). Specifically, the paper states: Transactions on the following instruments are not reportable: a future, forward or option on a commodity, interest rate or foreign exchange rate; and a swap between two interest rates Again we would be opposed to the collection of OTC derivatives based on commodities; foreign exchange, or interest rates. We would welcome CESR s clarification that firms will not be expected to report these instruments going forward. If CESR s position in respect to these exemptions has changed, we would ask CESR to demonstrate to the industry why such a change has been deemed necessary. Our membership also considers that stakeholders should be consulted before any such changes are introduced. Multiple Underlyings As CESR states in paragraph 40 of the consultation document, the main reason for the proposed extension of the reporting obligations is the possibility of market participants using OTC derivatives as a substitute to traditional securities to commit market abuse. Accordingly, the basic criteria used to define the scope of the extension would be whether the value of the OTC derivative depends on the performance of a financial instrument that is admitted to trading on a regulated market or on the credit risk of a single issuer of such financial instruments. On this basis, CESR have proposed that credit derivatives on baskets or indexes with no exposure to an individual issuer in particular should be excluded from the reporting regime. Therefore, we are unsure as to why CESR has limited this exemption to credit derivatives (credit default swaps and swaps only). Following CESR s logic, we consider that all OTC derivatives on baskets or indexes should be exempt from the disclosure obligation except in cases where all instruments within the basket have been issued by the same issuer. Indeed, limiting this exemption to credit derivatives would seem at odds with CESR s previous thinking as outlined in its decision on its technical standards for classification and identification of OTC derivative instruments for the purpose of the

8 8 exchange of transaction reports amongst CESR Members (CESR/09 987). Within these recommended standards, CESR state: only transactions on derivatives whose underlying instrument is traded on a regulated market should be exchanged, focusing on single name derivatives, except when different underlying instruments all refer to the same issuer. This suggests that all those OTC derivatives based on baskets or indexes would be exempt from the transaction reporting obligation, as opposed to only credit derivatives (assuming all underlings are have not been issued by the same issuer). We believe strongly that only OTC derivatives whose underlying instrument is traded on a regulated market (or MTF only) should be reported with a focus on single name derivatives. Neither our membership, nor indeed the UK FSA, consider it proportionate to require firms to transaction report routinely, OTC derivatives the value of which is derived from, or which is otherwise dependent on, multiple equity or multiple debt related financial instruments (unless all underlying instruments are issued by the same issuer). Notwithstanding this, we do acknowledge the overarching expectation on firms to examine transactions for possible market abuse and report any suspicious transactions to the relevant Competent Authority. In fact, it is probably the case that firms are in a better position to monitor their activity in OTC derivatives with multiple underliers than European supervisors. For instance, firms would expect internal monitoring functions to report a suspicious transaction to their Competent Authority if an OTC product was constructed with an unusually high weighting towards one particular security (providing the weighting was client driven). We hope that you will find these comments useful, and remain at your disposal should you wish to discuss this response. In such instances, please contact either Christopher Ford ( ; christopher.ford@bba.org.uk) or Sally Springer ( ; sally.springer@bba.org.uk) of the British Bankers Association.