A response to European Commission consultation Possible initiatives to enhance the resilience of OTC Derivatives Markets by Thomson Reuters

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1 August 2009 A response to European Commission consultation Possible initiatives to enhance the resilience of OTC Derivatives Markets by Thomson Reuters Thomson Reuters (TR) is the world s leading source of intelligent information for businesses and professionals. Active in over 120 countries, we provide real-time pricing data from more than 250 equity and derivatives exchanges worldwide, updated at over 200,000 times per second at peak times. A further 7,500 data sources contribute to our information coverage of over 8 million different instruments, spanning the range of asset classes. TR welcomes the opportunity to provide comments to the European Commission (EC) consultation on OTC derivatives markets. Our comments are provided in two sections. In the first section, we offer some general comments on OTC markets; in the second, we give specific responses to a number of the questions in the consultation paper. Key messages Different OTC market segments have different risk profiles. A uniform regulatory approach imposed across asset classes could have damaging spill-over effects. Regulation should be appropriately risk sensitive. Foreign exchange is an example of an OTC market segment that is transparent, wellestablished, mature and resilient as it continued to prove during the financial crisis. OTC markets will continue to have a vital and legitimate role to play in enabling transactions that are ill-suited to trading on exchange or MTF. A number of tools can serve to enhance the resilience of, and reduce the risks involved, in OTC trading. Access to clearing houses and payment and settlement systems should be based on fair and non-discriminatory terms and conditions. Section One: OTC markets OTC markets are highly diverse We fully support the EC s aim of ensuring financial stability into the future and recognise that efficient, safe and sound derivatives markets are a key prerequisite for achieving this aim. As part of its consultation, the EC has helpfully provided a broad overview of OTC derivatives and the specific characteristics of a number OTC market segments. We applaud this analysis and, in particular, the recognition that different instruments have specific characteristics and varying risk profiles. There is no single OTC market; OTC markets are numerous, highly diverse and comprise a range of different instruments. Not all of these instruments are essentially financial (for 1 OF 7

2 example, commodities); not all of these instruments are derivatives (for example, spot foreign exchange). OTC markets in certain asset classes, including foreign exchange, are well-established, mature, transparent, large and highly liquid. Other asset classes have different characteristics, as they may trade less frequently and the range of counterparties may be more limited (for example, credit default swaps). Therefore, any regulatory oversight of OTC markets should be appropriately risk sensitive and take full account of the differing characteristics of different market segments. A uniform, one-size-fits all regulatory approach, designed to resolve particular problems that relate to certain market segments, could have significant damaging spill-over affects if applied across all asset classes. so a careful, granular analysis is necessary Policy discussions on OTC markets tend to adopt a top-down approach by considering the various market segments in their totality. Analyses focus on aggregate data on overall turnover and trading volume in particular market segments. Such analyses are, of course, perfectly valid, but are incomplete unless supplemented with a detailed consideration of OTC markets at a more granular level. An exclusive focus on aggregate data may give the impression that all trades within OTC market segments are high volume and/or relatively homogenous. In fact, OTC markets comprise a broad spectrum of asset classes, ranging from relatively simple and standardised instruments (for example, spot forex) to highly bespoke and complex (for example, exotic credit default swaps). While trading in OTC markets, of course, includes some high volume transactions in standardised instruments, a focus on this core market should not ignore the diversity of trading that also takes place over-the-counter. The following hypothetical examples illustrate some of these kinds of transactions: 1) A foreign exchange dealer wants to purchase an emerging economy currency in exchange for an equivalent amount of Euros. The market for this emerging economy currency is very small and no exchange or other MTF currently admits this currency to trading (or any that do have very limited liquidity). 2) A non-financial firm has a risk exposure to the price of a number of commodities in Asia. The firm seeks to hedge this risk by means of a commodity derivative contract. This contract is tailor-made to the specific risk exposure to the price of the underlying commodities on a particular date in the future. 3) A multinational company needs to sell a precise amount of currency, for example 10, EUR, on an exact date in the future. These idiosyncratic transactions are well-suited to OTC trading because they precisely meet the specific requirements of the firms involved at a particular date. The terms of such contracts (such as coupons, strike prices, maturities) are tailor-made to address the underlying risk and it is appropriate that they should continue to be negotiated bilaterally. It would be impractical for all of these kinds of trades to take place on an exchange or MTF, which are generally designed to handle relatively large transactions in highly-liquid, standardised instruments. Therefore, OTC markets have a vital role where liquidity for certain instruments is limited, where instruments are specifically customised or where specific trade values are fixed. 2 OF 7

3 to avoid unintended, damaging consequences. A regulatory approach that seeks to force the migration of all OTC trading on to regulated markets and MTFs could therefore have a number of damaging consequences. Perhaps the most significant impact would be a restriction in the ability of both financial and non-financial (corporates) firms to hedge their risks effectively. Another consequence would be to complicate the trading environment and potentially raise the transaction costs for highly specific trades. By discouraging the OTC trading of bespoke contracts (through differential regulatory capital charges or other means), users of derivatives for risk management purposes may be obliged to attempt to hedge their risks using standardised instruments. This would likely only partially cover the totality of their exposures, which would ultimately increase their risk profile. If this partial risk coverage were extended to the range of market participants, risks would be inexactly hedged throughout the system, leading to a fragmentation of risk insurance and a net increase in system risk. It is also important to note that, while arguments in favour of OTC trading apply to nonstandardised instruments, they can also apply to standardised instruments (such as foreign exchange) where individual trades are of a fixed value, where liquidity is limited (such as some emerging economy currencies) or otherwise specific in nature. Thus, there will be a continuing need to retain a degree of OTC trading even in instruments that are judged standardised. As IOSCO points out, care should be taken not to advance recommendations that could unnecessarily discourage the tailoring of products for appropriate purposes such as hedging 1. Case study: foreign exchange Thomson Reuters is a major interdealer broker for spot foreign exchange and forex derivatives. Our electronic Reuters Matching platform is used by over 1,100 banks throughout the world to trade spot forex in 54 currency pairs, including a number of emerging economy currencies such as the South African Rand, Thai Baht and Turkish Lira. Reuters Matching is a registered MTF and is regulated by the Financial Services Authority in the UK and has authorisations from a number of other regulators worldwide. Several central banks, including the European Central Bank, Bank of England, U.S. Federal Reserve and the Bank of Mexico, receive daily reports of trading volumes within their jurisdictions from our platform. By bringing together the key wholesale dealers in a secure, transparent, regulated trading venue, Thomson Reuters plays a critical role in ensuring the transparency, efficiency and security of this market. Our automated systems also help to expedite post-trade processes, including facilitating access to CLS. The EU Working Paper that accompanies its consultation highlights that the foreign exchange market is large and mature. We strongly agree with this statement. As a market, foreign exchange is well-established, transparent and highly resilient. It is also a truly global market, where market participants from across the world transact with each other on a daily basis. 1 IOSCO, Unregulated Financial Markets and Products (May 2009) 3 OF 7

4 By volume, foreign exchange and interest rate derivatives are by far the two largest OTC derivative market segments. As a recent report notes: interest rate derivatives and FX derivatives, which together account for some 80% of all trades, had virtually no impact on the financial crisis 2. Forex trading is also a key strength of European financial markets, with 57% of trading taking place in Europe. 3 The resilience of foreign exchange, even during the recent financial crisis, highlights that not all OTC market segments suffer from fundamental weaknesses. Therefore, we strongly urge the European Commission to maintain its risk sensitive approach when considering further regulatory initiatives in OTC markets. We note that the draft legislative language from the U.S. Treasury on regulating OTC derivatives specifically excludes foreign exchange derivatives. 4 A number of tools serve to enhance OTC market infrastructure. There are a number of tools that can be used to enhance the resilience of OTC market infrastructure and reduce systemic risk. In many OTC market segments, these tools have a proven track record and can help to facilitate record-keeping and regulatory reporting. They can also contribute to a secure and efficient trading environment for transactions that are illsuited to exchanges and MTFs. Thomson Reuters is a key provider of transparency to financial market professionals throughout the world. There are a number of industry-led initiatives designed to boost the transparency of certain market segments and TR is actively contributing to these. For example, we are working with the European Securitisation Forum (ESF) on the RMBS Principles and the American Securitization Forum (ASF) with Project RESTART to enhance transparency for structured finance instruments. 5 Electronic, screen-based trading can provide a secure, efficient and transparent system for traders. As the EC notes in its Staff Working Paper, take-up of electronic trading has increased significantly in recent years. Electronic trading systems can provide visibility of trading positions and integrate directly into firms reporting and risk management processes. They can also facilitate post-execution reporting. Such trading systems are also particularly used in emerging economies, where alternative trading infrastructure may be lacking. Straight-through-processing (STP) significantly enhances the resilience of the trading environment by providing a seamless, automated, electronic processing of transactions. Our post-trade services provide counterparties with near real-time reports on the status of a trade once it has been executed. These services feed directly into risk management systems to provide up-to-date information on exposures and positions. These services can feed into any central trade repository designated by the European Commission to store records of completed trades and provide regulators with visibility over trading positions. 2 City of London/Bourse Consult, Current Issues Affecting the OTC Derivatives Market (April 2009) 3 Bank for International Settlements, Triennial Central Bank Survey of Foreign Exchange and Derivatives Market Activity (2007) 4 U.S. Treasury Department, Over-the-Counter Derivatives Markets Act of 2009 (August 2009) 5 More information at: and 4 OF 7

5 Straight-through-processing can also facilitate automated access to clearing and settlement systems where appropriate. In this regard, it is essential that access to clearing houses and payment and settlement systems should be based on fair and non-discriminatory terms and conditions. TR electronic trading systems help to route foreign exchange trades to CLS, which, as the EU communication notes, mitigates the key risk in foreign exchange settlement risk. We support the Commission s recommendations for broader uptake of CLS and for the system to extend to a wider range of currency pairs. Section Two: Responses to the specific questions Questions 1, 2, 3 and 12: What would be a valid reason not to use electronic means as a tool for contracts standardisation? Should contracts standardisation be measured by the level of process automation? What other indicators can be used? Should non-standardised contracts face higher capital charges for operational risk? Do you agree that the eligibility of contracts should be left to CCPs? The debate surrounding standardisation often seems to rest on an assumption that the ultimate goal should be the achievement of comprehensive standardisation of all derivatives. In fact, such a goal would be neither practicable nor desirable. Firms seek to hedge the specific risks to which they are exposed. These risks are necessarily unique to the firm in question (related for example to their geographic presence, markets and sectors in which they operate etc.). It is therefore essential that firms retain the ability to use bespoke derivative contracts to cover comprehensively the range of risks that they face. Such customised contracts will in most cases be ill-suited to exchange or MTF-trading, which are generally designed for relatively large transactions in highly-liquid, fungible instruments. There is no necessary correlation between the degree to which a contract is standardised and the degree of risk the contract presents. To the extent that standardisation is a desirable policy goal, it should not be pursued disproportionately to limit the ability of firms to manage their risks effectively. If the use of non-standardised derivatives to hedge risk were made prohibitively expensive through higher capital charges or otherwise discouraged, firms ability to manage their risks effectively would be severely compromised. It is unlikely in most cases that standardised derivatives available on exchanges or MTFs will be able to cover the totality and specificity of the risks that a firm faces. Attempts to manage idiosyncratic risks by using standardised derivatives will likely serve to increase risk precisely because such contracts are not tailormade to the specific risk exposures of a firm. In this regard, caution should be exercised to avoid inadvertently raising systemic risk through regulatory responses that are not appropriately risk sensitive. We support initiatives to increase electronic, screen-based trading. Even non-standardised derivatives can trade electronically, though moves towards process standardisation will help to facilitate automation. Straight-through-processing and electronic affirmation of trades can play a key role in efficient risk management. Standardised contracts would also be easier to manage within a trade data warehouse. 5 OF 7

6 The methodology governing what constitutes standardisation will need to be carefully defined. Care should be taken to avoid mandating standardisation to the extent that it would undermine the utility of a contract for risk management purposes. Hence, moves towards standardisation should focus on harmonisation of the legal terminology (as is currently done through ISDA master agreements in a number of asset classes including FX options) and process uniformity to facilitate automation (where STP can play a key role). Mandating standardisation of the economic terms of contracts (for example, harmonising coupons, strike rates and maturities) could significantly undermine their utility for hedging purposes. Any regulatory capital regime in this area should be appropriately risk sensitive. Therefore, we believe that to the extent that regulators pursue standardisation through regulation, there should be robust, clear and effective rules. We caution against the view that the acceptance of an instrument for clearing by a single clearing house should lead to a presumption of standardisation. This is for several reasons. Firstly, such a presumption appears to transfer a regulatory responsibility on to a clearing house. We do not believe that a clearing house should have to bear this responsibility, which more properly lies with regulatory authorities. Secondly, clearing houses are incentivised to attract order flow and therefore there may be a temptation to admit an excessively broad range of instruments. Finally, disparities in rules on what constitutes standardisation in different jurisdictions could unnecessarily complicate the trading environment for financial markets which are inherently global in nature. There should be global consistency in this critical area and especially between the EU and U.S. Questions 9 to 11: Are there market segments for which a central data repository is not necessary or desirable? Which regulatory requirements should central data repositories be subject to? What information should be disclosed to the public? We support the establishment of central data repositories and stand ready to provide such connectivity to any warehouses as may be necessary. We believe the coverage should be as wide as possible. One area of practical difficulty may be the ease of archiving highly bespoke contracts with diverse terms and conditions, as these may not fit easily within database architecture. We stand ready to provide regulators with whatever assistance may be helpful to them in this area. Questions 21: Should MiFID-type pre- and post-trade transparency rules be extended to non-equities products? Are there other means to ensure transparency? We support measured and targeted rules on post-trade transparency that take into account the specific characteristics of the instruments in question. We note CESR s recent recommendations to expand MiFID transparency criteria to cover corporate bonds. We caution that there is a risk of liquidity retrenching if permitted reporting delays are too short. We believe that end-of-day or weekly reporting may be appropriate. In any case, any data that is publishable under the new rules should be available in a non-discriminatory manner and on reasonable commercial terms. With regard to other asset classes, particularly those where trading is infrequent and/or liquidity is limited, MiFID-type rules on post-trade transparency may be unsuitable. Question 22: How could European legislation help ensuring safety, soundness and a level playing field between CCPs? 6 OF 7

7 Central counterparties have a key role to play in helping to mitigate counterparty risk in certain asset classes. However, by their nature they are a source of risk concentration, so they should be subject to adequate regulation to ensure that they are operationally sound at all times. Effective competition between clearing houses will help to ensure optimal efficiency and safety. Moreover, CCPs should be obliged to give access to their facilities on nondiscriminatory and equal terms. We note that a number of the Giovannini barriers remain to be resolved and urge further progress in this area. Interoperability between CCPs will be important, in particular to establish truly pan-european financial markets. Finally, in line with our comments on standardisation, it is likely that certain bespoke instruments will not be appropriate for central counterparty clearing. Question 24 How can further trade flow be channelled through transparent and efficient trading venues? What would be the appropriate level of transparency (price, transaction, position) for the different derivatives markets? The presupposition underlying this question is that more trading on public trading venues is necessarily beneficial. We do not take issue with this assertion, but instead highlight that OTC markets will continue to have a critical role to play into the future, for example where liquidity for certain instruments is limited, where instruments are specifically customised or where specific trade values are fixed. A good deal of this kind of OTC trading is perfectly legitimate, appropriate and safe, particularly when transacted electronically, and should not suffer from unduly high capital charges designed to offset a risk that does not apply to the specific instruments in question. Moreover, we note the EU Commission s comment in its consultation document that a system based on competition between different trading venues (OTC, exchanges and MTFs) is advantageous in terms of market efficiency. Contact details Nick Miller Government Affairs Thomson Reuters nick.miller@thomsonreuters.com 7 OF 7