European Market Infrastructure Regulation Research Articles

Assessing the Impact of Derivatives on the 2008 Financial Crisis and the Effectiveness of Subsequent Regulatory Reforms

The 2008 financial crisis was a global financial catastrophe that reflected the misuse of financial derivatives in financial markets, such as credit default swaps, asset-backed securities and collateralized debt obligations, exposing significant weaknesses in the global financial system. These financial instruments were designed to hedge against debt risk, but their lack of transparency and massive misuse ultimately led to the accumulation of systemic risk that accelerated the financial crisis. Since then, regulatory authorities around the world have realized the necessity for stronger regulatory frameworks, and a series of significant reforms have been implemented, such as the Dodd-Frank Wall Street Reform and Consumer Protection Act in the United States, the European Market Infrastructure Regulation in the European Union, and the Basel III international regulatory framework, with the objectives of increasing transparency in financial markets and improving the risk management measures of financial institutions. This paper will explore the role of derivatives in the 2008 financial crisis and examine the effectiveness of these regulatory measures introduced after the crisis in enhancing stability of financial system.

Does EU Regulation Adequately Address the Tension between CCPs Shareholders’ and Clearing Members’ Incentives?

Abstract 964The current EU regulatory regime of Central Counterparties (CCPs) falls short of addressing adequately the potential misalignment of incentives of CCPs’ shareholders on the one hand and clearing members on the other hand.Thus, according to the European Market Infrastructure Regulation (EMIR), while clearing members contribute substantially to the default waterfall of a CCP, they do not enjoy substantial governance rights: they merely participate in the risk committee of the CCP, whose role is only advisory.By contrast, although shareholders are vested with substantial governance rights, such as the right to appoint the members of the board which sets the CCP’s risk profile, they do not bear final losses first, as in ordinary companies: the shareholders’ contribution to a CCP’s default waterfall is limited and, in case the CCP enters resolution, they only bear losses, in principle, after the clearing members.It is however clear that when the owners of a firm are not the ones bearing the risks first, the firm may be inclined to excessive risk-taking. The objective of this article is therefore to discuss a number of ways to improve the corporate governance of CCPs, in particular the incentive setting for shareholders.965

Leverage and derivatives: The case of Archegos

In March 2021, the default of Archegos, a US family office, led to large losses for some global banks. Archegos was able to accumulate large exposures to, and leverage on, equities by entering into derivatives transactions with bank counterparties. When the price of the underlying stocks started to decline, the firm was unable to meet variation margins, resulting in the liquidation of the stocks by the counterparty banks. In this paper, European Market Infrastructure Regulation (EMIR) data is used to analyse Archegos’ positions and show that it is possible to track the steep increase in concentrated exposures that the family office undertook in February and March 2021. The findings show how regulatory data collected under EMIR can be used to monitor leverage and concentration risk in derivatives markets.

Uncovering the network structure of non-centrally cleared derivative markets: evidence from large regulatory data

The network structure of non-centrally cleared derivative markets, uncovered via the European Market Infrastructure Regulation, is investigated by reconstructing initial and variation margin networks to analyze channels of potential losses and liquidity dynamics. Despite the absence of central clearing, the derivative network is found to be ultra-small and a maximization-based filtering tool is proposed to identify channels in the network characterized by the highest exposures. I find these exposures to be mainly toward institutions outside the euro area, emphasizing the need for cooperation across different jurisdictions. Anomalous behavior in terms of diverging first and second moments of the degree and strength distributions are detected, signaling the presence of large exposures generating extreme liquidity outflows. A reference table of parameters’ estimates based on real data is provided for different network sizes, with no break of confidentiality, making it possible to simulate in a realistic way the liquidity dynamic in global derivative markets even when access to supervisory data is not granted.

Why should I start worrying about EMIR Refit 3.0?

The industry is expecting that the European Market Infrastructure Regulation Refit Technical Standards for Transaction Reporting (EMIR Refit 3.0) will be published shortly, but past regulatory implementations indicate that there are practical steps that could already be considered in preparation to be operationally ready and compliant. EMIR Refit 3.0 constitutes a significant number of changes for the industry, using past experiences this paper looks at some of the key challenges of EMIR Refit 3.0 as written in the draft regulation and what firms could consider as part of the planning phase of the programme to get a head start. Initiating the programme early on, frontloading operational readiness and considering the client journey are themes that are explored further for practical application.

MIFID II and EMIR impact on Romanian banking system performance

Abstract MIFID II/MiFIR represents comprehensive financial market reforms in trading and settlement of financial instruments. The greatest impact of the new regulatory framework in the banking sector relates to pricing, trading, and reporting of banking products and classification of financial institutions. The new role of the financial market infrastructure provides more protection for bank customers and significantly increases market transparency. Banks are required to show their customers the best execution price on the relevant trading venues, transaction costs and market behavior. The regulation will be aligned with other financial market regulations of over-the-counter markets and market abuse protection to avoid regulatory overlap - European Market Infrastructure Regulation (EMIR). The new regulatory framework requires the banking sector to fully comply with the rules governing the banking system of the European Union. Banks must incur significant costs in order to restructure internal processes, acquire new technological support, and forego additional profits in competitive and transparent markets. This study analyses the impact of MiFID II/MiFIR and EMIR implementation on local banks’ performance (credit institutions, Romanian legal persons). Using a unique dataset from banks that have been operating in Romania over the period 2004-2020, it is shown that the implementation of the new regulatory framework did not affect the net trading income ratio of the selected banks. Moreover, the average trading asset ratio in the post-financial crisis period increased in comparison with the average trading asset ratio in the pre-financial crisis period. Local banks that took advantage of the large economies of scale obtained due to branch banking did not reduce their investment banking activities and product offerings to customers in the period following the introduction of the regulatory framework. Most of the costs of implementing the new regulatory framework were borne only by the ultimate parents of the controlled Romanian subsidiaries. All subsidiary banks benefited equally from these economies of scale.

When does portfolio compression reduce systemic risk?

AbstractWe analyze the consequences of portfolio compression for systemic risk. Portfolio compression is a post‐trade netting mechanism that reduces gross positions while keeping net positions unchanged and it is part of the financial legislation in the United States (Dodd–Frank Act) and in Europe (European Market Infrastructure Regulation). We derive necessary structural conditions for portfolio compression to be harmful and discuss policy implications. We show that any potential harmfulness of portfolio compression arises from contagion effects. We show how portfolio compression affects systemic risk depends on the resilience of nodes taking part in compression, on the proportion of debt that they can repay, and on the recovery rates in case of default. In particular, the potential danger of portfolio compression comes from defaults of firms that conduct portfolio compression. If no defaults occur among the firms that engage in compression, then portfolio compression always reduces systemic risk.

Mitigating margin procyclicality: the effectiveness of anti-procyclicality measures during the Covid-19 stress event

The pronounced volatility of initial margins during the Covid-19 stress event revived discussions on regulatory measures to limit potential adverse effects on market liquidity. Anti-procyclicality (APC) tools are meant to tackle this problem by dampening margin dynamics that could otherwise create liquidity strain during periods of market stress. In this paper we use daily portfolio-level data (collected under the European Market Infrastructure Regulation) to analyze the effectiveness of APC measures implemented by central counterparties for clearing member and client margins. Using simulation, we show that the effectiveness of the APC measure is highly sensitive to the details of calibration and to the type of portfolios to which the measure is applied. Employing a regression analysis, we then quantify the relative ability of APC measures to limit portfolio margin growth during the Covid-19 stress period, controlling for observed and unobserved heterogeneity. This approach reveals that models that have implemented margin floors displayed lower levels of margin growth during the Covid-19 stress. We conclude with a policy discussion on the benefits of margin model transparency and advocate for the provision of additional regulatory guidance on the implementation of APC measures.

Securitisation special purpose entities, bank sponsors and derivatives

This paper documents the use of derivatives by securitisation special purpose entities (SPEs), also known as financial vehicle corporations (FVCs), domiciled in Ireland using transaction-level data established by the European Market Infrastructure Regulation. We show that these entities primarily engaged in interest rate derivatives over the period of 2015–2017. We find that larger entities that already engage in international capital markets are more likely to have derivative exposures. We also show that entities sponsored by banks and non-bank financial institutions are relatively more likely to engage in derivative markets. The characteristics of these bank sponsors are important in determining SPEs’ engagement in derivative markets. SPEs’ heavy reliance on debt finance coupled with their strong interconnectedness with bank sponsors underscores the importance of continuous monitoring and macroprudential surveillance of their derivative activities.

Outsourcing services in a challenging time

The buy-side industry has for many years been looking into outsourcing operational processes to focus more on creating Alpha and value adding to the business. Regulatory requirements increased the aftermath of the financial crisis in 2008, where especially the introduction of Dodd-Frank in the United States and European Market Infrastructure Regulation (EMIR) in Europe has changed the role of the operations department. Reporting, monitoring, confirmations, reconciliation, digitalisation in the trading space and collateral management were all part of the new transparency and risk mitigating regime, putting pressure on all players in the financial industry, but the regulation has also catered for innovation, new market players and new services, and we have also seen a shift in the staffing in the back- and middle-office area. You need business analysts who knows more than just how to match a trade, execute payments and do classic reconciliation, and you need an outsourcing provider who is treating the relationship as a true partnership — and what has become even more obvious in 2020 is that you need to have a partner who knows how to (re-) act in a time of stressed market conditions and have prudent business contingency plan (BCP) in place.

Central Counterparties are Too Big for the European Securities and Markets Authority (Alone): Constructive Critique of the 2019 CCP Supervision Regulation

Once seen as the solution to the systemic risk of over-the-counter derivatives, central counterparties (CCPs) have become a source of concern for the financial stability of the European Union (EU). Distress of a single CCP might be transferred to clearing members and others CCPs, thereby endangering EU monetary and fiscal stability. However, the European Market Infrastructure Regulation (EMIR) has left fiscal responsibility as well as day-to-day supervision of EU-based CCPs (EU-CCPs) at the national level, albeit cross-border colleges of authorities can overturn key decisions of national supervisors. The Commission concluded that these supervisory arrangements needed to be reformed because they hamper the development of a single coherent EU approach to CCP supervision. Although the Commission had proposed to centralise EU-CCP supervision in the European Securities and Markets Authority (ESMA), the final 2019 CCP Supervision Regulation seeks to improve EMIR’s ineffective collegial framework by establishing an internal CCP Supervisory Committee within ESMA. Nevertheless, the continuing lack of loss mutualisation would keep on hindering the development of a single approach to EU-CCP supervision. Moreover, the new regulation adds another layer of complexity to the EMIR framework and clashes with the European monetary constitution. If an agreement on loss mutualisation was reached, EU-CCP supervision should be centralised in two EU bodies along objective lines: while the European Central Bank should be tasked with EU-CCP prudential supervision, ESMA should be responsible for EU-CCP conduct of business supervision. This framework would improve EU-CCP supervision and fit in with the current EU governance at once.

Regulatory effects on short-term interest rates

We analyze the effects of prudential regulation on short-term interest rates. The European Market Infrastructure Regulation (EMIR) induces clearing houses (CCPs) to supply large amounts of cash in reverse repurchase agreements (repos). Basel III, in contrast, disincentivizes the borrowing demand by tightening banks’ balance sheet constraints. Using unique regulatory data of CCP investment activity and repo transactions, we find compelling evidence for both the supply and demand channels. The overall effects are decreasing short-term rates and increasing market imbalances in various forms, all of which entail unintended consequences due to the new regulatory framework.

A descriptive analysis of the client clearing network in the European derivatives landscape

We present the findings of a detailed descriptive analysis of client clearing activity for derivatives in the euro area, as well as that of clearing members more broadly. To the best of our knowledge, this study, which covers all over-the-counter and exchange-traded asset classes and contract types, represents the first such detailed exploration and characterization of derivatives client clearing in the literature. Our findings highlight the concentrated nature of client clearing service provision, with 15 clearing members accounting for almost 90% of the total client-cleared notional. We show the magnitude, type and location of clearing carried out by members for their own house trades and on behalf of clients. Our analysis encompasses the clearing activity of over 36 000 clients domiciled in over 70 countries, and over 330 clearing members from 26 countries. The data used to conduct this analysis is trade-level information on derivatives positions made available to authorities under the European Market Infrastructure Regulation, and reported by market participants to trade repositories. This big financial data set, while highly granular and rich, presents a number of challenges related to issues of data quality, as well as the effective management and analysis of the volume of information.

Energy trading and the exchange of information between supervisors: effectiveness of fragmented supervision and information sharing

Energy companies trading in derivatives which have a value based on an energy product (‘energy trading’) are subjected to a fragmented regulatory framework. They are supervised by a multitude of authorities on a national and European level. These authorities cooperate horizontally (between EU agencies or between national regulatory authorities – NRAs) or vertically (between EU agencies and NRAs) and in a formal and informal way. They share information on energy trading to detect market abuse. This article aims to provide insight on the effectiveness of supervisory activities within the energy trading landscape. In doing so, the obligation for energy companies to report fundamental data on the derivatives they trade in is used for illustrative purposes and explained in light of the European Market Infrastructure Regulation (EMIR), the Markets in Financial Instruments Directive and Regulation (MiFID II and MiFIR) and the regulation on wholesale energy market integrity and transparency (REMIT). The article finishes with a conclusion which advocates the necessity of information sharing and professional secrecy in the current regulatory landscape and intends to contribute to a discussion on the effectiveness of information sharing within an international context.

A Critical Analysis of the Rationale for Financial Regulation Part I: Theories of Regulation

The aim of this paper is to critically examine and comment on the continued validity of the theories and the generally accepted objectives of financial regulation in the light of the policy response to the financial crisis and the regulatory activism of the last decade in the EU and US. The main position of this paper is that the post-crisis policy response and the current state of affairs may be explained as a combination of factors that surface from past theories of regulation and that the causes of the financial crisis and subsequent regulatory measures, such as the Dodd Frank Act in the US and the establishment of the European Supervisory Authorities (‘ESAs’) in the EU, sustain the continued validity of the objectives of financial regulation. However, recent measures, such as, the Financial Choice Act in the US, and the European Market Infrastructure Regulation (‘EMIR’) Refit in the EU, seem to have objectives which go beyond existing and internationally accepted objectives of regulation. It is also argued that regulatory and supervisory action to realise a specific objective of financial regulation could, at times, generate tensions with and weaken the realisation of other regulatory and economic objectives. This paper also demonstrates the difficulties that could surface in finding the right balance between achieving the objectives of financial regulation, while avoiding instances of over-regulation by respecting the principles of proportionality, subsidiarity and the fundamental rights of members of society such as the promotion of fair competition and consumer choice.

Energy Trading and Its Multiplicity of Supervisors: Effectiveness of Fragmented Supervision and Information Sharing in View of Reporting Obligations for Energy Trading Companies

Energy companies trading in derivatives which have a value based on an energy product ( “Energy Trading”) are subjected to a fragmented regulatory framework. They are supervised by a multitude of authorities on a national and European level. These authorities cooperate horizontally (between EU agencies or between national regulatory authorities) or vertically – between EU agencies and NRA’s) and in a formal and informal way. They share information on Energy Trading to detect market abuse. This article aims to provide insight in the effectiveness of supervisory activities within the Energy Trading landscape. In doing so, the obligation for energy companies to report fundamental data on the derivatives they trade in, is used for illustrative purposes and explained in light of the European Market Infrastructure Regulation (‘EMIR’), the Markets in Financial Instruments Directive and Regulation (‘MiFID II and MiFIR’) and the regulation on wholesale energy market integrity and transparency (‘REMIT’). The article finishes with a conclusion which advocates the necessity of information sharing and professional secrecy in the current regulatory landscape and intends to contribute to a discussion on the effectiveness of information sharing within an international context.

In CCP we trust … or do we? Assessing the regulation of central clearing counterparties in Europe

As part of financial market infrastructures, central counterparties (CCPs) have long been deemed systemically important and are likely to gain in importance due to the regulatory developments mandating central clearing for an increasing number of financial products. This paper focuses on the regulation as well as the recovery and resolution of CCPs in Europe. The existing CCP regulatory framework consists of ex-ante measures, including, among others, capital and liquidity requirements, initial and variation margins, and loss sharing mechanisms. In addition, the European proposal for the recovery and resolution of CCPs (the Proposal) contains several ex-post regulatory measures mainly in the form of rules for recovery and orderly resolution. Having studied the prudential regulatory measures for CCPs contained in the European Market Infrastructure Regulation and the ex-post recovery and resolution measures of the Proposal, this paper puts a spotlight on the specific shortcomings of the existing and proposed rules, in particular in terms of misaligned incentives, externalities, collective action problems, and certain practical impediments, and concludes that it would be misguided to inordinately rely on ex-post measures. Highlighting the limitations of the recovery and resolution mechanisms, this paper proposes that given the systemic importance of CCP functions, it is critical to improve the ex-ante measures whose objective is to prevent the failure of a CCP, rather than ex-post measures, which kick in after its failure. Accordingly, recommendations for making such improvements are proposed.

Securisation Special Purpose Entities, Bank Sponsors and Derivatives

This paper documents the use of derivatives by securitisation special purpose entities (SPEs), also known as financial vehicle corporations (FVCs), domiciled in Ireland using transaction-level data established by the European Market Infrastructure Regulation. We show that these entities primarily engaged in interest rate derivatives over the period of 2015-2017. We find that larger entities that already engage in international capital markets are more likely to have derivative exposures. We also show that entities sponsored by banks and non-bank financial institutions are relatively more likely to engage in derivative markets. The characteristics of these bank sponsors are important in determining SPEs' engagement in derivative markets. SPEs' heavy reliance on debt finance coupled with their strong interconnectedness with bank sponsors underscores the importance of continuous monitoring and macroprudential surveillance of their derivative activities.

Regulatory Effects on Short-Term Interest Rates

We analyse the effects of prudential regulation on short-term interest rates. The European Market Infrastructure Regulation (EMIR) induces clearing houses (CCPs) to supply large amounts of cash in reverse repurchase agreements (repos). Basel III, in contrast, disincentivises the borrowing demand by tightening banks' balance sheet constraints. Using unique regulatory data of CCP investment activity and repo transactions, we find compelling evidence for both supply and demand channels. The overall effects are decreasing short-term rates and increasing market imbalances in various forms, all of which entail unintended consequences originated from the new regulatory framework.

What you need to know about the new Securities Financing Transaction Regulation

After the most recent economic recession in 2008– 2009, the European financial market has seen a great deal of regulatory changes. These changes have significantly impacted how firms, entities and counterparties operate and manage securities as well as manage and report transactions. In addition to the European Market Infrastructure Regulation (EMIR), the Markets in Financial Instruments Directive1 (MiFID II, 2014/65) and the Markets in Financial Instruments Regulation2 (MiFIR, 600/2014) entered into force. Securities Financing Transaction Regulation (SFTR), the newest regulatory change, aims to increase transparency by requiring all entities to report the specifics of their securities financing transactions (SFTs) to an approved European Union (EU) trade repository (TR). While the rules for these reports have not yet been officially finalised (at the time of this writing), these new rules will present a number of challenges to firms, entities, counterparties, TRs and investment companies. From data fragmentation to new costs related to disclosure requirements, all entities and counterparties will be required to adapt to these new obstacles sooner rather than later in order to be prepared for the planned start date in 2019. Furthermore, pending finalisation of the SFTR, all repos, securities loans, buy and sell back, total return swaps and similar transactions will need to be declared to an EU TR. Both financial and nonfinancial counterparties will be subject to these requirements. Aside from the challenges that the new SFTR regulation will likely impact firms, branches, entities, institutions, repositories and so on, there are also a number of basic solutions that can be utilised to mitigate challenges and risks and also successfully satisfy the new reporting requirements. This paper addresses the scope of SFTR, the overall impact, the challenges and even solutions to help entities and counterparties prepare for SFTR to go into force.